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Originally published: March 24, 2017
Kevin Fine is Director of the Derivatives Branch at the Ontario Securities CommissionOntario Securities Commission An independent Crown corporation that is responsible for regulating the capital markets in Ontario. Its mandate is to provide protection to investors from unfair, improper or fraudulent practices, to foster fair and efficient capital markets and confidence in capital markets, and to contribute to the stability of the financial system and the reduction of systemic…+ read full definition (OSCOSC See Ontario Securities Commission.+ read full definition). The Investor Office recently sat down with Kevin to discuss his background, what derivatives are and the role of the Derivatives Branch.
Prior to working at the OSC, I worked for the legal department and capital marketsCapital markets Where people buy and sell investments.+ read full definition group at one of the major banks for many years where I provided legal support for the derivatives desks of the bank all over the world.
I came to the OSC, along with Deb Foubert, on a secondment. The OSC needed assistance from a couple of the banks to draft new derivatives legislation as an amendment to the Securities Act. The legislation was passed in 2010, and in 2011, I stayed on as Director of the Derivatives Branch.
What is a derivative?
A derivativeDerivative An investment that is based on a contract that gives you the right to buy and sell at set prices. Value is based on performance of an underlying financial asset, commodity or other investments. Examples: Futures, options and swaps.+ read full definition is a contractContract A binding written or verbal agreement that can be enforced by law.+ read full definition whose market priceMarket price The amount you must pay to buy one unit or one share of an investment. The market price can change from day to day or even minute to minute.+ read full definition or value is derived from an underlying reference or assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition.
When we give our education seminars, we give standard examples like interest rateInterest rate A fee you pay to borrow money. Or, a fee you get to lend it. Often shown as an annual percentage rate, like 5%. Examples: If you get a loan, you pay interest. If you buy a GIC, the bank pays you interest. It uses your money until you need it back.+ read full definition swaps, credit default swaps, commodityCommodity A raw material that trades in large amounts on a stock exchange. For example, grain, gold, and oil.+ read full definition swaps, and equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition swaps. But we also like to give the ‘sofa example’. When you go to a furniture store and buy a sofa but don’t pay right away, you’re agreeing to pay a certain amount at a time in the future. That’s technically a derivative contract – though not one that is covered under the Securities Act.
But that’s mostly what it is: an instrument related to fluctuations or changes in pricing in the future. Corporations can fix the prices for commodities that they use or future payments they are owed or owe. They would do this if they are worried about fluctuations, for example, in the US or Canadian dollar exchange rates.
The movie The Big Short has some great tutorials in regards to some of the more complicated derivatives and how these types of products absolutely contributed to the international financial meltdown of 2008. If someone is trying to get a better sense of what these products are, I think the movie is a fun place to start.
On the role of the Derivatives Branch…
We do a variety of things related to derivatives. Our first job was to create the regulatory framework and rules the G-20 mandated post financial crisis to lower systemic risks. We have lawyers, risk managers, and a group that take care of our data governance and data collection. We draft the rules regulating derivatives, and process exemption requests for the rules that are in place.
We are also, in conjunction with the Compliance & RegistrantRegistrant A person or company that is registered with the securities regulator in the province or territory where they do business. They must be registered before they can legally sell securities or offering investment advice.+ read full definition Regulation (CRR) Branch, doing audits of our earliest rule in place: the tradeTrade The process where one person or party buys an investment from another.+ read full definition reporting rule. We are in the process of doing audits on Canadian banks, which is a first for a Canadian securities commission and an important piece in ensuring that we are getting the most accurate data and that the banks are complying with the rules.
On the data side, we currently have over one billion data points and we receive approximately 4 to 6 million records a week. In order to process all of this information efficiently and accurately we are working on expanding our capabilities and automating the loading of the data that comes into the system. This will put us in a position to expand the capabilities of the system and eventually bring in other data sets so that we can better monitor and surveil from both a systemic risk and enforcement point of view.
On his current priorities…
We are about to release a business conduct rule that will apply to derivatives dealers including banks. We recently finalized a Segregation and Portability Rule which is our version of an investor protection rule. If you are participating in the derivatives markets as an end user, not as a dealer, and you provide collateralCollateral Property or assets that you pledge as a borrower as a guarantee that you will repay the loan. You may lose your collateral if you don’t pay back your loan.+ read full definition for a cleared transactionTransaction The process where one person or party buys goods or services from another for money. Examples include taking money out of an account, buying something with a credit card or taking out a loan.+ read full definition, this rule will provide certain protections. This rule will go into force by summer of 2017.
We are also working on a rule to deal with the electronic trading of derivative products. Those platforms have the potential to change the way the market works.
Any final thoughts?
One of my main messages is that derivatives are not inherently bad. Warren Buffett’s famous quote about them being ‘weapons of mass destruction’ really did a disservice to the hedging products. In general, basic hedging of your obligations is good for business. It’s encouraged by accounting practices and it’s absolutely legitimate. The problem lies within excessive risk-taking, poor credit and risk management and market misconduct. All of those factors can introduce significant risk to our financial system. Our objective is to make the derivatives market safer for all market participants.