Derivative regulation needs team effort

Yesterday, Ontario Finance Minister Dwight Duncan outlined a plan to introduce “a robust regulatory framework” governing over the counter derivatives, which as a group have been cast as the villains behind the global financial crisis of 2008.

The tricky part will be developing the mandated uniform regulation for a market made up of highly customizable arrangements.

Once upon a time, credit default swaps (to look at one example) were a legitimate insurance policy held by parties at risk. But they’ve evolved into just another tradable asset among parties who hold little direct interest in the underlying risk.

Globally, the notional value of OTC derivatives has ballooned to over $300 trillion, eclipsing the value of the assets they are based upon, leading many to question the economic purpose they serve.

The proposed legislative plan puts the Ontario Securities Commission in the driver’s seat for Canadian regulation of this market, but that isn’t necessarily a good thing.

This decision to forge ahead unilaterally could put the province at loggerheads with other provincial securities commissions, particularly the Autorité des Marchés Financiers, which should see itself as the natural regulator for Canada’s leading derivatives marketplace: the Montréal Exchange.

At a time when Ontario remains the primary champion of a single national regulator, putting a thumb in the eye of Quebec will likely be counter-productive.

Ontario must tread carefully. If it gets too far ahead of the other jurisdictions—both international and domestic—it risks being on the wrong side of regulatory arbitrage, with traders bypassing the Ontario market in favour of laxer jurisdictions.

Less problematic is the existence of the Canadian OTC Derivates Working Group, which is dominated by federal parties. A Bank of Canada spokesman has said the provincial move is consistent with federal goals.

But the announcement should not come as a surprise, as it is a step toward commitments already made by all G-20 member nations. And given the $12 trillion notional value of the Canadian OTC derivatives market, the move to impose closer regulatory scrutiny is overdue.

If Ontario can play nice and rally the rest of the country to a common effort, Canada stands a much better chance of keeping pace with its trading partners. The stakes are too high for one province to strike out alone.

(11/19/10)