Category: Regulation

Contingent Capital

NVCC: “Minimum Reset Guarantee” = “Incentive to Redeem”?

I have long accepted that banks cannot offer minimum reset guarantees on their FixedResets because this is considered to be an incentive to redeem by the regulators. I’m almost certain that I saw an authoritative statement to this effect at one point and reported it here, but when I tried to find it my search was fruitless.

The OSFI Definition of Capital is quite emphatic about incentives:

The following is the minimum set of criteria for an instrument issued by the institution to meet or exceed in order for it to be included in Additional Tier 1 capital:

Is perpetual, i.e. there is no maturity date and there are no step-ups [Footnote15] or other incentives to redeem [Footnote16]

The footnotes read:

Footnote 15
A step-up is defined as a call option combined with a pre-set increase in the initial credit spread of the instrument at a future date over the initial dividend (or distribution) rate after taking into account any swap spread between the original reference index and the new reference index. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread would not constitute a step-up. [Basel Framework, CAP 10.11 FAQ4]

Footnote 16
Other incentives to redeem include a call option combined with a requirement or an investor option to convert the instrument into common shares if the call is not exercised. [Basel Framework, CAP 10.11 FAQ4]

… but I couldn’t find anything from (or attributed to) OSFI that stated that a Minimum Reset Guarantee constituted a step-up.

I did, however, find a notice from the European Banking Authority:

Question:
Article 489 of Regulation (EU) No 575/2013 (CRR) provides for the grandfathering treatment of hybrid instruments with a call and an incentive to redeem. A bank has issued a bond with a fixed coupon before the first call date and a floating rate coupon after the first call date. The credit spread of the fixed coupon as of the issuance date is the same as the margin of the floating rate coupon after the first call date, so there is no immediate step-up there. However, the floating rate coupon is floored at the level of the fixed rate coupon. Does this constitute an incentive to redeem ?

Final Answer:
Pursuant to Article 20(1) of Commission Delegated Regulation (EU) No 241/2014 an incentive to redeem shall mean all features that provide, at the date of issuance, an expectation that the capital instrument is likely to be redeemed. A floating rate coupon floored at the level of the initial fixed rate coupon, such as in the case described by the submitter, constitutes an incentive to redeem, as the new coupon after the first call date will always be equal or higher than the initial coupon.

So to some extent, this post is my bookmark for this little fact. But it is also a request that perhaps somebody with a better memory than mine find the reference I’m thinking of!

Contingent Capital

NVCC & Credit Suisse

OSFI has announced:

OSFI is issuing this statement to reinforce guidance around the design of the regulatory treatment of Additional Tier 1 and Tier 2 capital instruments.

Canada’s capital regime preserves creditor hierarchy which helps to maintain financial stability.

If a deposit-taking bank reaches the point of non-viability, OSFI’s capital guidelines require Additional Tier 1 and Tier 2 capital instruments to be converted into common shares in a manner that respects the hierarchy of claims in liquidation. This results in significant dilution to existing common shareholders.

Such a conversion ensures that Additional Tier 1 and Tier 2 holders are entitled to a more favorable economic outcome than existing common shareholders who would be the first to suffer losses. These capital requirements are administered by OSFI as well as the conversion of the Additional Tier 1 and Tier 2 capital instruments.

Additional Tier 1 and Tier 2 instruments are and will remain an important component of the capital structure of Canadian deposit-taking banks.

Canadians can be confident that we have a sound and effective regulatory and supervisory foundation that works to protect depositors and creditors.

And the European Central Bank teamed up with other regulators to announce:

ECB Banking Supervision, the Single Resolution Board and the European Banking Authority welcome the comprehensive set of actions taken yesterday by the Swiss authorities in order to ensure financial stability.

The European banking sector is resilient, with robust levels of capital and liquidity.

The resolution framework implementing in the European Union the reforms recommended by the Financial Stability Board after the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses.

In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions.

Additional Tier 1 is and will remain an important component of the capital structure of European banks.

This announcement appears to be due to the treatment of AT1 instruments in the collapse of Credit Suisse:

Trading in Credit Suisse’s bonds rose sharply at the end of last week as strain in the banking sector mounted, according to official trade data.

There were two types of trades that the investors conducted: one that is set to make money, the other that is set to lose money.

The second trade that investors plowed into was in Credit Suisse’s roughly $17 billion of so-called AT1 bonds. This is a special type of debt issued by banks that can be converted to equity capital should they run into trouble. This made that debt inherently riskier to hold, because it carried the chance that bondholders could be wiped out. Investors saw the buying of the bonds for as low as 20 cents on the dollar as a kind of lottery ticket — a long shot, but with a big reward if it had worked out.

On Sunday, the Swiss Financial Market Supervisory Authority, or Finma, approved a deal for UBS to take over its smaller rival. “The transaction and the measures taken will ensure stability for the bank’s customers and for the financial center,” said a statement from Finma.

It said that the AT1 bonds would be wiped out as part of the deal, to add roughly $16 billion of equity to support UBS’s takeover.

That raised eyebrows among some investors because it upended the normal order in which holders of different assets of a company expect to be paid in bankruptcy. Stock investors are at the bottom of that repayment list and usually lose all their money ahead of other investors.

However, in this instance, regulators chose to trigger the conversion of the AT1 bonds to equity capital to help the bank, while still offering Credit Suisse shareholders one UBS share for every 22.48 Credit Suisse shares held.

As further explained:

The eleventh-hour Swiss rescue is backed by a massive government guarantee, helping prevent what would have been one of the largest banking collapses since the fall of Lehman Brothers in 2008.

However, the Swiss regulator decided Credit Suisse’s additional tier-1 (AT1) bonds with a notional value of $17 billion will be valued at zero, angering some holders of the debt who thought they would be better protected than shareholders.

AT1 bonds – a $275 billion sector also known as “contingent convertibles” or “CoCo” bonds – can be converted into equity or written off if a bank’s capital level falls below a certain threshold. The deal will also make UBS Switzerland’s only global bank and the Swiss economy more dependent on a single lender.

“Massive guarantee”? Yes:

The deal includes 100 billion Swiss francs ($108 billion) in liquidity assistance for UBS and Credit Suisse from the Swiss central bank.

To enable UBS to take over Credit Suisse, the federal government is providing a loss guarantee of a maximum of 9 billion Swiss francs for a clearly defined part of the portfolio, the government said.

This will be activated if losses are actually incurred on this portfolio. In that eventuality, UBS would assume the first 5 billion francs, the federal government the next 9 billion francs, and UBS would assume any further losses, the government said.

And UBS boasted:

UBS benefits from CHF 25 billion of downside protection from the transaction to support marks, purchase price adjustments and restructuring costs, and additional 50% downside protection on non-core assets.

This caused an immediate drop in the price of other AT1s:

The write-down to zero at Credit Suisse will produce the largest loss in the $275 billion AT1 market to date, dwarfing the 1.35 billion euros ($1.44 billion) bondholders of Spain’s Banco Popular lost in 2017.

Bid prices on AT1 bonds from banks, including Deutsche Bank , HSBC, UBS and BNP Paribas, were among those under pressure on Monday. They recovered marginally but were still down 6-11 points on the day, sending yields sharply higher, data from Tradeweb showed.

A UBS AT1 bond callable in January 2024 was trading at a yield of 27%, up from 12% on Friday, demonstrating how much more costly this type of debt could become in the wake of the Credit Suisse rescue.

Funds that track AT1 debt also fell sharply.

Invesco’s AT1 Capital Bond exchange-traded fund was last down 6%, having been over 10% lower earlier. WisdomTree’s AT1 CoCo bond ETF was indicated 9% lower.

At Credit Suisse, the bank’s AT1 bonds were bid as low as 1 cent on the dollar on Monday as investors braced for the wipeout.

But the lawyers will get rich, as usual:

Lawyers from Switzerland, the United States and UK are talking to a number of Credit Suisse Additional Tier 1 (AT1) bond holders about possible legal action after the state-backed rescue of Credit Suisse by UBS wiped out AT1 bonds, law firm Quinn Emanuel Urquhart & Sullivan said on Monday.

Quinn Emanuel said it was in discussions with Credit Suisse AT1 bondholders representing a “significant percentage” of the total notional value the instruments. Quinn Emanuel did not name the bondholders.

Under the UBS-Credit Suisse merger deal, holders of Credit Suisse AT1 bonds will get nothing, while shareholders, who usually rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.

In Switzerland, the bonds’ terms state that in a restructuring, the financial watchdog is under no obligation to adhere to the traditional capital structure hierarchy, which is how Credit Suisse AT1 bondholders lost out.

And so … what it are the implications for Canadian NVCC preferred shares? I have to say: not much, based on the following two factors.

First, it looks like Credit Suisse was in even worse shape than everyone thought last Friday. As reported above, “shareholders, who usually rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.” This is after wiping out 16- or 17-billion in AT1 capital (reporting differs according to source, presumably due to rounding and difference in exchange rate conversion). So, if we take these figures at face value – i.e., there hasn’t been too much jiggery-pokery in the values received – the Credit Suisse common had a market value of about NEGATIVE 14-billion on Friday, a far cry from the 8-billion valuation at the close on Friday, never mind the values of previous years:

This is before considering the value of the ‘massive guarantee’ that the Swiss central bank has given UBS, which are quite substantial. So it would seem that AT1 holders wouldn’t have gotten much of a recovery anyway.

Secondly, ‘when in doubt, look at the prospectus’, as the adage goes. Here’s the prospectus for RY.PR.H, taken from RBC’s preferred share page:

Upon the occurrence of a Trigger Event (as defined below), each outstanding Series BB Preferred Share and each outstanding Series BC Preferred Share will automatically and immediately be converted, on a full and permanent basis, into a number of Common Shares equal to (Multiplier x Share Value) ÷ Conversion Price (rounding down, if necessary, to the nearest whole number of Common Shares) (an “NVCC Automatic Conversion”). For the purposes of the foregoing:

“Conversion Price” means the greater of (i) $5.00, and (ii) the Current Market Price of the Common Shares. The floor price of $5.00 is subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the TSX, if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

“Multiplier” means 1.0.

“Share Value” means $25.00 plus declared and unpaid dividends as at the date of the Trigger Event.

So, mainly there’s no ‘writedown to zero’ provision, which is one good thing. And secondly, on a trigger event they’re converted to common at a defined price.

It’s not all rosy! The conversion price for the common is defined as the VWAP for two weeks prior to the Trigger (or $5, it that’s higher, which could very well be the case. I bet nobody saw Credit Suisse being taken out for less than $1/share!), and that could be substantially higher than the price at the end of the period, or the price received in some kind of takeover or recapitalization scenario. As a mitigating factor, the value converted at this conversion price is par, or roughly 50% higher than what RY preferreds are trading at now. But the main thing is that the effects of a trigger are conversion into common, which means that whatever else might be the case, preferred shareholders will get some kind of recovery after a trigger event (as long as the common shareholders get something, which will not necessarily be the case), and not be left out in the cold as the Credit Suisse AT1 holders have been. And, as I have always said, expectations for preferred shareholders (NVCC or otherwise) of an operating company in a bankruptcy scenario are basically zero anyway, so any recovery should be considered a bonus!

Now, make no mistake: I do not like Canada’s implementation of the NVCC rules. I don’t like the ‘low trigger’, which basically guarantees that any loss will take place at a time of maximum confusion (as well as acting entirely to mitigate damage to senior creditors, as opposed to forestalling problems before they get more serious), and I don’t like the arbitrary power granted to OSFI to declare a ‘Trigger Event’, which circumvents the courts and gives civil servants one heckofa lot of power. But, it appears to me, a Credit Suisse scenario is not something to worry about.

Update, 2023-3-22: DBRS has released an analysis titled Credit Suisse’s AT1 Controversy Unlikely Outside Switzerland (at time of writing, no password or log-in was required):

Credit Suisse´s AT1 Write-Down Based on a Specific Swiss Contractual Clause

It is important to note that FINMA has not framed the sale of Credit Suisse AG to UBS as a resolution action (restructuring under Swiss terminology). This is a key consideration, as under a resolution, FINMA could have written-down the AT1s but only after CS´s shareholders equity had been completely written-off and cancelled (see link). We consider that FINMA avoided initiating a resolution, asthat could have had unknown consequences for the Swiss and global financial markets. In addition, CS was still not fully resolvable as explained by FINMA in their last Resolution Report in 2022 (see link). As a result, opening resolution procedures (even just during the weekend) might have had important implications on an operative level (derivatives, deposits, other critical contracts). Nevertheless, in order to close the deal, it seems that UBS required downside protection. The deal was closed after granting this protection by writing-off CHF 15.8 billion of AT1s and adding government protection of CHF 9 billion (which applies only after UBS has absorbed the first CHF 5 billion of losses).

We understand that FINMA’s interpretation was that the AT1 write-down was legally possible under a contractual clause called “viability event”. In particular, according to the AT1 prospectus, an irrevocable commitment of extraordinary support from the public sector would trigger this “viability event” thus allowing the total write-down of AT1s. FINMA interpreted the CHF 9 billion protection as extraordinary support from the public sector. However, some investors are arguing that the public sector support was not given to CS but to UBS. As a result, we anticipate CS AT1 bondholders could initiate legal action against these decisions. Furthermore, we observe that the possibility
to writedown and cancel AT1 bondholder rights based on this specific contractual clause is a feature particular to the Swiss banks’ AT1s. Swiss banks issued some of the first AT1s after the previous financial crisis and they were intended to strengthen a bank, both as going concern as well as a gone concern situation.

Implications for Other Resolution Jurisdictions
We view the sale of CS to UBS as positive for financial stability, reducing potential negative market reaction and contagion from a disorderly resolution or bankruptcy of CS. However, it raises some questions as to how authorities will apply their powers. We note some important takeaways from this case, that are applicable to all regimes, including the EU, UK and Canada. First, the complexity of resolution and quasi resolution situations makes the reality different from theoretical resolution planning. Second, the interpretation of the law made by national authorities could be different from what markets expect in these situations. Third, that bail-in strategies for Globally Systemically Important Banks (G-SIB) are difficult and the too big to fail issue is still present.

Nevertheless, we also consider that there are some differences between Switzerland and other regions. Specifically, we view that the decision to impose larger losses on the AT1 securities than on shareholders will not set a precedent in the EU, UK or Canada. We consider that the instruments in these regimes have different wording and authorities have been vocal to clarify that AT1 securities are always senior to equity.

Update, 2023-3-23: DBRS has released a commentary on LRCNs that is very similar in tone to their piece on preferred shares.

Regulation

T+1 Settlement is Coming!

The SEC has announced:

The Securities and Exchange Commission today adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one (T+1). The final rule is designed to benefit investors and reduce the credit, market, and liquidity risks in securities transactions faced by market participants.

“I support this rulemaking because it will reduce latency, lower risk, and promote efficiency as well as greater liquidity in the markets,” said SEC Chair Gary Gensler. “Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Taken together, these amendments will make our market plumbing more resilient, timely, orderly, and efficient.”

In addition to shortening the standard settlement cycle, the final rules will improve the processing of institutional trades. Specifically, the final rules will require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of trade date. The final rules also require registered investment advisers to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions.

Further, the final rules add a new requirement to facilitate straight-through processing, which applies to certain types of clearing agencies that provide central matching services. The final rules will require central matching service providers to establish, implement, maintain, and enforce new policies and procedures reasonably designed to facilitate straight-through processing and require them to submit an annual report to the Commission that describes and quantifies progress with respect to straight-through processing.

The adopting release is published on SEC.gov and will be published in the Federal Register. The final rules will become effective 60 days after publication in the Federal Register. The compliance date for the final rules is May 28, 2024.

This is wonderful news, albeit of more interest to institutional investors and their fund managers than to retail. Back in my Canada bond trading days, it was unusual, but not unknown, for clients of the firm to have trades totalling 100-million per side (buy and sell) with a single dealer. Say the market has moved by a buck after trade time but before settlement. Then one side has a loss of 1-million odd, and the other side has a gain of about the same amount. Now say the dealer goes bust before the trade gets settled. The losing side of the trade would settle, but the winning side … maybe. When Confederation Life went bust in the nineties, if you had an outstanding FX trade that you were losing money on, it settled. If you were winning … get in line, buddy! So this is a risk that is reduced by faster settlement.

There are implications for retail, though … everybody remembers the Robin Hood / Meme Stock problem, when Robin Hood suddenly started getting very fussy about what orders they would accept … and although you’ll find lots of vitriol on the web directed at them by newbie retails, you’ll also learn that few of these guys understood the problem: the problem was that clearing corporations demand collateral to mitigate the settlement risk described above:

New York markets had just fired up, and the investing world was tuning in for Thursday’s episode of the continuing drama: Legions of Robinhood Markets investors versus hedge-fund Goliaths.

But within minutes, a shock wave invisible to the outside world rattled the mechanics of Wall Street — sending Robinhood rushing for more than $1 billion of additional cash. The stock market’s central clearing hub had demanded large sums of collateral from brokerages including Robinhood that for weeks had facilitated spectacular jumps in shares such as GameStop Corp.

The Silicon Valley venture with the wildly popular no-fee trading app came to a crossroads. It reined in the risk to itself by banning certain trades and unwinding client bets — igniting an outcry from customers and even U.S. political leaders. By that night, word was emerging that Robinhood had raised more than $1 billion from existing investors and drawn hundreds of millions more from bank credit lines to weather the storm.

The question is whether such critics will dig into the industry’s inner workings, where pressure mounted on Robinhood and other firms to limit certain trades. That would put a rare spotlight on arcane parts of the market designed to prevent catastrophe, such as the Depository Trust & Clearing Corp.

One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is in the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday’s session.

The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.

A spokesman for the DTCC wouldn’t specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.

Brokerage executives rushed to figure out how to come up with the funds. Robinhood’s reaction drew the most public attention, but the firm wasn’t alone in limiting trading of stocks such as GameStop and AMC Entertainment Holdings Inc.

In fact, Charles Schwab Corp.’s TD Ameritrade curbed transactions in both of those companies on Wednesday. Interactive Brokers Group Inc. and Morgan Stanley’s E*Trade took similar action Thursday.

So, faster settlement will alleviate, to a large degree, the amount of settlement risk there is in the system and, hopefully, reduce the chance of serious volatility freezing the markets.

There was a lot of self-congratulation. Chair Gary Gensler stated:

First, the amendments will shorten the standard settlement cycle by half, from two business days (“T+2”) to one business day (“T+1”). The amendments also will halve the settlement cycle for trades relating to initial public offerings, from T+4 to T+2. As they say, time is money. Halving these settlement cycles will reduce the amount of margin that counterparties need to place with the clearinghouse. This lowers risk in the system and frees up liquidity elsewhere in the market.

Now, that’s not to say this change will be new; in fact, this change simply brings us back to the T+1 settlement cycle our markets used up until the 1920s. It also aligns with the T+1 cycle used in the $24 trillion Treasury market.

Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Further, the implementation for these amendments will be set to after Memorial Day weekend (May 28, 2024). This implementation comes more than three years after key industry members first proposed shortening the settlement cycle, and a year and a quarter from now, providing sufficient time in my view for the transition. Further easing the transition, the implementation date will occur during a three-day holiday weekend.

Commissioner Jaime Lizárraga stated:

Why does this matter to the investing public? Because buyers and sellers of securities will receive their cash and securities a day earlier under T+1 than they do currently. And because market participants can allocate their capital more quickly and efficiently. Based on the public comments to the proposal, these benefits accrue to retail investors in particular.

Reducing the current settlement time in half will alleviate some of the downsides of the current T+2 cycle, such as counterparty, market, liquidity, credit, and other risks. A longer settlement time also requires risk management tools, such as margin requirements, that carry significant costs. Shortening the settlement cycle not only helps reduce these risks and costs but lowers volatility and makes our markets more fair and efficient.

The risks of longer settlement times are not just theoretical. In January 2021, unprecedented price volatility in so-called “meme stocks” challenged many retail investors’ faith in our in financial markets. Clearing agencies in equities and options experienced record volumes cleared. In the face of high volume and volatility, market utilities had to issue significant margin calls. In reaction to these margin calls, certain brokers restricted trading in some, or all, of the meme stocks. According to media reports, at least one broker’s decisions to halt trading came at the peak of the market and infuriated many retail investors. Investors have filed approximately 50 class action lawsuits claiming substantial harm from this broker’s trading halt.

Commissioner Caroline A. Crenshaw stated (with lots of valuable footnotes):

Specifically, a shorter settlement cycle should reduce the number of outstanding unsettled trades, reduce clearing agency margin requirements, and allow investors quicker access to their securities and funds. Longer settlement periods, on the other hand, are associated with increased counterparty default risk, market risk, liquidity risk, credit risk, and overall systemic risk.[7]

Commenters were overwhelmingly in favor of shortening the settlement cycle.[8] We received supportive comments from a broad range of stakeholders, including individual investors, investor advocates, clearing agencies, and broker-dealers.[9] Some commenters raised concerns regarding the proposed changes related to the processing of institutional trades,[10] firm commitment offerings,[11] and security-based swaps,[12] and the final rule reflects certain changes from the proposal in response to those comments. A number of commenters also raised concerns about the implementation timeline, which has been extended by several months from the proposed date to facilitate a smooth transition.[13] The new compliance date would provide market participants more than fifteen months to prepare for the transition.[14]

The proposal also included a request for comment on the possibility of settling trades by the end of the trade date, or what we call “T+0.” Some commenters highlighted challenges relating to multi-lateral netting, securities lending practices, and other issues.[15] However, many others expressed support for an eventual move to T+0.[16] While it is clear that T+0 will entail greater operational and technological challenges than the move to T+1, I agree with commenters that such a move may be both desirable and feasible in the future, and I look forward to working with my colleagues and stakeholders toward that important goal.[17]

Commissioner Mark T. Uyeda was a little bitter (bolding added):

While the net benefits of a shorter settlement cycle are clear, T + 1 can potentially increase some operational risks. There will be less time to address errors within the process and, in some circumstances, less time to deal with trading entities that are suddenly confronting massive and unexpected trading losses within the settlement cycle timeframe. There is also less time for regulators to identify and freeze the potential proceeds from potential frauds, such as, insider trading and market manipulation, before those proceeds exit our jurisdiction. These arguments and considerations, however, do not ultimately weigh against shortening the settlement cycle, but they provide reason for ensuring readiness among market participants. This speaks to the implementation date.

Ensuring a smooth transition will take significant investment and systems changes as well as operational and computational testing among broker-dealers, clearing firms, investment advisers, custodians, payment systems, and so on. Detailed planning is required, as is process adjustment, organizational change, and changes in the relationships among market participants. There is asymmetry in terms of costs and benefits—a smooth transition would provide net benefits for investors and U.S. markets to be accrued over the long-term in the future. On the other hand, the downside of a rough, turbulent transition could be steep, and could induce substantial harm in the short-run. That asymmetry cautions us to provide sufficient time to ensure a smooth transition.

Many comment letters have emphasized the need for more time than the Commission proposed.[5] Many have pointed to the 2024 Labor Day weekend as the implementation date. It would have the added advantage that Canada is also moving forward with T + 1 around the same time. Instead, the Commission appears to be ready to adopt May 28, 2024 as the implementation date.[6] In my view, we are in an imprudent rush away from a sensible transition date and, for that reason, I am unable to support the final rule.

Commissioner Hester M. Peirce also complained about implementation (bolding added):

I support the plan to move to T+1, but do not support the proposed timeline for making this change. Shortening the settlement cycle is a way to remove some risk from our markets. Mandating that the change occur in May 2024, however, could pose risks of its own by forcing the transition before market participants are ready. I propose instead a September 3, 2024 implementation date. Let me explain why:

  • Although preferable to the proposed March 31, 2024 implementation date, the May 28, 2024 date is still too early. Shortening the settlement cycle by one business day is a big change with implications all across the market. We cannot afford a cavalier approach.
  • Many commenters called for a September 3, 2024 date to ensure that the transition would happen with minimal disruption to the markets.
  • Tuesday, September 3, 2024 is the first business day after the 3-day Labor Day weekend, and Canada, the only jurisdiction currently planning on moving with us to T+1, shares this 3-day weekend. The transition from T+3 to T+2 occurred successfully over Labor Day weekend in 2017.
  • This later date would give other foreign market participants the time to work out some of the challenges they will face from our transition to a shorter settlement cycle than they have in their markets.
  • The additional three months will allow more time for firm-specific and coordinated, industry-wide testing, which will make a smoother transition more likely.
  • The transition from T+2 to T+1 is likely to present numerous operational challenges—some of them more difficult than in the last transition—related to, among other things, pre- and post-trade processes, securities lending, foreign exchange transactions, and processing corporate actions.
  • The transition is happening at the same time the market is processing many other regulatory changes.

I do not have any questions for the staff, but do want to make one final plea to Chair Gensler. Why not adopt a September 3, 2024 compliance date? I will vote for the rule if you make this change.

Contingent Capital

OSFI Revises Rules for LRCNs; Finally Provides Information for Insurers

The Office of the Superintendant of Financial Institutions Canada (OSFI) has announced:

OSFI has published an update to its July 18, 2020 capital ruling on the Limited Recourse Capital Notes (LRCNs). The revised ruling now addresses LRCN issuances from institutions of all sizes and across different industry sectors.

The revisions include a number of clarifications to the ruling’s conditions and limitations, which are part of OSFI’s prudent approach to assessing the quality and quantity of financial instruments used as regulatory capital. This is consistent with our mandate to protect the rights and interests of depositors, policyholders and financial institution creditors, while also allowing financial institutions to compete effectively and take reasonable risks.

The ruling continues to conclude that federally regulated financial institutions may recognize the LRCNs as regulatory capital subject to the capital treatment, conditions and limitations set out in the revised ruling. Should you have any questions, please contact CapitalConfirmations@osfi-bsif.gc.ca.

The new limits are set out in the appendix to the new rules:

LRCN Issuance Limitations by FRFI Sector
Note: For life insurers, the following limitations supplement and are subject to any existing capital composition limits set out in OSFI’s capital guidelines. P&C insurers and mortgage insurers should consult OSFI’s Capital Division in respect of the limitations applicable to any prospective LRCN issuances.

FRFI
Sector
Regulatory
Capital
Treatment
LRCN Issuance Cap Floor
Deposit-
Taking
Institutions
AT1 Greater of $150 million, 0.75%
RWA, or 50% of the
institution’s aggregate net AT1
capital
Lesser of 0.30% RWA or 20% of
the institution’s aggregate AT1
capital
Life Tier 1 Capital
other than
Common
Shares
Greater of $150 million or
12.5% of Net Tier 1 capital
5.0% of Net Tier 1 capital

The “Floor” has the following effect:

The Cap may be removed with the prior approval of OSFI’s Capital Division. In seeking this approval, a FRFI must demonstrate that it has issued institutional preferred shares and/or other Additional Tier 1 capital instruments (other than LRCNs) targeted towards institutional investors that, in aggregate, are no less than the applicable limit, or Floor, set out in the Appendix. If the FRFI’s outstanding institutional preferred shares and/or other Additional Tier 1 capital instruments issued to institutional investors were to subsequently drop below the Floor, the FRFI would not be permitted to issue additional LRCNs in excess of the Cap until it has re-established compliance with the Floor. The Floor will not apply where the LRCNs are issued exclusively to a FRFI’s affiliates.

Issue Comments

FixedReset Prospectuses Are Imprecise!

As we all know, FixedResets will reset their dividend every five years based on the Government of Canada Five Year yield (“GOC-5 rate” or “GOC-5 yield”) and therefore the prospectus for each issue needs to include information regarding exactly how that yield is determined.

The prospectus for ALA.PR.G (chosen because I can link to it!) contains typical language with respect to this process:

“Bloomberg Screen GCAN5YR Page” means the display designated as page “GCAN5YR” on the Bloomberg Financial L.P. service (or such other page as may replace the GCAN5YR page on that service) for purposes of displaying Government of Canada bond yields.

“Government of Canada Yield” on any date means the yield to maturity on such date (assuming semi-annual compounding) of a Canadian dollar denominated non-callable Government of Canada bond with a term to maturity of five years as quoted as of 10:00 a.m. (Toronto time) on such date and that appears on he Bloomberg Screen GCAN5YR Page on such date; provided that if such rate does not appear on the Bloomberg Screen GCAN5YR Page on such date, then the Government of Canada Yield shall mean the arithmetic average of the yields quoted to AltaGas by two registered Canadian investment dealers selected by AltaGas as being the annual yield to maturity on such date, compounded semi-annually, that a non-callable Government of Canada bond would carry if issued, in Canadian dollars, at 100% of its principal amount on such date with a term to maturity of five years.

I am not aware of any material differences in the definitions between prospectuses.

So this sounds pretty good, right? The GOC-5 yield will be calculated by an independent third party with no ambiguity and complete verifiability, right? Wrong.

As noted in the post Reset Calculation Oddity for 2019-9-30 / 2019-10-1, the following four issues had the GOC-5 rate underlying their dividends recalculated by their issuers on September 3:

Basis Comparison of Resets
Ticker Issue Reset Spread Announced Rate Implied GOC-5 Yield Screenshot
ALA.PR.G 306bp 4.242% 1.182% LINK
EFN.PR.E 472bp 5.903% 1.183% LINK
BAM.PF.F 286bp 4.029% 1.169% LINK
DC.PR.B 410bp 5.284% 1.184% LINK

The AltaGas screenshot shows they made a slight mistake: the time of the screenshot is 10:00:18, so they missed their proper time by 18 seconds, although they could argue that the prospectus only uses four significant figures and therefore their calculation is completely OK. However, each of the other screenshots shows a genuine effort being made to determine just what exactly the GOC-5 rate was at 10:00:00.00000 and each methodology resulted in a different answer.

Four companies, four identically specified calculations, four different answers.

I will be the first to agree that the variance is minor: the spread between the highest and lowest measurement is only 1.5bp and that’s not a lot. On a typical issue size of $250-million, that comes to $37,500 annually or $187,500 over the full five years. On a per-share basis, a 1.5bp yield difference comes to $0.00375 p.a., slightly less than two cents over the full five years.

But that’s not the point. First, the prospectus should specify the yield to be used in a completely precise manner. To quote again from the representative language of the ALA.PR.G prospectus:

“Annual Fixed Dividend Rate” means, for any Subsequent Fixed Rate Period, the annual rate of interest (expressed as a percentage rounded to the nearest one hundred thousandth of one percent (with 0.000005% being rounded up)) equal to the sum of the Government of Canada Yield on the applicable Fixed Rate Calculation Date and 3.06%.

What’s the point of being so horrifyingly precise about the rounding of the Annual Fixed Dividend Rate when the underlying figure is nowhere near that precisely measured?

In addition, once this becomes widely known, what’s to prevent a company from determining the GOC-5 yield in as many ways as their Bloomberg users can invent and choosing the lowest answer?

Clearly, the Bloomberg methodology is not adequate for the task of determining a precise, public, third-party figure and the procedure needs to be changed. The first alternative that leaps to mind is the Bank of Canada’s bond yield reporting:

Selected benchmark bond yields are based on mid-market closing yields of selected Government of Canada bond issues that mature approximately in the indicated terms. The bond issues used are not necessarily the ones with the remaining time to maturity that is the closest to the indicated term and may differ from other sources. The selected 2-, 5-, 10-, or 30-year issues are generally changed when a building benchmark bond is adopted by financial markets as a benchmark, typically after the last auction for that bond.

Yes, it’s not quite the same thing and yes, there might be a perceived problem if the benchmark changes near the time of calculation (typically, new benchmarks will trade to yield less than the ‘off the run’ issues they supersede). I don’t care. I want something precise, public (certainly more public than a subscription to a Bloomberg terminal!) and prepared by an independent third party. If somebody has a better idea, let’s hear it.

Contingent Capital

S&P Revises Bank Outlook to Stable on Federal Complacency

Standard & Poor’s has announced:

  • •We continue to evaluate the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework.
  • •We now expect that the timeframe could be substantially longer than we had previously assumed. We see the absence of the topic from the new government’s Dec. 4 Speech from the Throne as recent, incremental evidence in this regard.
  • •We now do not expect to consider the removal of rating uplift for our expectation of the likelihood of extraordinary government support from the issuer credit ratings (ICRs) on systemically important Canadian banks until a point beyond our standard two-year outlook horizon for investment-grade ratings, if at all.
  • •When and if we remove such uplift, the potential ratings impact will also consider uplift for additional loss-absorbing capacity, as well as any changes to our stand-alone credit profiles on these banks.
  • •As a result, we are revising our outlooks on all systemically important Canadian banks to stable from negative.

RATING ACTION
On Dec. 11, 2015, Standard & Poor’s Ratings Services revised its outlooks on the Canadian banks that it views as having either “high” (Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, The Toronto-Dominion Bank), or “moderate” (Caisse centrale Desjardins and National Bank of Canada) systemic importance, to stable from negative (see ratings list). The issuer credit ratings (ICRs) on the banks are unchanged.

RATIONALE
We believe that the potential negative ratings impact of a declining likelihood of extraordinary government support, at least within our standard two-year outlook horizon, has subsided. This reflects our updated view that there could be an extended implementation timetable–2018 or later–for the proposed Canadian bail-in framework. Importantly, at the point we would consider removing any uplift from the likelihood of extraordinary government support from our ratings, we would also consider the potential ratings impact of any uplift for additional loss-absorbing capacity (ALAC), as well as any
changes to our stand-alone credit profiles (SACPs) on these banks. In our view, the extended timetable introduces some potential that either the presence of ALAC or fundamental changes in credit quality at individual banks might come into play more than under the previously contemplated timetable.

We had revised our outlooks on systemically important Canadian banks to negative chiefly in reaction to the former government’s “Taxpayer Protection and Bank Recapitalization Regime” consultation paper of Aug. 1, 2014, as we then expected a bail-in regime could be fully implemented by 2016 (see “Outlook On Six Big Canadian Banks Revised To Negative Following Review Of Bail-In Policy Proposal,” published Aug. 8, 2014, on RatingsDirect). A number of subsequent developments have caused us to re-evaluate this expectation:

  • •In its April 2015 budget proposal, the former government affirmed its intention to introduce a bank bail-in regime in Canada, but it provided only very limited additional information relative to what it had outlined in its 2014 consultation paper; nor did the government make substantial subsequent public statement on the topic; nor did it specify timing for the announcement of its fully-developed (post-consultation) legislative proposal.
  • •The Oct. 19 federal election changed the party in government to Liberal (center-left), from Conservative (center-right). The former government’s proposed bail-in regime did not feature prominently in election debates.
  • •The new government’s Dec. 4 Speech from the Throne made no mention of the proposed bail-in framework, nor were any of the legislative priorities enumerated therein closely related, in our opinion. We believe this indicates the introduction of a bail-in framework is not among the immediate priorities of the new government.

Moreover, with Canada experiencing no government bank bail-outs, nor large bank failures, for decades, we believe the political incentive to rapidly end “too-big-to-fail” is less in Canada than in the U.S. and several EU countries, which are jurisdictions under which we have already removed uplift for our expectation of the likelihood of extraordinary government support from our ratings (see “U.S. Global Systemically Important Bank Holding Companies Downgraded Based On Uncertain Likelihood Of Government Support,” and “Most European Bank Ratings Affirmed Following Government Support And ALAC Review,” both published Dec. 2, on RatingsDirect). We will take this factor into consideration as we continue to evaluate our view on the likelihood of extraordinary government support in Canada relative to not only the U.S. and Europe, but also other jurisdictions where we maintain a government support assessment of “supportive” or “highly supportive” under our criteria (such as for many countries in Latin America and Asia-Pacific; see “Banking Industry Country Risk Assessment Update: November 2015,” published Nov. 27).

We now believe the procedural hurdles to passing legislation and related regulations (the latter after passage of the former) for a bail-in regime will alone require a minimum of one-to-two years, after the new government decides on a final legislative framework to propose to Parliament. Considering all of this, we now expect the eventual date for initial implementation of the bail-in regime (that is, banks issuing bail-inable debt) could be in 2018 or later.

In addition, and in contrast to bail-in frameworks outlined by U.S. authorities or in European countries like Germany, Canadian officials’ statements have made clear that only debt issued or renegotiated after an initial implementation date would be subject to conversion. It will take some time for the banks to issue or renegotiate bail-inable debt. We believe this means it could take several years after the initial implementation date before we would consider a Canadian bail-in regime effective, so as to provide a viable alternative to the direct provision of extraordinary government support.

As well, and again in contrast to the U.S. and EU jurisdictions, Canadian governments have made no attempt to limit their ability to provide direct extraordinary support to their banks, if needed. We expect bailing in senior creditors to be the first Canadian policy response in the face of a crisis. At the same time, we believe Canadian governments would be likely to consider all policy options, in such a circumstance. It is therefore not certain that the introduction of a bail-in regime would of itself result in our revising our government support assessment on Canada to “uncertain” from the current “supportive” and the removal of rating uplift for our view on the likelihood of extraordinary government support from our ICRs on systemically important Canadian banks. Rather, our decision would depend, among other factors, on the details of the eventual bail-in regime, including the extent to which bail-inable and unbail-inable senior debt is distinguishable.

Partly to honor G-20 and other international commitments, the Canadian government will, we expect, present a finalized legislative proposal for the bail-in framework in 2016 or 2017. However, we expect an implementation date that could be in 2018 or later, and we think it could take at least one and possibly several years more for substantial bail-in eligible debt to be in place. With a runway that long, the potential ratings impact from removing uplift for the likelihood of extraordinary government support is beyond our standard two-year outlook horizon for investment-grade ratings, and could by then be more meaningfully affected by either ALAC uplift (from the bail-inable debt, assuming our related criteria are met) or SACP changes, than under the previously contemplated timetable.

When the government presents the detailed provisions of the framework, along with a more specific timeframe, we will review the applicable notching for various bank liabilities, taking into account the framework’s implications on different instruments. We expect that issue ratings on new bail-inable instruments will be at a level that is notched in reference to banks’ SACPs, while ratings on non-bailinable senior debt may continue to incorporate rating uplift above the banks’ SACPs, based on our expectation of the likelihood of extraordinary government support, or ALAC.

OUTLOOK
Our outlooks on the systemically important Canadian banks are stable, based on our reassessment of the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework. We believe that the likelihood of extraordinary government support will continue to be a factor in systemically important Canadian bank ratings throughout the current outlook period.

Moreover, we believe these banks will continue to exhibit broad revenue diversification, conservative underwriting standards, and strong overall asset quality. Our current view is that the impact of low oil prices on their profitability and credit quality will be contained, given the modest direct exposure of the banks to the oil and gas sector, and the limited knock-on impact so far on consumer credit in regional economies affected by low oil prices.

On the other hand, we continue to monitor a number of key downside risks to our ratings on these banks, including low margins, high Canadian consumer leverage, residential real estate prices we believe are at least somewhat inflated in some parts of Canada, a Canadian macroeconomic outlook that is very tentative, and the higher-risk nature of certain recent foreign acquisitions.

The August 2014 imposition of Outlook-Negative was reported on PrefBlog, as was the federal consultation on the recapitalization regime. As far as I can tell, the comments received on the consultation paper have not been published; I believe this is because Canadians are too stupid to understand smart stuff like legislation and parliament and all that – if given a pile of comments to work through, we’d probably try to eat them.

Issues affected are:

BMO.PR.K, BMO.PR.L, BMO.PR.M, BMO.PR.Q, BMO.PR.R, BMO.PR.S, BMO.PR.T, BMO.PR.W, BMO.PR.Y and BMO.PR.Z

BNS.PR.A, BNS.PR.B, BNS.PR.C, BNS.PR.D, BNS.PR.L, BNS.PR.M, BNS.PR.N, BNS.PR.O, BNS.PR.P, BNS.PR.Q, BNS.PR.R, BNS.PR.Y and BNS.PR.Z

CM.PR.O, CM.PR.P and CM.PR.Q

NA.PR.Q, NA.PR.S and NA.PR.W

RY.PR.A, RY.PR.B, RY.PR.C, RY.PR.D, RY.PR.E, RY.PR.F, RY.PR.G, RY.PR.H, RY.PR.I, RY.PR.J, RY.PR.K, RY.PR.L, RY.PR.M, RY.PR.N, RY.PR.O, RY.PR.P RY.PR.W and RY.PR.Z

TD.PF.A, TD.PF.B, TD.PF.C, TD.PF.D, TD.PF.E, TD.PF.F, TD.PR.S, TD.PR.T, TD.PR.Y and TD.PR.Z

Contingent Capital

Update On OSFI Insurer Regulation

OSFI Assistant Superintendent Neville Henderson gave a speech to the 2015 Life Insurance Invitational Forum:

Domestic Insurance Capital Standards

On the domestic front, we are still on track to implement OSFI’s new life insurance regulatory capital framework in 2018. The new capital framework will provide a superior risk based assessment methodology for determining capital requirements. The new test will make use of more current analysis and methodologies as well as explicitly taking into account mitigating actions and diversification benefits. It will allow our capital requirements to remain state of the art compared to those of other jurisdictions.

The capital changes in the new framework are explicitly calibrated to a consistent level of conditional tail expectation (CTE) across the various risks. Actuarial valuation of insurance company liabilities are explicitly intended to include conservative margins with the degree of conservatism varying across risks.

To help ensure that this approach results in consistent capital measures across companies, OSFI has asked the Canadian Institute of Actuaries and the Actuarial Standards Board to consider certain issues with a view to updating actuarial standards and /or guidelines if required.

To avoid double counting and inconsistent treatment of different risks, this new framework will include margins for adverse deviations as an available capital resource.

While we are awaiting the results of Quantitative Impact Study (QIS)7, we are in the process of planning to conduct two framework runs, one in 2016 followed by another one in 2017. These “test drives” will allow us to validate the new capital test and help insurers gear up for the updated regulatory compliance requirements under the new framework.

We should also have a final guideline ready for issue in July 2016, following input from the industry on the draft. Any anomalies uncovered in the testing will be taken into consideration prior to implementation. This will allow time for industry feedback and enable insurers to plan and prepare their systems for implementation of the framework in early 2018.

Global Insurance Capital Developments

While work continues on the domestic front, there are also developments in standards for internationally active insurers.

The International Association of Insurance Supervisors (IAIS) is refining the Basic Capital Requirement (BCR) and Higher Loss Absorbency (HLA) requirements for Global Systemically Important Insurers (GSIIs) for implementation in 2019. Work in this area is aimed at mitigating or avoiding risks to the global financial system.

To eventually replace the BCR, the IAIS is developing an internationally agreed upon risk based capital test. The Insurance capital standard (ICS 1.0) for the broader list of Internationally Active Insurance Groups (IAIG) will be ready by the end of 2016, for implementation in 2019.

OSFI looks carefully at the Canadian marketplace and Canadian requirements before deciding whether to adopt international standards. We will take ICS into consideration as we fine tune our current capital tests. The work we do on the OSFI life insurance framework already includes many of the changes stemming from these international standards and we don’t expect ICS 1.0 to be as sophisticated as our current Minimum Continuing Capital and Surplus Requirements (MCCSR) capital test. Consequently, we do not foresee a need to implement any significant changes.

The significant changes will likely come as ICS 2.0 is finalized. It may bring sufficient worldwide convergence for OSFI to start thinking about implementation.

The important thing about ICS is that this is what will determine whether or not preferred shares must be convertible into equity (or have other pre-bankruptcy capital loss absorption features) in order to be counted as Tier 1 capital. This proposal is outlined in the Consultation Paper “Risk-based Global Insurance Capital Standard” which is available in a ludicrously inconvenient manner, paragraph 92 with associated question 25:

92. The IAIS is considering a requirement for a principal loss absorbency mechanism to apply to Tier 1 instruments for which there is a limit. This principal loss absorbency mechanism would provide a means for such instruments to absorb losses on a going-concern basis through reductions in the principal amount in addition to cancellation of distributions.

Question 25. Should Tier 1 instruments for which there is a limit be required to include a principal loss absorbency mechanism that absorbs losses on a going-concern basis by means of the principal amount in addition to actions with respect to distributions (e.g. coupon cancellation)? If so, how would such a mechanism operate in practice and at what point should such a mechanism be triggered?

OSFI’s response to this question is available in the document “Compiled Responses to ICS Consultation 17 Dec 2014 – 16 Feb 2015”, which is also available in a ludicrously inconvenient manner:

No, OSFI does not support the inclusion of a principal loss absorbency mechanism on Tier 1 instruments for which there is a limit. Tier 1 instruments must be able to absorb losses on a going concern basis, which these instruments do through coupon cancellation.

Despite this, I expect that OSFI will adopt whatever ends up being in ICS, as in this way any future criticism will be deflected to the international body and they will be able to keep their jobs and continue angling for future employment with those whom they currently regulate.

OSFI’s response to this – and other – questions has never been explained to the Canadian public as far as I know, because we’re disgusting taxpayer and investor scum, not worth the dirt underneath our own fingernails.

Further discussion of the capital standard and my reasons for believing that the NVCC rule will be applied to insurers and insurance holding companies are provided in every edition of PrefLetter.

Regulation

CSA To Commence Crippling Canadian Corporate Bond Market

The Canadian Securities Administrators have announced that they have:

published for comment CSA Staff Notice 21-315 Next Steps in Regulation and Transparency of the Fixed Income Market, which describes the CSA’s plan to enhance fixed income regulation.

The Notice sets out the steps CSA staff are taking to improve market integrity, evaluate access to the fixed income market and facilitate more informed decision making among market participants.

The CSA Staff Notice can be found on CSA members’ websites. The 45-day comment period will close on November 1, 2015.

Naturally the CSA can’t put actual links on the press release announcing their existence. That would be too simple, but after some poking around we find on the OSC website CSA Staff Notice and Request for Comment 21-315 Next Steps in Regulation and Transparency of the Fixed Income Market:

On April 23, 2015, staff of the Ontario Securities Commission (OSC) published a report titled The Canadian Fixed Income Market 2014 (the Report).{2} The Report presented a fact-based snapshot of the $2 trillion fixed income market in Canada, with particular emphasis on the $500 billion in corporate debt outstanding.{3} The Report also highlighted the following:

1. fixed income data available is limited and fragmented across a number of sources, which makes it difficult to conduct a comprehensive assessment of the fixed income market;

2. the secondary fixed income market is a decentralized, over-the-counter market where large investors have significantly more bargaining power than small investors;

3. there is limited adoption of electronic trading and alternative trading systems, especially for corporate bonds; and

4. direct retail participation in the primary and secondary fixed income market is low and retail investors typically access the fixed income market by purchasing investment funds.

The purpose of this notice is to set out the CSA staff’s plan to enhance fixed income regulation to:

1. facilitate more informed decision-making among all market participants, regardless of their size;

2. improve market integrity; and

3. evaluate whether access to the fixed income market is fair and equitable for all investors.

Each of these steps is discussed in the sections below.

The report was discussed on PrefBlog in the post The Canadian Fixed Income Market: 2014.

It is noteworthy that not one of the objectives involves answering the question “What is the corporate bond market for?”. If this question was ever asked and it was decided that the purpose of the corporate bond market was to give Granny a good place to invest her $5,000 in a single particular bond at a good price then the other objectives make sense. If, however, the purpose of the market is to give corporations access to debt funding that is less constraining and cheaper than bank funding, so they can invest money, help the economy grow and create jobs, then other conclusions might be drawn.

However, CSA staff already has jobs, currently on the public payroll and quite often with the banks afterwards, so job creation by other corporations is hardly a meaningful concern.

As they are on the public payroll, they have very prudently not commenced crippling the government bond market:

NI 21-101 sets out transparency requirements for government debt securities. Specifically, marketplaces and inter-dealer bond brokers are required to report order or trade information, or both, to an information processor. However, an exemption from these transparency requirements is in place and was recently extended until January 1, 2018, through amendments to NI 21-101. As indicated in the notice published with the amendments,{9} no other jurisdiction has mandated transparency for government debt securities. The extension was granted in order to allow CSA staff to monitor international developments, including the expected implementation of the transparency regime that will be established across the European Union by the new Markets in Financial Instruments Directive (MiFID II) and the Markets in Financial Instrument Regulation (MiFIR) adopted by the European Commission,{10} and to determine whether the NI 21-101 transparency requirements for government debt securities should be implemented or whether changes are appropriate.

It is laughable that CSA staff boasts about the wonders of public dissemination of information via SEDAR without permitting direct links to these public documents, but the funniest part of this diktat is their lip service to liquidity:

As noted above, it is CSA staff’s goal to achieve transparency for trades in all corporate debt securities by the end of 2017. We have considered how to achieve this goal in light of:

• the fact that IIROC will be implementing the IIROC Debt Reporting Rule in two phases (described below); and

• concerns that have been raised globally about a decrease in the liquidity in corporate debt markets, and the potential impact of additional transparency on liquidity.{19}

It is intended that transparency for all corporate debt securities will be phased in over the next two years in two phases, as follows:

• in Phase I (expected to occur in mid-2016), IIROC, as an information processor, will disseminate post-trade information for all trades in the Designated Corporate Debt Securities and for retail trades{20} for all other corporate debt securities reported to IIROC; and

• in Phase II (expected to occur in mid-2017), IIROC will disseminate information for all trades in all corporate debt securities and for new issues of corporate debt.

Footnote 19 reads: Specifically, concerns have been raised globally about a potential decrease in the liquidity of the fixed income markets due to a number of factors, including an increase in corporate bond issuances coupled with, some believe, decreases in dealers’ inventories resulting from changes in regulation. We have also heard these concerns raised by Canadian buy-side and sell-side firms during our discussions regarding liquidity and transparency.

Oh, isn’t that just the sweetest thing you can imagine! They’ve “heard these concerns” and, of course, having heard them we can rely on our Wise Masters to have made the correct decision. Just what these concerns were and just why certain decisions were made is none of your business – not only are you mere investor scum but you’re not even government employees, so dry up and blow away, vermin.

I have written about liquidity ant transparency many times on this blog and provided some of the links in my review of the OSC literature survey that is being used as cover for the CSA’s shenanigans. The short version is: increasing transparency leads to markets with a narrower bid-ask spread, but less depth. This has been shown time and time again by academics studying all sorts of markets. Naturally, the regulators are focussing on a definition of liquidity that emphasizes the bid-ask spread; Granny will be able to trade her $5,000 worth of bonds much more cheaply. Investors who trade corporates in $1-million+ sized chunks, however, experience a sharp decline in liquidity. This, naturally, increases the risk of flash-crashes and ‘crowded-trades’ as retail dumps ETFs … but who cares? That will merely give the regulators another excuse for some crocodile tears and another expensive study.

Institutional level liquidity is not a joke and it’s not trivial. When investments are more volatile and less liquid, you want to get paid more for holding them. That is to say, you demand more yield. It is the issuers who are paying that yield and increases in this yield increase their costs, and make building that new factory just that much less attractive.

But nobody cares and the regulators can’t even be bothered to ask ‘What is the corporate bond market for?’.

I’ve had it with this sham. However, for those who are interested, there was a story in the Globe about this issue titled Canadian regulators unveil new system to report corporate bond trading data. The plan has been greeted with rapturous applause from non-investors.

Coming up next: industry regulators take on the Ontario Food Terminal. It is disgusting that purchase of food at wholesale prices is restricted! Let’s see some FAIRNESS!!!

Update, 2015-9-19: Other press mentions have been Canada to Boost Corporate Bond Market Transparency by 2017 and CSA seeks comments on enhancing fixed-income transparency. The former article is notable for the paragraph:

“The steps we have set out to enhance regulation in the fixed income market will improve market transparency and better protect investor interests,” Tracey Stern, head of market regulation at the Ontario Securities Commission, said in an e- mailed statement. “With increased transparency, investors will be in a better position to assess the quality of their executions.”

Do I really need to point out that the concept of judging “quality of their executions” is a concept that applies only to brokered trades, while virtually all bond transactions are done on a principal basis? It would appear that I do.

Regulation

Scapegoat For Flash Crash Isolated!

Assiduous Readers will remember the highly politicized SEC Flash Crash Report. It’s taken five years, but they’ve finally isolated a scapegoat who spends his spare time rubbing his hands together and cackling about the triumph of evil:

NAVINDER SINGH SARAO was a futures trader
who operated from his residence in the United Kingdom and who traded primarily through his company, Nav Sarao Futures Limited.

“Layering” (a type of “spoofing”) was a form of manipulative, high speed activity in the financial markets. In a layering scheme, a trader places multiple, bogus orders that the trader does not intend to have executed-for example, multiple orders to sell a financial product at different price points-and then quickly modifies or cancels those orders before they are executed. The purpose of these bogus orders is to trick other market participants and manipulate the product’s market price (in the foregoing example of bogus sell orders, by creating a false appearance of increased supply in the product and thereby depressing its market price). The trader seeks to mislead and deceive investors by communicating false pricing signals to the market, to create a false impression of how market participants value a financial product, and thus to prevent legitimate forces of supply and demand from operating properly. The trader does so by creating a false appearance of market depth, with intent to create artificial price movements. The trader could then exploit this layering activity by simultaneously executing other, real trades that the trader does intend to have executed, in an attempt to profit from the artificial price movements that the trader had created. Such layering and trading activity occurs over the course of seconds, in multiple cycles that the trader repeats throughout the trading day. Given the speed and near simultaneity of market activity in a successful layering scheme, such schemes are aided by custom programmed, automated trading software.

Beginning in or about June 2009, SARAO sought to enrich himself through manipulation of the market for E-Minis. By placing multiple large-volume orders on the CME at different price points, SARAO created the false appearance of substantial supply in order to fraudulently induce other market participants to react to his deceptive market information. SARAO thus artificially depressed EMini prices. With the aid of an automated trading program, SARAO was able to all but eliminate his risk of unintentionally executing these orders by modifying and ultimately canceling them before execution. Meanwhile, he exploited his manipulation to reap large trading profits by executing other, real orders.

Matt Levine of Bloomberg – who I respect greatly as a reporter who really puts a lot of intelligence and sweat to work when writing his columns – writes a wonderful column regarding the indictment:

So straightforward that one of the biggest puzzles here is why it took so long — and the help of a whistleblower — for regulators to figure it out. They came tantalizingly close:

As reflected in correspondence with both SARAO and an FCM he used, the CME observed that, between September 2008 and October 2009, SARAO had engaged in pre-opening activity — specifically, entering orders and then canceling them — that “appeared to have a significant impact on the Indicative Opening Price.” The CME contacted SARAO about this activity in March 2009 and notified him, via correspondence dated May 6, 2010, that “all orders entered on Globex during the pre-opening are expected to be entered in good faith for the purpose of executing bona fide transactions.” The CME provided a copy of the latter correspondence to SARAO’s FCM, which suggested to SARAO in an email that he call the FCM’s compliance department if he had any questions. In a responsive email dated May 25, 2010, SARAO wrote to his FCM that he had “just called” the CME “and told em to kiss my ass.”

Emphasis added because come on: The futures exchange wrote to Sarao on the day of the flash crash, telling him to stop spoofing, and he called them back “and told em to kiss my ass.” And then regulators pondered that reply for five years before deciding that they’d prefer to have him arrested in London and extradited to face criminal spoofing charges. One conclusion here might be that rudeness to regulators really works.

It’s a tempting idea!

The CFTC claims that Sarao basically started his spoofing career by causing the flash crash, and then went ahead and kept spoofing for another five years without much interruption. I guess he got more subtle at it? Not very subtle though; he was a consistently large trader, “placing, repeatedly modifying, and ultimately canceling multiple 200-, 250-, 300-, 400-, 500-, 550-, 600-, and 900-lot sell orders,” versus an average order size of seven contracts. He also seems to have had some patterns (like putting in orders for exactly 188 or 289 contracts that never executed) that you’d think would make him easier for regulators or exchanges to spot.6 If regulators think that Sarao’s behavior on May 6, 2010, caused the flash crash, and if they think he continued that behavior for much of the subsequent five years, and if that behavior was screamingly obvious, maybe they should have stopped him a little earlier?

Also, I mean, if his behavior on May 6, 2010, caused the flash crash, and if he continued it for much of the subsequent five years, why didn’t he cause, you know, a dozen flash crashes?

And Mr. Levine closes with the key point:

I have always been impressed and puzzled that low-tech spoofers have much success ripping off whomever they rip off. It’s such a minimal fraud; it’s just saying that you want to sell when you don’t want to sell.10 It’s always surprising that that could have a major effect on markets. John Arnold has argued here at Bloomberg View that spoofing only hurts front-running high-frequency traders, while others point out that “algorithmic trading tools are used by a wide class of traders,” including long-term investors like Waddell & Reed who use algorithms to try to avoid the front-running HFTs. But the FBI’s and CFTC’s theory here is far more troubling: It suggests that existing algorithms are not just dumb enough to give spoofers some of their money, but dumb enough to give spoofers so much of their money that they destabilize the financial markets. It’s not especially confidence-inspiring to read that a guy with a spreadsheet can trick everyone into thinking that the market is crashing, and thereby cause the market to crash.

Well, if the extremely well-paid hard-nosed deep-thinking portfolio managers at Waddell & Reed have their naivety and incompetence exploited by someone who plays the game a little better than they do, you won’t find any tears here.

I hadn’t read the argument linked with “others point out” before, but it doesn’t impress me:

Even if we exclude cases such as this one and legalize the submission of spoofed orders with the proviso that they stay live for less than 100ms, there are plenty of unsophisticated market participants who would still be harmed. These days, algorithmic trading tools are used by a wide class of traders. There is an entire industry, possibly larger than that of vanilla HFT, focused on creating and marketing these tools. Tremendous volume is executed via algorithms on behalf of traditional long-term traders.[2] I’m not an expert on such algorithms, but my impression is that they tend to be much less sophisticated than a lot of vanilla HFT, and thus more likely to be tricked by spoofing. A basic example of one such execution algorithm would be a peg order, which is priced in a very simple fashion somewhere in between the best bid and ask. If a spoofer alters the best bid then a peg order will change its price in response, leaving the user open to losses.

The open question here is: why should anybody in his right mind care about unsophisticated market participants? If they show up at a gunfight with a boxing glove, that’s their problem; the sooner they go bankrupt and go on welfare, the better, as far as I’m concerned. If they are placing orders with no other thought than ‘Golly, I guess I’ll do whatever the rest of the market is doing’ then they are contributing to market inefficiency and harming the market’s price discovery function. So screw ’em; give a medal to the guys who punish ’em. Markets and market regulation should concentrate on the best interests of fundamental traders; any help, succor or encouragement given to techno-weenies is misplaced.

The other major argument in the linked objection is:

Say that you wanted to change this definition to allow spoofing with the intention of damaging order-anticipation strategies. Could you do so in a fashion that didn’t also allow other kinds of nasty manipulation? I don’t see how. Manipulation via self-trading is probably a behavior that everybody agrees should be prohibited. When a manipulator trades with themselves, they can do so risk-free at an arbitrary price, giving other traders a false sense of the market price.[3] Self-trading can be extremely damaging to market integrity. But which group, I wonder, is most hurt by self-trading? One could argue that so-called “front-runners” are. For example, say Apple stock is currently trading at $100, and a manipulator trades 10 million shares with themselves at $90. There could be order-anticipation algorithms, ‘predicting’ selling to come, that react to this and sell Apple stock.[4] There could also be strategies that take this as a signal that there will soon be selling across the entire sector, and sell stocks in related companies. These algorithms fall under Arnold’s definition of “front-running,” and would be expected to lose money when the manipulator decides it’s time to push Apple stock back to $100. Does that mean we should celebrate the manipulator? No.[5]

That’s a big leap of logic in the last word there! I will certainly celebrate the manipulator: he’s punished a few stupid rat-turds who aren’t trading on fundamentals. Good for him!

To his credit, the guy at Mechanical Markets does address my view in his footnote:

[5] If you’re a long-term investor, this scenario seems great, right? You can buy Apple stock at a $10 discount. So, if you thought the stock had an intrinsic value of $105, you’re getting a real bargain. In practice though, I’d imagine that you would hesitate to start buying stock in such a scenario. At least until you had confirmed that the price wasn’t plummeting because of some news that you hadn’t heard yet. By the time you could rule out any news, the manipulator would have pushed the price back to $100.

He who hesitates is lost! Many limit orders entered by fundamental traders during the manipulation phase will be executed prices more attractive than would otherwise be the case. In the long run, fundamental traders who pursue incredibly sophisticated strategies like “paying what they consider a fair price for their purchases” will scoop up all kinds of money from the empty-headed game-players.

But, of course, the Boo-Hoo-Hoo Brigade is in full cry:

“It’s incumbent upon regulators not to be asleep at the switches,” said Donald Selkin, who helps manage about $3 billion as chief market strategist at National Securities Corp. in New York. “They have been, time and time again.”

“Things like this don’t build a lot of confidence,” said Timothy Ghriskey, the chief investment officer at Solaris Asset Management LLC in New York, who helps manage about $1.5 billion. “It’s a risk that regulators are always going to be a step behind. That’s why they should be more aggressive.”

“It’s ridiculous, it’s the government at its best — inept,” Rick Fier, director of equity trading at Conifer Securities LLC in New York, said in a phone interview. “It really is just another one of many things to deal with, it’s extremely frustrating. We’ve seen flash crashes and we’ll see them again and it’s definitely disconcerting.”

“The [high-frequency trading] term’s just become meaningless at this point; it’s just a boogie-man,” said Dave Lauer, president of Kor Group, a market structure lobbying and research firm.

“There are high-frequency market-makers, there are high-speed proprietary traders who don’t care about making markets and I do think there are predatory high-speed traders and manipulative high-speed traders,” Lauer said. “What this guy was doing was using computers in a manipulative, high-order-volume manner.”

no more than 20 trading days when volatility was high.

“On the surface, the headline isn’t comforting, but perhaps it provides the avenue to prevent something of this nature from happening again,” said Walter Todd, who oversees about $1 billion as chief investment officer for Greenwood, South Carolina-based Greenwood Capital. “I’m glad we know definitively how it happened, but at the same time, the headline isn’t a great thing.”

Go have lunch with a client, guys, if that’s all you’re good for.

Update: Here’s more argument in favour of ditching the completely artificial spoofing and layering rules – look at just just who Navinder Singh Sarao is and how he did it:

Sarao, 36, has no record of having worked at a major financial firm in the U.S. or the U.K. At the time of the flash crash, Sarao was renting space from a proprietary-trading firm in the City of London and clearing his transactions through MF Global Holdings Ltd., the now-defunct firm headed by Jon Corzine, said a person with knowledge of the matter.

That picture, according to U.S. authorities, belies a years-long history of lightening-quick computer trading that netted Sarao $40 million in illicit profits.

By all accounts, the flash crash was more than a mere technical glitch. It raised fundamental questions about how vulnerable today’s complex financial markets are to the high-speed, computer-driven trading that has come to dominate the marketplace.

Sarao’s computer screen almost always flashed futures data tied to the Standard & Poor’s 500 Index and his interactions were typically limited to workers installing new trading algorithms, said the person, who spoke on the condition of anonymity.

When he started his allegedly manipulative trading in 2009, Sarao used off-the-shelf software that he later asked to be modified so he could rapidly place and cancel orders automatically. At one point, he asked the software developer for the code, explaining that he wanted to play around with creating new versions, according to regulators.

So he wasn’t an expert trader, using his years of industry experience to exploit infinitesimal little bugs in standardized software, or his deep knowledge of trade-matching and clearing to exploit some bizarre mismatch in the interface between various systems.

He was one guy, using slightly modified off-the-shelf software, who broke one rule. And a rule, by the way that I feel is probably bent many, many times per day despite a very expensive army of regulators devoted to enforcing the silly thing.

If the US financial system is so vulnerable to one guy breaking one silly rule then we’ve got a problem that will not be fixed by doubling the number of regulators who check out trade cancellations and try to decide just what the intent was when each order was originally placed. If the rule is so vulnerable to exploitation and so unenforceable: get rid of it. Unleash the real players in the industry to detect and enforce a level playing field, with spoofing algorithms, spoofing detection and counter-exploitation algorithms, spoofing cloaking algorithms, anti-spoofing-cloaking algorithms … the whole nine yards. And bring some sanity back to the world.

Update, 2015-4-22: Zero Hedge is irritated:

While we eagerly await for the SEC to retract its official 104 page report summarizing the “Findings regarding the market events of May 6, 2010” in light of “recent developments”, and as we follow the shift in the official narrative to the outright bizarre, in which the entire Flash Crash is now blamed on just one man (as opposed to just Waddell & Reed as per the previous narrative), we learn that the latest scapegoat for a broken, fragmented and manipulated market, Navinder Sarao, is not quite so eager to go to minimum security prison in the US for doing what leads to a slap on the wrist when someone like Citadel or Virtu does it, and will challenge the CFTC’s attempt to pin everything on him.

As previoisly reported, Sarao engaged in what every other HFT firms on a daily basis: namely spoofing. However, because he is a foreigner, he was easy prey for the US “justice” system, and as a result it is he that has been picked as a scapegoat (perhaps because the official investigation into Virtu, Citadel and the other HFT firms revealed something so dramatic it needed an easy and available cover up).

Eric Scott Hunsader of Nanex, whose work has been quoted admiringly on PrefBlog in the past, has posted a series of tweets:

If this futures trader *was* spoofing during Flash Crash, it means the CFTC completely missed what should have been easy to spot

Flash Crash Brit was just one of many #HFT ass-hats in the market on 5/6 contributing to a fragile system

We spotted the Flash Crash Brit years ago – red/yellow on this eMini chart is from his algo on 5/6

What Singh Sarao is being accused of is as common as Oxygen. I can’t stress this enough.

It is wrong to say Sarao caused flash crash. He contributed to causing it, yes, but it was Barclay’s leak that sent it down

Why didn’t the CME say anything about Sarao for what.. 5 years now?

How did Andrei Kirilenko (CFTC) miss Sara’s spoofing while analyzing a week’s worth of AUDIT TRAIL DATA??

Why is Sarao (DOJ flash crash spoofer) being singled out from so many other #HFT spoofing algos?

When I 1st saw Sarao’s algo in Summer 2010, I thought it was Tradebot because it stopped when Cummings said they pulled the plug

“Exploratory Trading” – another #HFT strategy used by top firms to manipulate eMini’s $ES_F http://www.nanex.net/aqck2/4136.html

What really caused Flash Crash: Someone LEAKED that a mutual fund was selling 75K eMini’s via participation algo. Wall St pounced

Sarao turned off his algo at 14:40:12. The market flash crash began 2 minutes 32 seconds later at 14:42:44 – an eon in market time

Detailed forensic evidence on the flash crash: http://www.nanex.net/aqck2/4650.html

FT Alphaville has some harsh words:

In a series of moves variously known as “layering” or “spoofing,” Sarao allegedly created the appearance of substantial supply in the market which didn’t actually exist — sparking a short-lived 600 point fall over in the Dow Jones Industrial Average in the space of five minutes.

Except you know, instinctively, that this is nonsense. It’s pure financial keystone cop-ery. This is a laughable piece of regulatory grand-standing from the Americans, which the British authorities look like fools for going along with.

The S&P futures market, across its various guises, is colossal. It is dominated by robot traders and other, highly capitalised professionals. The simple idea that a chap in West London, playing around at home with an off-the-shelf algo programme on his PC while his parents are off at the gurdwara, can up-end the entire US equity market is comical.

Or rather, if there’s any truth here at all, the guys under arrest should be those at the top of the CME and other key pieces of US market infrastructure.

Interesting External Papers

Jack Mintz On Exempt Market Regulation

Jack Mintz has published an excellent commentary titled Muddling Up The Market: New Exempt-Market Regulations May Do More Harm Than Good To The Integrity Of Markets:

From private debt and equity markets to crowd funding, exempt markets have been used to raise more money for Canadian enterprises in recent years than all public offerings put together. Vastly more: Between 2010 and 2012, exempt-market offerings raised four times as much capital as the initial and secondary public offerings during the same period. The precise reasons behind the immense popularity of exempt markets can only be guessed at; it may well be due to the desire, by both issuers and by investors, to avoid the regulatory costs associated with raising capital in public markets. We are left to speculate, however, because the Canadian exempt market remains relatively unstudied, despite its enormous role in funding capital investments in Canada.

The lack of information about exempt markets, however, is not stopping provincial regulators in Canada’s largest markets from charging ahead with new proposals for rules that would govern exempt markets. Unfortunately, with so little information available about these markets, whatever the aim of the reforms in pursuing the goals of effective market regulation, they may end up being more harmful than helpful.

Ontario is proposing to broaden the category of investors eligible to participate in these markets under a new exemption. But the category will remain stricter than in many other markets and Ontario proposes to also put very low limits on how much each investor is allowed to put at risk. Quebec, Alberta and Saskatchewan are also proposing the same $30,000 limit for any given 12-month period. And Ontario will prohibit the sale of exemptmarket securities by agents that are related to, or affiliated with, the registrant, even if measures are employed that have previously been accepted in managing and mitigating conflicts of interest. This will have a direct and damaging impact on exempt-market dealers, who are only allowed to sell exempt-market securities.

All of these proposals are intended to protect investors from the higher risks that are presumed of exempt markets. However, there is no evidence — given the paucity of information about them — that exempt markets necessarily pose a greater risk of fraud or poorer returns and losses than do heavily regulated public markets. And if risk is indeed higher in the exempt markets, one would expect these proposed regulations to assist high quality firms from distinguishing themselves in the exempt market from low-quality firms. However, these regulations may actually have the opposite effect, making it harder for better-quality firms to signal their worthiness to investors.

Canadian productivity — which continues to lag relative to other developed economies — relies heavily on businesses being able to acquire capital for investing in new technologies. Canadian companies and investors appear to be voting with their feet for exempt markets in raising that capital, possibly discouraged from public markets by regulatory costs and inefficiencies. For policy-makers to layer additional regulation on top of exempt markets without fully understanding the impact that it will have, could well result in making Canadian markets, and Canada’s economy, weaker, rather than stronger.

The paper was prompted by an initiative led by the OSC:

Currently, Ontario primarily limits exempt markets to “accredited investors” who must satisfy certain rules, such as an investor and spouse having at least $1 million in net financial assets, or $5 million in total net assets, or net income above $200,000 (or $300,000 with a spouse) over the previous two years with a reasonable expectation of exceeding that in the current year.

Generally, few limitations are imposed on how much equity an investor may acquire or the size of offerings of exempt securities, and there is no requirement for the issuer to provide any disclosure to the accredited investor.

The proposed Ontario rules will broaden the category of investors to include “eligible investors” in a way that is similar, but not the same as, existing rules in all other provinces. The proposed Ontario rules would allow investors to invest in exempt securities, if they have:
(i) $400,000 in net assets or more, including their primary residence; or
(ii) $250,000 in net assets or more, excluding their primary residence; or
(iii) $75,000 in net income (or, with a spouse, $125,000 of net income) in the previous two years, with the expectation of having the same or larger net income in the year of the offering.

This is all provided that the issuer gives to the investor an offering memorandum (described below) prior to the investment.

Each “eligible investor” will also be restricted from purchasing, in aggregate from the market as a whole, no more than $30,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption. Investors in Ontario who are not accredited investors or eligible investors will be restricted to acquiring, in aggregate from the market as a whole, not more than $10,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption.

Mr. Mintz points out:

Certainly, risks can be significant for ill-informed investors, and exempt securities can have significantly less liquidity than securities issued by some public issuers. Yet, despite these risks, the exempt markets are a significant source of capital. This raises the question of whether businesses are accepting the higher financing costs due to any additional investor risk with less information disclosure, in exchange for faster speed of raising capital and lower regulatory costs than would be faced in the public markets. In other words, are businesses and investors voting with their feet to move to exempt markets? If so, this raises questions about the effectiveness of financial-market regulations with respect to market efficiency, financial stability and investor protection, to which I now turn.

Well, sure. While Mr. Mintz is exclusively concerned with firms raising bricks-and-mortar capital on the exempt market, Assiduous Readers will remember that my fund Malachite Aggressive Preferred Fund is not a public fund because it would cost too much. At least $500,000 for a prospectus, probably more, and grossly inflated operating costs due to the necessity for an Independent Review Committee and a Custodian; the cost of which means better distribution is absolutely required, which means membership in the big boys’ FundSERV which is not exactly cheap, and trailer fees because, bleating of do-gooders notwithstanding, ain’t nobody gonna sell it for free, (or if trailer fees are banned, I might just as well burn my money because of the ‘nobody ever got fired for buying IBM’ mindset, as well as the not-really-tied-selling-honestly in bank channels) … all of which would mean

  • higher costs for investors
  • I have to change my title to “Chief Salesman”, a job for which I am ill-suited and totally disinterested
  • I’d have to employ an ex-regulator whose job would be to tell his old buddies how totally on top of compliance he is

Screw that, as they say in French. But it would be nice, very nice, to be able to offer the fund to a wider potential clientele.

Mr. Mintz concludes:

The largely unstudied exempt markets account for a major share of securities issues by Canadian businesses. This paper provides an overview of the regulatory framework, suggesting that much more effort is needed to study this important market. The exempt market plays an important economic role in Canadian capital markets — regulations should be optimal in their design to balance market efficiency, financial stability and investor protection as objectives.

Regulations vary by province with different standards used to regulate disclosure requirements and investor qualifications for holding exempt securities. However, these regulations are set in a vacuum of information, as we do not understand the characteristics of exempt markets, the economic impact of various restrictions and alternative forms of investor protection. Certainly, regulators should consider not just the characteristics of investors but also other factors, such as different levels of disclosure, in formulating regulatory policy.

In a recent panel discussion:

Mr. Mintz isn’t so sure such a cap is necessary, nor is he convinced the current rules must be changed. After thorough research, he’s concluded there is almost no data on the private markets. “The first question we should be asking is: what is the problem?” he said during a panel discussion to discuss his new paper in Toronto Monday.

When it comes to regulation, [former OSC chair] Mr. [Ed] Waitzer said, “we don’t know what works in protecting investors from fraudsters. We don’t know what works in protecting investors from themselves.” That doesn’t meant the OSC’s proposals are bad, but he believes the rules may not be necessary or the best means of protection. Instead of targeting caps on private investments, maybe regulators should simply ensure investment advisers follow their fiduciary duties, he argued.

The OSC has responded in a letter that has been published as a PDF image, in order (as far as I can tell) to hinder public dissemination via copy-pasting. Interested parties are assured that the OSC is “taking a more balanced approach that includes important investor protections”. The letter addresses process, not evidence and argument.

Terence Corcoran commented in the Financial Post:

Instead of responding to the substance of Mr. Mintz’s paper, Mr. Turner waffled through hundreds of words that said nothing.

There were ‘extensive consultations that support our proposals,’ he said. There is data, he insisted, there have been stakeholder meetings, and in any case “we believe an incremental approach to broadening access is appropriate.”

Sounds like the precautionary principle creeping into the regulator’s office.

And Mr. Mintz has responded:

“I believe the Ontario Securities Commission is following a prudent path in creating an Offering Memorandum regime similar to those in Quebec, Alberta, BC and other provinces.

However, Ontario is also considering imposing new restrictions on the exempt market that have not existed before. Particularly, the $30,000 cap on individual investments. Now, a similar cap is being considered by other provinces.

Per my research, I remain concerned that this cap could do more harm than good by inhibiting business capital financing, especially for better companies. Further, there remains an absence of empirical evidence that a ‎cap is needed at all. Before imposing a cap like this, it is important to take a step back, gather empirical data, and understand the potential impacts of a cap on investment into the exempt market.

Finally, I am grateful that the OSC has taken such an interest in my research. However, to the points made in the letter, I do not believe that “consultation” is a substitute for empirical, data-based research on the impacts of regulatory changes to the exempt market. The onus is on regulators to engage in this research and gather data before proposing changes that could have a significant negative impact on what is a very important source of business funding in Canada.”