On March 24, 2014, Bank of Canada Deputy Governor Timothy Lane announced that steps were being taken by industry and regulators to put in place a code of conduct with regards to the submissions made by the banks on the panel that provides the daily quotes used to determine the Canadian Dealer Offered Rate ("CDOR"). This follows an announcement in January 2014 by the Office of the Superintendent of Financial Institutions (Canada) ("OSFI") that it will begin supervising the effectiveness of governance and risk controls surrounding the submissions reporting participants make relating to CDOR.
As will be discussed in greater depth below, OSFI's announcement and expected framework aims to create greater consistency between the processes used to calculate CDOR and those being introduced to calculate its international equivalents. Further, the framework aims to enhance market integrity of and market confidence in CDOR.
1. Calculation of CDOR
Historically, CDOR has been determined daily from a survey of market makers in bankers' acceptances ("BAs"). Participation in the CDOR survey is voluntary and the inclusion of a reporting participant (i.e. a market maker) is not governed by any published criteria. Currently, the reporting participants are: (1) BMO Nesbitt Burns, (2) CIBC World Markets, (3) HSBC Bank Canada, (4) National Bank Financial, (5) RBC Dominion Securities, (6) Scotia Capital Inc. and (7) TD Securities Inc. Prior to January 31, 2014, Deutsche Bank Securities Limited and its affiliate also participated in the CDOR survey.
According to a report issued by the Investment Industry Regulatory Organization of Canada ("IIROC") in January 2013 (the "IIROC Report"), no consistent method is used by the reporting participants to establish the submitted rate. However, some similarities exist in terms of calculation methodology between reporting participants. For example, typically, a reporting participant will begin the calculation with its previous day's submission and the resultant CDOR rate. The reporting participant will then apply a calculation methodology that factors in: (1) the Bank of Canada overnight rate, (2) any funding pressures that exhibit a predictable pattern (mid-month and month end), (3) known funding commitments, (4) secondary BA trading (to the extent such information is available) and (5) changes in the overnight indexed swap (OIS) curve). After the rates are submitted, the highest and lowest rate are removed from the survey. High and low bid prices are excluded to minimize bias in the results.
2. CDOR Administration & Regulation
Since 2003, CDOR has been administered by (Thomson) Reuters ("Reuters"). Each business day, the survey is conducted at 10:00 and the calculated average appears on the Reuters Screen CDOR Page by 10:15 am. Reuters reports late, missing or unusual submissions to IIROC for further investigation.
Notably, neither current legislation nor IIROC rules explicitly address CDOR rate-setting activity and IIROC does not administer or regulate CDOR. Accordingly, OSFI has stated that its decision to commence regulating CDOR stemmed from an agreement reached among members of the Canadian Heads of Regulatory Agencies stating that "OSFI is best placed to assume a role, consistent with its mandate and expertise, in supervising the effectiveness of governance and risk controls surrounding banks' CDOR submission processes".
3. Controversies Surrounding International Benchmark Rates
The recent attention given to CDOR regulation followed from the international controversies surrounding international reference rates. In 2009, survey-based reference rates garnered international attention when the UK Financial Services Authority ("FSA") commenced an investigation relating to reference rates such as the London Inter-Bank Offered Rate ("LIBOR").
In June 2012, the British Chancellor of the Exchequer established the Wheatley Review of LIBOR ("Wheatley Review"). In September 2012, this review published a series of recommendations and steps for implementation. In brief, these recommendations stated: (1) that LIBOR should be reformed rather than replaced, (2) that submissions used for fixing LIBOR should be supported by transactional evidence in lieu of estimates and (3) that reporting participant should continue to play a significant role in the production and oversight of LIBOR.
4. IIROC Audit and Report
Although the aforementioned investigations and related settlements did not involve allegations with respect to CDOR and Canadian-based institutions given the vital role CDOR plays in the Canadian financial system, IIROC commenced a formal review of CDOR as a first step towards strengthening governance. The stated purpose of the review was to further explore practices related to the calculation, supervision and use of CDOR. As part of the review process, each reporting participant met with representatives from both IIROC and the Bank of Canada.
Following the IIROC review, IIROC published a report which noted differences between LIBOR and CDOR and also provided recommendations for the future of CDOR. The report's recommendations were in large part consistent with those published in the Wheatley Review. For example, IIROC stated that steps should be taken to strengthen the safeguards around the integrity of CDOR. Additionally, the report stated that market participants should continue to play a significant role in the production and oversight of CDOR. In contrast to the Wheatley Review, IIROC's report stated that it would not be appropriate for CDOR rates to be based on transactional evidence.
5. CDOR in Common Use
Credit agreements using CDOR as a loan pricing benchmark will typically refer to the yield rates for Canadian Dollar BAs, for a specified term, that are listed on the Reuters Screen CDOR Page as of 10:30 am (Toronto time) on the applicable quotation day. The Reuter Screen CDOR Page is the display on the Reuters Monitor Money Rates Service for the purpose of displaying bid quotations for BAs, accepted by banks participating in the daily CDOR survey. If the quotation day is not a banking day, the CDOR rate will be the rate that appears on the Reuters Screen CDOR Page on the next preceding banking day.
Should CDOR not be available on the Reuters Screen CDOR Page on the applicable quotation day, credit agreements often contemplate various fallback methods for determining CDOR. One such method is the use of average discount rates applicable to Canadian Dollar BAs, as quoted by one or more reference banks. In the event that reference banks are unwilling or unable to quote, lenders may consider what other options are available to address the issue.
Some credit agreements may also state that CDOR may be determined from the rate quoted on the Bloomberg CDOR Page for the applicable quotation day. If used as a fallback method, this way of determining CDOR is problematic as Reuters calculates CDOR, while Bloomberg lists CDOR. Accordingly, it is difficult to foresee a situation where Bloomberg could list CDOR in the absence of a Reuters listing.
Notably, Canadian Dollar LIBOR cannot be used as a substitute for CDOR as the British Bankers' Association ("BBA") ceased quoting LIBOR in certain thinly-traded currencies, including Canadian Dollars, effective May 31, 2013. The BBA made this decision following the conclusions of the Wheatley Review that these benchmarks were difficult to support using actual trade data and were not heavily used by market participants.
6. Future of CDOR
The BBA's decision to cease quoting LIBOR has had the consequence of drawing additional international attention to the use of CDOR as a commercially-accepted benchmark for pricing Canadian Dollar obligations. For instance, the UK-based Association of Corporate Treasurers has noted CDOR as a possible alternative to Canadian Dollar LIBOR.
With the increasing international focus on the use of CDOR as a benchmark it is perhaps not surprising that CDOR has drawn the attention of Canadian regulators.
Although OSFI's framework has yet to be published, OSFI has stated that the framework can be expected to be "informed, inter alia, by new international expectations and developments, and adapted to the unique characteristics of CDOR". Additionally, OSFI's expectations of reporting participants will be "principles-based and focused on their internal benchmark submission activities and processes." Similarly, the submitters' code of conduct being prepared by the banks on the CDOR panel in consultation with IIROC and the Bank of Canada has yet to be published, but it is known that the code "will specify minimum standards for submission methodology, internal oversight and records retention" relating to CDOR submissions.
We will continue to monitor the ongoing initiatives by Canadian regulators and industry to strengthen the governance of CDOR and will provide market participants with information about any new developments as they arise.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2014