In response to perceived concerns about the lack of
understanding of the risks associated with investments in
derivatives, the Financial Services Commission of Ontario (FSCO)
has developed guidelines for pension plans investing in derivatives
and similar financial instruments. Currently in draft form, FSCO's Investment Guidance Note on Prudent
Investment Practices for Derivatives is posted for public
comment until November 24, 2014.
FSCO's Note is framed as a set of expectations of those
investing in derivatives and is intended to serve as a starting
point for plan administrators. It contemplates a system for
internal oversight of derivatives practices that is extremely broad
in scope and will increase the costs to pension plans that invest
directly in derivatives or that invest in pooled funds that use
derivatives. The suggestion in the Note is that prudence might
require more, but not less, rigorous practices.
FSCO's Note sets out explicit expectations for
documentation, risk mitigation and risk monitoring as follows:
Documentation is expected to include
more robust authorization regarding derivatives investment and
collateral use in the Statement of Investment Policies and
Procedures (SIPP) and to include risk monitoring practices (RMP)
policies or guidelines relating to derivatives investments.
Risk mitigation strategies for
over-the-counter (OTC) derivatives should include an evaluation of
pricing and other terms and conditions to ensure they are
appropriate, and standardized netting agreements. Administrators
should also consider appropriate collateral requirements for all
derivatives, impose "specific and unambiguous"
quantitative limits on a fund's exposure to derivatives
(including "soft limits, where positions must be analyzed, and
hard limits, where positions must be liquidated"), and ensure
compensation for staff involved in derivatives activities is set to
avoid undue risk-taking.
Risk monitoring for derivatives is
expected to be more precise and frequent than for other
investments, including monitoring of market risk, liquidity risk,
counterparty risk, basis risk and operations and systems risk.
Scenario analysis and stress testing are expected to be carried
A notable aspect of FSCO's expectations regarding risk
management and monitoring is the setting of a 10% limit on exposure
to derivatives transactions with the same counterparty or
associated counterparties. This is similar to the 10%
diversification rule for investments under Schedule III to the
Pension Benefits Standards Regulations, 1985, which is adopted in
Ontario. FSCO's expectation is that prudence may require a
limit lower than 10% to be set. Such a rule would require new
levels of monitoring of OTC derivative and repo contracts to ensure
that they do not exceed this limit (or such other lower limit as is
set by the administrator).
It is also worth noting that FSCO sets out its expectation that
administrators will implement appropriate risk management practices
and procedures for pooled fund and master trust investments that
engage in derivatives transactions. While FSCO recognizes that it
may not be possible for a plan administrator to ensure that a
pooled fund that is open for investment to unrelated entities meets
the standards set out in its Note, FSCO nonetheless sets out due
diligence requirements with respect to pooled fund investments that
may involve derivatives, including reviewing the pooled fund
constituent documents and considering whether the operation of the
pooled fund meets the standards set out in FSCO's Guidance
Based on our experience, FSCO would welcome comments from the
industry. If you have concerns about the new guidelines, you should
take advantage of the opportunity to provide FSCO with your
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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