On October 24, 2014 the Financial Services Commission of Ontario (FSCO) published for public consultation a draft investment guidance note entitled Prudent Investment Practices for Derivatives – IGN-002 (Note). The Note, a copy of which can be found here​, applies to pension plans registered in Ontario.

The Note is intended to provide guidance to Administrators with respect to prudent investment practices related to derivatives including guidance to assist Administrators who indirectly invest in derivatives through a pooled fund or master trust arrangement that invests some of its assets in derivatives. The principles outlined in the Note should also be applied to repurchase agreements.

The Note sets out FSCO’s expectations in relation to the Administrator’s standard of care of a prudent person in the administration of a pension plan and how this fiduciary standard must be met in respect of investments in derivatives, specifically (i) Documentation, (ii) Risk Mitigation, (iii) Risk Monitoring as well as outlining risk management practices (RMP) and due diligence procedures for investment in derivatives through pooled funds. Each is discussed in turn below.

Documentation

The Administrator of a pension plan must ensure that the plan’s Statement of Investment Policies and Procedures (SIP&P) documents the authorization for the use of derivatives inclu​ding a listing of each category  of derivative and the proportion of the fair value of the plan’s portfolio that may be invested in derivatives. The extent and terms to which assets of the plan may be pledged as collateral must also be clearly set out in the SIP&P.

The Administrator must establish RMP documentation, review it annually and update it promptly for any change of statutory requirements and investment processes. RMP documentation must include:

  • the uses and strategies to which derivatives will  be put in light of the prudent person rule, the overall investment objectives, risk appetites and risk tolerances of the fund and the nature of the plan benefit liabilities, taking into consideration the funding and solvency of the plan and the ability of the plan to meet its financial obligations
  • risk management considerations which include, among other things, descriptions of the main types of risks associated with derivatives positions, risk measurement methodology, risk mitigation strategies, timely risk monitoring and reporting as well as the establishment of specific and unambiguous limits on derivative activities
  • identifying the individuals or organizational units authorized to trade, settle, value and/or manage the risk created by derivatives positions having regard to segregation of responsibilities and management  oversight

Risk Mitigation

The Note outlines a number of risk mitigation best practices that can be applied by market participants in respect of non-standard OTC derivatives (defined to mean a derivative that does not trade  on an exchange and includes swaps, options and swaptions), exchange traded derivatives and OTC derivatives, whether the investment is done directly by the Administrator or through delegation to an external investment manager. In cases where an external manager is used the Administrator must conduct “appropriate operational due diligence….to ensure that appropriate RMP are employed”. FSCO’s expectations regarding risk mitigation include:

  • Administrators should use independent value measurement methodology for non-standard OTC derivatives and should not rely on counterparties as the exclusive source of derivative values
  • appropriate legal documentation with appropriate collateral requirements should be used with counterparties of non-standard OTC derivative trades and repos
  • appropriate legal advice should be obtained and appropriate legal due diligence completed, including consideration of the ability to contain potential losses
  • the Administrator will not enter into non- standard OTC derivative or repo contracts with a counterparty or associated counterparties where the exposure or mark-to-market position of all contracts with the counterparty or associated counterparties is greater than 10% of the fair value of the fund’s investment assets (net of investment liabilities), or such other limit as may be prudent
  • compensation policies are set so as to discourage excessive risk-taking

Risk Monitoring

The Note reinforces that although derivatives are subject to the same risks as other investments, because of the lack of transparency and the leverage effect of some derivatives, more precise assessment and more frequent monitoring of such risks are required including an evaluation of market risk leverage, liquidity risk, counterparty and basis risk as well as operations and systems risk. FSCO’s expectations regarding risk monitoring include:

  • appropriate mechanisms in place for precise and frequent monitoring of the risks associated with all investment positions, including derivatives
  • fund portfolio monitoring with a view to triggering loss mitigation mechanisms
  • initial approval and ongoing review of counterparties in non-standard OTC derivatives positions performed by persons independent of those engaging in derivative transactions
  • counterparties who suffer a credit rating downgrade by an independent credit rating agency are automatically reviewed
  • ongoing monitoring is conducted to ensure that the exposure or mark-to-market position of all non-standard OTC derivative and repo contracts with a specific counterparty or associated counterparties does not exceed 10% of the fair value of the fund’s investment assets (net of investment liabilities), or such other limit as may be prudent in the circumstances

Pooled Funds And Master Trusts

The Note emphasizes that notwithstanding that a pension fund invests in derivatives indirectly through a pooled fund or master trust arrangement it is still necessary for Administrators to implement appropriate risk management policies and procedures. Before deciding to invest in a pooled fund, Administrators should

  • review available relevant information or disclosure regarding the proposed arrangement
  • consider whether the operation of the pooled fund, as described in its constitutional documents, meets the standards set out in the Note
  • consider the suitability of any investment manager of the pooled fund assets
  • consider any risks associated with the lack of control over the investments in the pooled fund
  • having considered the above factors, consider the percentage of the fund, if any, that it is prudent to invest in the pooled fund; and
  • obtain such independent advice or expertise as is prudent and reasonable

If after due consideration, the Administrator decides to invest in the pooled fund, the Administrator should carry out such supervision or monitoring of the investment as is prudent and reasonable.

Similarly, where all investors in a Master Trust are all pension funds governed by pension plans that have related employers and sponsors, FSCO has an expectation that the investment in derivatives through the master trust, will be made in accordance with the Note.

Deadline for submissions on the Note is November 24, 2014. If you would like assistance in providing comments to FSCO please contact the author or your usual lawyer in BLG’s Pension & Benefits Group. ​

Author

Scott McEvoy 
SMcEvoy@blg.com
416.367.6117

Expertise

Labour and Employment
Labour and Employment Law
Pension and Benefits