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The Globe and Mail

A Canadian solution needed for OTC derivatives trading

Once a month, the chief executives of the country's six big bank-owned securities firms and top officials at the Bank of Canada gather to find a solution to an arcane but critical problem that will help to define Canada's future as a financial centre.

Few outside the industry know they are happening. Yet, aside from keeping the economy rolling, and Canadians from loading themselves up with too much debt, the subject of the meetings is one of the highest priorities for Bank of Canada Governor Mark Carney in the short term.

This group of bank executives is charged with making the call on how to move Canada's over-the-counter (OTC) derivatives trading onto a central clearing platform, a big goal of international financial reform, and doing it fast. They have only two years to make it happen under a commitment Canada made as part of the Group of 20.

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The executives must choose and implement a solution that balances the reality that Canada is a small player in global derivatives trading with the desire to ensure that the country remains a strong, sovereign player in finance.

"The market is slowly coming to realize the impact of all of this reform, and it's transformational," said Glenn Goucher, head of clearing at market operator TMX Group Inc., which is pitching a solution. "It's hitting the awareness at the most senior levels now."

Right now, OTC derivatives deals are done one-on-one between banks and other financial institutions. That means a risk that if one party to the trade goes bankrupt, the other won't get paid. The financial crisis and the failure of banks like Lehman Brothers Holdings Inc. highlighted that risk, as banks started to fear trading with one another, deepening the shock to markets.

For regulators looking to stop future panics, the plan is to require that such trades in future go through a clearinghouse, much like stock trades already do. In that case, each side deals with the clearinghouse, which has the financial backing of many trading firms. If one fails, the clearinghouse still has the financial strength to make good on all the trades.

The Bank of Canada's position has been that it is up to the banking industry to come up with a solution for clearing OTC derivatives, but whatever is done should preserve Canada's stature as a financial centre.

"We are firmly in the Mark Carney camp here," Ed Clark, chief executive officer of Toronto-Dominion Bank, said in an interview. "Toronto by market capitalization is the second most important financial centre in North America. So I would say that if the world is going down this [path] can we find a Canadian solution?"

For Canada's biggest banks, the easy way out is just use the big clearinghouses that already exist in places like London and Chicago. But that risks ceding expertise and clout in derivatives, a market that for all its perceived troubles and dangers is still hugely important to banks and finance. That solution also puts smaller Canadian banks at a disadvantage, because they don't have the heft to be members of the international clearinghouses, and leaves the Bank of Canada at risk of losing regulatory oversight.

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For that reason, the optimal answer for Canada appears to be creating a derivatives clearinghouse here in Canada that is linked to those in other countries. The Bank of Canada could still play cop and products could be tailored to Canada's market need. The links would mean the local operation would be able to access international markets, which is key because more than half of the OTC derivatives trading by Canadian banks involves foreign banks on the other side of the deals.

However, that solution is also the most complicated. Where links have been tried, such as with European stock trade clearing, they have not yet succeeded.

Mr. Goucher of TMX, which is pushing a plan involving links, say it can be done by 2012 if decision making happens quickly. Mr. Clark isn't so sure, but he says that shouldn't stop the focus on the idea.

"We may well end up having to have interim solutions that allow banks to play on the existing clearinghouses but what I think Mark Carney wants from the Canadian banks is a firm commitment if they allow those interim solutions, that that doesn't mean we will then say why would we bother spending the energy creating a Canadian thing?" Mr. Clark said.

Mr. Carney isn't likely to give up easily on the Canadian solution, Mr. Clark said.

"This is again one of the great features of Canada. The six bank CEOs can get in a room with Mark Carney and he can say if you want to be able to do that, I want your personal word that I will get this commitment. And if six months from now you're not doing it, you're going to hear from me [and]you're not going to like the telephone call you'll get. That's how we'll settle this."

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