Canadian banks permitted to clear derivatives outside country

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A much-anticipated ruling from Canadian authorities, led by the Bank of Canada, allows Canada's banks to clear their derivative trades in other countries, rather than requiring them to build their own costly clearing system at home.

In the wake of the financial crisis, which fed concerns that a complex network of trillions in derivative contracts could have brought down the global financial system in 2008, the Group of 20 countries pledged to make contracts such as credit default swaps more transparent and robust.

Historically, banks negotiated these derivatives "over-the-counter," or privately, and kept few public records of their liabilities, making it difficult to discern who owed what to whom. If the bank on one side defaulted, the other side would be stuck with a loss.

To tidy the mess, Canadian authorities, including the Department of Finance and the Office of the Superintendent of Financial Institutions, followed U.S. regulators and mandated that Canada's banks must "clear" their contracts through central counterparties, or central bodies that keep track of all the outstanding agreements. The clearinghouse would also make good on trades if a bank on one side failed to do so.

However, the authorities had to decide whether it was worthwhile to create Canada's own system, or allow the banks to use existing ones such as the Chicago Mercantile Exchange or LCH Clearnet in London, which were not too active because derivative contracts historically were not legally required to clear through a central body.

After much deliberation, Canadian authorities support using a central counterparty outside Canadian borders because building one at home would be much too costly.

Yet the authorities aren't simply handing over all responsibility to other countries. They have stipulated that the global clearing houses must meet four criteria – something Bank of Canada Governor Mark Carney has preached as head of the international Financial Stability Board.

Chiefly, they must offer "fair and open access" for all market participants so that Canada, or another small market such as Australia, cannot be put at a disadvantage simply because it does not have the same scale as the U.S.

The other criteria include: the need for regulatory oversight; mechanisms to ensure that the central bodies survive major crises; and setting up emergency liquidity arrangements in different currencies.

So far, existing clearing houses have shown they are willing to abide by these rules. In a statement Monday, the Bank of Canada said it is "satisfied with the direction and pace of the international efforts on the four safeguards, including with regard to implementation at global [central counterparties] serving the Canadian market."

The central bank's decision had been anticipated; earlier this year, some members of the Big Six banks began testing a U.S. clearing system in Canada. Early on in the review process, it became obvious to them that Canada did not have enough derivatives volume to justify creating its own central clearing body.