Office of the Superintendent of Financial Institutions
OSFI is issuing the final version of the Derivatives Sound Practices for Federally Regulated Private Pension Plans Guideline, which replaces the 1997 guideline “Derivatives Best Practices”. The purpose of the Guideline is to communicate OSFI’s expectations of federally regulated private pension plans with respect to their derivative activities.
The new Guideline builds on the 1997 version by reflecting current practices with respect to the risk management of derivatives activities, and covers both exchange traded and over-the-counter (OTC) derivatives. The Guideline also sets out OSFI’s expectations for plan administrators who invest in derivatives indirectly through various types of funds, including pooled funds and hedge funds.
OSFI expects plan administrators to consider how this Guideline applies to their pension plan, keeping in mind the plan’s investment objectives, risk tolerance and other relevant factors. Prudence may require some plans to have more rigorous practices and procedures than others, depending, for example, on the scale and complexity of their derivative activities. Prudence may also lead an administrator to a determination that derivative transactions, or certain types of derivatives, are inappropriate for a particular pension plan. It is the responsibility of the plan administrator to make these determinations.
The Guideline incorporates several revisions resulting from comments received during the public consultation process, which began in July 2017. The attached table (Annex 1) summarizes the comments received from stakeholders and provides an explanation of how they have been addressed. We thank all those who participated in the consultation process.
Questions and comments on the Guideline can be sent by email to Chris Eccles, Senior Pension Analyst, Private Pension Plans Division Christopher.Eccles@osfi-bsif.gc.ca.
Definition (Section 1.0)
The definition of derivative that is used in the guideline is broad and in addition to covering traditional derivative contracts (options, futures, etc.), may capture securities which are technically not considered derivatives (e.g. direct bond and stock holdings).
It would be helpful to obtain clarification on how non-traditional exposures are considered. For example, repurchase agreements (repos) may not be considered by some to be derivative contracts but their value is determined by fluctuations in some underlying interest.
Many repurchase and securities lending arrangements are similar in structure and economic result to many of the financial instruments addressed by the Draft Guideline. In light of this, OSFI should consider what application, if any, the principles articulated in the Draft Guideline may have with respect to those arrangements.
No change has been made to the definition that is used in the Guideline. The definition is based on the definition of “derivative” used in the Bank Act and in the OSFI B-7 Derivatives Sound Practices Guideline. Plan administrators can use their judgement when determining how the definition should be applied.
Section 2.0 of the Guideline was amended to provide that while the Guideline is intended to address sound practices regarding investment in derivatives, other financial instruments (e.g., repurchase agreements) may exhibit some of the same risks. Plan administrators should consider applying similar prudence and risk management processes and procedures in respect of those financial instruments in order to guard against similar risks.
Use of Derivatives (Section 2.0)
Risk management for pension plans should take into account both plan assets and liabilities, and the potential interaction between the two. Section 6 of the Guide should also be reviewed to ensure that the focus is not solely on assets, but the impact on the entire plan.
In the first sentence of Section 2.0, the words “asset and/or funded status” could be included immediately before the word “risks”.
In the third sentence of Section 2.0, the words “hedge a part of interest rate risk inherent in liabilities or” could be included immediately after the words “derivative transactions to”.
The words “and risk management” could be included after the words “pension fund’s overall investment” in the second paragraph.
Section 2.0 of the Guideline has been amended to provide that risk management strategies should take into account both plan assets and liabilities. Section 6 was reviewed and no changes were deemed necessary.
Suggested change has been made.
Documented Policies and Procedures (Section 4.2)
A plan’s documented policies and procedures should include a “detailed” description of authorized derivative investment strategies including the objective of the strategy.
A plan’s documented policies and procedures should be reviewed at least annually, due to the rapidly changing environment of derivative strategies.
As derivatives can be high-cost investments, the issue of cost should be explicitly addressed.
Section 4.2 of the Guideline has been amended to require a detailed description of authorized derivative investment strategies including the objective of the strategy. The description should indicate whether the objective is for hedging, portfolio rebalancing or return seeking purposes.
The Guideline has been amended to require that the policies and procedures governing the use of derivative be reviewed at least annually.
The Guideline has been amended to provide that the pension plan’s risk management framework should include documented policies and procedures for identifying and evaluating the costs associated with any derivative transaction.
Types of Risk and Risk Mitigation Techniques (section 5.0)
The suggestion that a plan administrator should exercise appropriate oversight to ensure that the external manager is following best practices for risk mitigation suggests a frequency of on-going oversight informed by a level of sophistication requiring an understanding of best practices that would be unrealistic for most plan administrators to meet.
The Guideline has been amended to provide that rather than performing on-going oversight of an external managers risk mitigation practices, a plan administrator should exercise appropriate due diligence before delegating authority to ensure that the external manager has established best practices for risk mitigation. Section 10 of the Guideline has been amended to provide OSFI’s expectations for the due diligence process.
Market Risk (Section 6.0)
Risk management for pension plans should take into account both assets and liabilities, and the potential interaction between the two, and therefore that risk management should be viewed in the context of the entire plan and not solely in terms of the assets (i.e., the fund). For the most part, the Guideline has also been drafted with this perspective; however, there are a few instances where this could be further reinforced. Section 6 could be reviewed to ensure that the focus is not solely on assets, but the impact on the entire plan.
Monitoring Market Risk and Leverage
A description of leverage use should be added to the Guideline.
Measures of risk should be considered on the entire pension plan level and not just on the individual derivative strategy.
When establishing limits on the permitted amount of exposure when it comes to leverage, the limit should take into account the overall exposure of the pension plan from all derivative exposure.
We propose that you add the concept that market risk as systemic risk will impact other risks differently so those other risks should be considered when examining market risk. This can be achieved by adding the phrase “in combination with other types of risk” to market risk.
Independent Pricing and Value Measurements
It is not clear whether OSFI expects an independent valuation to be performed by a third party that is not a party to the ISDA Agreement, or whether an independent valuation could be performed by the pension plan administrator where it has the expertise to value derivatives. It was also recommended that administrators consider seeking independent valuation inputs, rather than being required to do so.
As described above, changes were made to Section 2.0 to reflect this comment. Section 6 was reviewed and no changes were deemed necessary.
A description of leverage use has been added to section 6.1 of the Guideline.
Section 6.1 of the Guideline has been amended to require market risk and leverage use to be measured at the level of the pension plan.
The Guideline has been amended to provide that when setting limits on leverage, the plan administrator should take into account the pension fund’s overall exposure from all of the derivative transactions that the plan has entered into.
No change has been made to the Guideline. Section 11 of the Guideline states that plan administrators should, as appropriate, conduct stress testing of the pension plan’s derivative transactions under various market conditions and scenarios. This would include how market risk impacts other types of risks. Stress testing procedures should include the likelihood of adverse events affecting derivative exposures (including adverse market movements, heightened counterparty credit or liquidity risks, or other possible events) to ensure that the plan administrator is aware of potential losses that the plan is exposed to from its derivative transactions.
The Guideline has been amended to clarify that a plan administrator should consider seeking independent valuation inputs and that the independent valuation can be performed by the pension plan administrator where it has the appropriate expertise.
Mitigating Counterparty Credit Risk (Section 7.1)
It is not clear whether the guideline suggests that low credit counterparties may be acceptable, if the level of volatility is limited.
The section refers to numerous counterparties so the implication is that it is good to diversify risk though multiple counterparties. We suggest stating explicitly that best practice is to diversify counterparties.
This section of the Guideline refers to both “close-out netting” and “payment netting” in connection with the appropriate legal due diligence. Close-out netting is the most relevant concern with respect to counterparty credit risk. Payment netting is more of an operational consideration.
To eliminate the suggestion that low credit counterparties may be acceptable, the Guideline has been amended to delete the reference to limiting investments to less volatile derivative transactions.
The Guideline has been amended to state that a best practice is for plan administrators to diversify their counterparty exposure by limiting the concentration of their derivative positions per counterparty and be satisfied that any counterparty risk is properly factored into margins and requests for collateral.
The reference to payment netting has been deleted.
Mitigating Operational Risk (Section 9.0)
The Guideline should indicate that plan administrators need to establish an appropriate framework and infrastructure before entering into derivative transactions, as well as the importance of on-going education for key decision makers.
Section 9.1, “Regulatory Compliance”, the word “reporting” in the second paragraph, second sentence is unnecessary and it should read “… may be subject to specific regulatory requirements for registering, central clearing, risk mitigation and trade reporting if they transact in OTC derivatives”.
Section 9.1 of the Guideline was amended to require that before entering into a derivative transaction, a pension plan is to have controls in place to manage operational risk. A bullet was also added to this section to state that staff who are involved with making decisions regarding the use of derivatives should be provided with on-going education
Suggested change has been made.
Indirect Investment in Derivatives (Section 10.0)
More clarity should be provided as to OSFI’s expectations regarding the plan administrator’s oversight process when it comes to indirect investments in derivatives.
Section 7.0 of FSCO’s Investment Guidance Note titled “Prudent Investment Practices for Derivatives” should be considered in order to addresses the practical considerations that plan administrators should consider in the due diligence process.
While the pension plan needs to be aware of the practices and controls, it is not clear whether there are specific expectations around what information is retained and in what way. To avoid misinterpretation, it would be useful if the guideline:
Section 10.0 of the Guideline has been amended to provide OSFI’s expectations regarding the due diligence process that a plan administrator should undertake before investing indirectly in derivatives. FSCO’s “Prudent Investment Practices for Derivatives” Guide was reviewed to ensure consistency with the additions that were made to section 10.0.
Section 10 was amended to provide that the plan administrator should carry out such supervision or monitoring of the investment as is prudent and reasonable. This may include obtaining periodic compliance certifications from the external manager.
Third bullet in section 10 states that the plan administrator should consider whether the internal control procedures and risk management framework appropriately mitigate the risks that are set out in Sections 6 to 9 of the Guideline.
A bullet was added to section 10 to require the plan administrator to document the procedures that were performed to validate the external manager’s overall internal control procedures and risk management framework.