Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 27 - Evidence - November 21, 2012

OTTAWA, Wednesday, November 21, 2012

The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:18 p.m. to study the subject- matter of those elements contained in Divisions 1, 3, 6 and 14 of part 4 of Bill C-45, A second Act to implement certain provisions of the budget tabled in Parliament on March 29, 2012 and other measures.

Senator Céline Hervieux-Payette (Deputy Chair) in the chair.


The Deputy Chair: Welcome to the Standing Senate Committee on Banking, Trade and Commerce. Today, the committee is holding a fourth meeting within the framework of its study of certain provisions of Bill C-45, A second Act to implement certain provisions of the budget tabled in Parliament on March 29, 2012 and other measures.

At this meeting, our committee will be looking at one of the provisions of this act. We shall look at division 3 of part 4 which amends the Canada Deposit Insurance Corporation Act, to, among other things, provide for a limited, automatic stay in respect of certain eligible financial contracts when a bridge institution is established. It also amends the Payment Clearing and Settlement Act to facilitate central clearing of standardized over-the-counter derivatives.

I will now introduce the witnesses with us today: from the Canadian Derivatives Clearing Corporation, Glenn Goucher, President and Chief Clearing Officer, and from the Montreal Exchange, Pauline Ascoli, Vice President, Legal Affairs (Derivatives).

Welcome to both of our witnesses.


Glenn Goucher, President and Chief Clearing Officer, Canadian Derivatives Clearing Corporation: Thank you, ladies, gentlemen and members of the Standing Senate Committee on Banking, Trade and Commerce. I will read a few prepared remarks; my colleague will join me. At the end, we would be happy to take your questions.

As President and Chief Clearing Officer of the Canadian Derivatives Clearing Corporation, it is my pleasure to make some short introductory remarks on Bill C-45, A second Act to implement certain provisions of the budget tabled in Parliament on March 29, 2012 and other measures, to be entitled the jobs and growth act, 2012. My particular focus and interest is on Part 4, Division 3, entitled ``Preserving the Stability and Strength of Canada's Financial Sector.''

As you well know, at the Pittsburgh Summit in 2009, Canada agreed that:

All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties . . .

The CDCC has spent considerable time, energy and resources over the past three years preparing to become Canada's premier central clearing counterparty.

In order to facilitate the clearing of OTC derivative transactions, it is imperative that the Canadian legal system provide legal certainty to all participants in the clearing process. Although the Canadian legal system is robust, perhaps further amendments to Canadian insolvency legislation — namely the Bankruptcy and Insolvency Act, the Companies' Creditors Arrangement Act and the Winding-up and Restructuring Act — are needed to further enhance this legal certainties.

We welcome Bill C-45, which recognizes that certain minor gaps needed to be addressed to give better certainty to market participants. More generally, we welcome Parliament's recognition that the stability of the financial system and maintenance of efficient markets are important to the health and strength of the national economy.

I would like to address only two aspects of Bill C-45 today. The first is addressing definitional issues in the Payment Clearing and Settlement Act, and the second is addressing the effect of stays under the Canada Deposit Insurance Corporation Act.


Pauline Ascoli, Vice President, Legal Affairs (Derivatives), Montreal Exchange: I will first address definitional issues in the Payment Clearing and Settlement Act. The notion of clearing and settlement system is defined in section 2 of the PCSA and it includes conditions which must be met.

One condition set forth in c) states that the payment obligations that arise from clearing within the system or arrangement are ultimately settled through adjustment of accounts of one of or more of the participants of the bank. Some commenters have requested that this requirement be removed in respect to a system or arrangement for the clearing or settlement of derivatives contracts, and Bill C-45, as it currently reads, removes this requirement.

The effect of this amendment is to remove the need for a designated clearing and settlement system to settle Canadian dollar payments in central bank money. This implies that such payments would be settled through a Canadian chartered bank or perhaps a foreign bank.

The use of non-central bank money will expose the applicable designated system to greater credit risk and perhaps greater liquidity risk. We note that this could potentially increase systemic risk in Canada.

I would like to draw your attention to Principle 9 of the CPSS IOSCO Principles for Financial Market Infrastructures dated April 2012, which states that:

An FMI (refers to a financial market's infrastructure) should conduct its money settlements in central bank money, where practical and available, to avoid credit and liquidity risks.

It also states that if central bank money is not used, an FMI should conduct its money settlements using a settlement asset with little or no credit or liquidity risk.

By removing this condition altogether, the legislation becomes inconsistent with the PFMI principles. We therefore respectfully submit that this section should be revised to reflect that as a general principle, central bank money is to be used in the case of a system or arrangement for the clearing or settlement of derivative contracts.

It is our view that it is too early to consider exceptions to this principle and that in the event that Parliament wished to introduce exceptions, further parameters should be set as to what constitutes using a settlement asset with little or no credit risk.

In sum, we continue to oppose the implicit carte blanche given to use of non-central bank money for settlements by an FMI and ask that the Senate reconsider this provision. .


Mr. Goucher: I would like to move to the second part of our speech now and address the effects of stays under the Canada Deposit Insurance Corporation Act.

Under existing legislation, when a bank is subject to a receivership under the Canada Deposit Insurance Corporation Act, the federal government may incorporate a bridge bank to take over its assets and run the bank until such time as it can sell the bank.

CDCC welcomes the fact that Bill C-45 now clarifies in a new subsection — namely subsection 39.15 — that clearing houses whose systems have been designated as systemically important will not be subject to this temporary bridge bank stay. CDCC's clearing system was designated systemically important by the Government of Canada on April 27, 2012. This exception is consistent with worldwide market reforms and paves the way for standardized OTC derivatives to be cleared by a Canadian-based clearer.

The proposed changes will enhance the stability of clearing houses by ensuring they can quickly apply their default rules as against a defaulting member and, importantly, will better client protection by ensuring that a clearing member's insolvency will not hinder the transfer to new clearing members of client positions. In our view, it would be useful to provide express protection for porting client positions to new clearing members where the porting process does not involve termination of the cleared transactions.

CDCC also welcomes the broadening of section 13.1, which now references:

. . . collateral that has been granted to it as security for the performance of an obligation incurred in respect of the clearing and settlement services provided by the securities and derivatives clearing house.

We interpret this as applying not only to collateral held by a derivatives clearing house generally but also to the default funds that mutualize risk of other clearing members defaulting.

Thank you for your kind attention. That is the end of our prepared remarks.


The Deputy Chair: Ms. Ascoli, you were very clear on the issue of introducing a risky measure that would put Canada in a separate category. When you speak of a separate category, are you referring to OECD countries in general?

Ms. Ascoli: Can you please repeat the question?

Senator Hervieux-Payette: When you say that Canada would not be respecting the Principles for Financial Market Infrastructures, are we dealing with a world standard or a standard within OECD countries?


Mr. Goucher: This is a standard that has been developed by these two separate organizations. CPSS is the Committee on Payment and Settlement Systems out of Basel, and IOSCO is the International Organization of Securities Commissions, and they have jointly developed a set of best principles for clearing houses, which is a global standard applying to every country.


The Deputy Chair: How many countries comply with this principle?


Mr. Goucher: I do not think the question is how many countries. The question is how many clearing houses. Any clearing house in the process of or wishing to clear OTC derivatives must respect these principles.

The Deputy Chair: We would be apart?

Mr. Goucher: The principles are guiding principles, and we noted that there is an option that, if central bank money is not used, there is another further requirement. In the instance, in our rules, we are recognizing the fact that it may be possible not to use central bank money for the Canadian marketplace.

The Deputy Chair: However, representing higher risk than if the Canadian central bank was involved?

Mr. Goucher: Yes.

The Deputy Chair: Maybe other people want to clarify this because you have one point where you praise the government and say that everything is fine and another one where you say that, really, we have to look at it. Maybe look at what the avenues are or what kinds of amendments we could bring to the legislation so that we can comply with all other clearing houses.

Senator Massicotte: Further to that same line of questioning, the part that you do not like is that a clearing house could be a non-central-bank guarantee. You are the expert; I am not. However, I would sort of say that that is right. If you deal with the Bank of Nova Scotia, the credit risk is higher than with the central bank. Therefore, why do the parties to the transaction not adjust for that risk? Maybe the stretch would be a bit higher, but it cannot be that significant. Am I missing something here?

Mr. Goucher: The issue is that, without picking on any particular financial institution, there is a difference between a commercial bank and a central bank. The challenge is to guarantee settlements and payments. If a payment and settlement agent — if it is a commercial bank — is responsible for systemically important payments and that particular institution is in a credit crisis, the concern would be how to ensure that the Canadian system works in an event where a commercial financial institution was, perhaps, in jeopardy. That is the concern being expressed. It is, we would hope, a low probability event, but that is what the PFMIs are addressing when they point out that the preference would always be to use central bank money, where available.

Senator Massicotte: You are concerned that the clearing house per se could be part of the systemic risk issue, and, therefore, the problem would get bigger. The objective was to get around that issue, to clear it to know where everyone stood.

Who chooses the clearing house? Is it the Government of Canada who will choose the clearing house?

Mr. Goucher: As it relates to the OTC derivatives market, there is no current OTC clearing organization. CDCC is presently not clearing OTC derivatives. Our banks and financial institutions are using foreign clearing houses for that activity right now.

Senator Massicotte: Does the government have to approve the solvency of that entity to allow it to be acceptable?

Mr. Goucher: There is where CPSS-IOSCO kicks in. This is a very small part of a total framework on safety and soundness for clearing houses in general; this is one of the requirements. The regulatory environment in Canada will have some responsibility to ensure that those clearing houses are meeting those standards.

Senator Massicotte: Your issue is very appropriate. I presume that the choice would be made such that that organization would be independent of any inherent, systemic risk in Canada to avoid the risk that you are talking about. I agree that there is a covenant risk, which is obviously higher than with the central bank, but at least you avoid the systemic risk that you are worried about. Am I correct?

Mr. Goucher: That is correct. The systemic question is being addressed with the use of the clearing house, regardless of whether it is in Canada or in another marketplace. This is a small piece of the arrangement that we would be subject to some incremental risk as a result of.

Senator Massicotte: What did the government officials say to your suggestion?

Mr. Goucher: The government officials, when we would have this conversation, would recognize that this is not the best because central bank money is the best solution. They would likely insist that any other clearing house using non- central-bank money have certain safeguards and processes in place to ensure that payment and settlement continues in a stressed environment.

Senator Massicotte: You are concerned that that choice will not be satisfactory to your clients?

Mr. Goucher: Potentially. That would be the concern that we would like to highlight for everyone to be aware of in this situation.

Senator Massicotte: Thank you.

Senator L. Smith: Following up on the deputy chair and Senator Massicotte's questions, as you look at the major financial institutions in Canada, do you have any input as to which one of them should be deemed a clearing house?

Mr. Goucher: The clearing house decision is made by all of the banks. That is not a decision that we make as the clearing house. We have to offer the service. Today, the Canadian banks could not choose CDCC as a solution for their interest rate swap clearing. The banks, individually, make those decisions on the best forms of liquidity and where they have the best entity to support their customers' activity. They would choose their clearing houses appropriately.

Senator L. Smith: Is it the Bank of Canada or the governor of OSFI who oversees that function to ensure that they do everything that they are supposed to do?

Mr. Goucher: There is a whole host of regulators that get involved with that decision making. The Bank of Canada has principal responsibility for the systemic risk, in conjunction with the Canadian Securities Administrators. That involves Finance, as well as all of the securities commissions. They are putting together the regulatory framework now to ensure that those decisions are the best decisions.

Senator L. Smith: Do you see it evolving to the point that the Bank of Canada would ultimately be the central clearing house?

Mr. Goucher: I do not think the Bank of Canada will become a central clearing house. The intention, globally, is that, for the most part, clearing houses are generally privately owned entities that are held to a series of rules — the CPSS-IOSCO framework. It is not the role of the central bank to provide clearing services for the OTC market; that is it not one of its functions.

Senator Massicotte: But you are asking the government to support that swap?

Mr. Goucher: We have an account with the Bank of Canada in making our payments for our current business. All of our payments are done through the Bank of Canada.

Senator Massicotte: Through the payment system.

Mr. Goucher: Yes. This change is allowing for payments to be made outside of the central bank.

Senator Tkachuk: Your concern is that, for a commercial bank, there would be a little risk. Not big risk but little risk. Would you not be taking into account that you are not dealing with the central bank but with the Bank of Nova Scotia or the Bank of Montreal?

Mr. Goucher: Yes. To be clear, there would be backup banks, and there are mitigating strategies to avoid that worst- case scenario. Historically, before these new guidelines were put into place, the practice was that clearing houses used commercial banks to effect payment and settlement. Moving to central bank money is a very recent phenomenon in terms of regulatory reform. Traditionally, commercial banking payment and settlement was the norm. The principles articulate only that a better situation, where possible, is to use central bank money where appropriate and, if it is not available, to have other standards in place.

Senator Tkachuk: That is missing, or that is not missing? I am not sure exactly what your point is here.

Mr. Goucher: What I am saying is that, in the principles for best practices, best practices would be to use central bank money, but that is best practices.

In the instance where central bank money was not available for some reason, it is probable and required that you would have to use a commercial bank. The system will function as designed; it just has that different and smaller risk that commercial banks are not central banks; and that is all we are saying.

Senator Tkachuk: If a commercial bank exposed itself, for whatever reason, to a position where it was in danger of not successfully continuing its enterprise, would the other banks not step in? Would the central bank not have a role to play? Would the Government of Canada not have a role to play?

Mr. Goucher: That moves us into a place of moral hazard that we try to avoid with all of these principles. We try to engineer and develop the central counterparty role so as to avoid that type of moral hazard. In practice — and this is where I was suggesting that historically to minimize that commercial banking risk — we have multiple commercial banking relationships. In the event that the primary bank was experiencing difficulty, you would move the payment and settlement function to another bank. We would not step in. We would do that in advance. I speak broadly from the clearing industry in general.

Senator Tkachuk: When that bank was in trouble, you would remove that risk to another bank that was not in trouble.

Mr. Goucher: You would mitigate that risk, hopefully. Our job in running central counterparties is to manage to the worst-case scenarios. We design ourselves to manage against things that we do not like to think about. We concern ourselves with having multiple banks in difficulty simultaneously. That is why, in the end, the best solution is central bank. However, as I said, there are many different strategies to mitigate that risk from the system as a whole.

Senator Ringuette: You have brought another angle to the clauses that we are studying.

Essentially we are talking about the clearing of derivatives. You talk about the Canada Deposit Insurance Corporation Act, which is guaranteed by the Government of Canada, that is, the taxpayers of Canada, to a certain level of deposit in our commercial banking system. Are you saying that with these changes, the taxpayers would be involved, through the Canada Deposit Insurance Corporation Act, for the clearing of those derivatives?

Mr. Goucher: I absolutely am not saying that. That is the easy part of this answer.

Bill C-45 is a large bill with many different components. The piece around the CDIC is unrelated to that previous discussion. It is related only in the context of the bridge bank facility when it was originally proposed for the clearing house to operate so we do not pass on incremental risks. We have to have the right of the first call on any pledged assets. The original drafting of the law as proposed made some confusion over who had first priority. It has been cleared up; and we are happy with where it is now.

Senator Ringuette: Where is it?

Mr. Goucher: The clearing house has first call on deposits to the clearing house in the event of the insolvency of a bank, which allows us to manage the risks associated with the unwinding of those positions that are with the clearing house away from the trustee process for the defaulting bank.

The Deputy Chair: We are talking about derivatives, but not in general. Who is trading these derivatives and on behalf of whom? Is it just institutional, or is it also related to individuals?

Mr. Goucher: Generally when we are speaking of OTC derivatives, we are talking about the largest financial institutions in the country. The market being serviced here is not for individuals.

The Deputy Chair: Are we talking mainly about banks?

Mr. Goucher: Banks, pension funds, insurance companies.

The Deputy Chair: I suppose you do not exist by prayers alone, and there is a fee. To operate this clearing house, who is paying what for the transaction? There must be a small token somewhere. Probably you are paid a salary.

My question is this: If we were switching to another institution, would there be a benefit to them to do that? Would there be a profit for them?

Mr. Goucher: Not quite the Tobin tax. Yes, we do work in the financial services sector; and fees are paid for this service. It is not a public utility. Every clearing house in general runs with a different commercial model. Some are member-owned utilities that charge membership fees and then transactions are not charged on an individual basis. Other clearing houses charge on a transaction-by-transaction basis for this service. In general, there is a wide range of different clearing houses, between for-profit, full for-profit and full industry utility globally that would provide these services.

The Deputy Chair: If we keep the Bank of Canada in the loop, is it an expense for the bank or a revenue, no matter the amount?

Mr. Goucher: The Bank of Canada oversees another system called the Large Value Transfer System, LVTS, which effectively is the infrastructure we speak of right now. I am not aware of the commercial nature of the LVTS service. There is a fee for participating, but it is not transaction-oriented, so I could not comment.

The Deputy Chair: We are talking about a daily operation, something that happens every day, all the time.

Mr. Goucher: Yes.

The Deputy Chair: What would be the average amount in Canada per day going through a clearing house?

Mr. Goucher: That depends on how you would like that measured.

The Deputy Chair: Are we talking about hundreds of millions or billions?

Mr. Goucher: In context, on a notional basis at CDCC today for exchange-traded derivatives, we have notional amounts in the hundreds of billions of dollars being transacted daily.

The Deputy Chair: My colleague certainly would appreciate knowing that this is a big figure.

What is the status of U.S., Germany and Japan with the system?

Mr. Goucher: Those are the three jurisdictions that have the most advanced clearing houses probably in the world. The Europeans, through LCH in London, have the most advanced OTC clearing infrastructure globally. I will misquote their actual numbers, but I believe that they have cleared $300 trillion in OTC swaps. In the United States, there are two OTC clearing houses, CME Group and ICE, with different markets. They are both newer developments but growing quickly to support their marketplace. The Germans recently launched interest rate swap clearing last month, I believe; it is a new facility.

There are new clearing houses or existing clearing houses providing OTC clearing services in Japan, Singapore, and Hong Kong. CDCC will provide OTC clearing services in the future. It is a fallout from the reform process, but it is a big part of the financial landscape today.

The Deputy Chair: Which organizations is the Canadian Derivatives Clearing Corporation attached to?

Mr. Goucher: We are a wholly owned subsidiary of the Montreal Exchange, which is a member of the TMX Group of companies in Canada. We are unaffiliated with any of those other organizations.

The Deputy Chair: You are not affiliated to the U.S. or to England?

Mr. Goucher: Not at all.

The Deputy Chair: It is a Canadian —

I think it is important.

Mr. Goucher: I do not want to go back there. That was last year's story.

The Deputy Chair: We know that if you mention Europe, many countries are dealing with —

Mr. Goucher: Many countries are dealing with the same issues simultaneously right now.

The Deputy Chair: What is the point of view of your Canadian banks and other financial institutions? Do you think they would have some reservations with the new system, or would they be more inclined to support the system that is now being proposed in the legislation?

Mr. Goucher: Without representing the Canadian banks, I believe the only systems that are available to them today for meeting the Canadian G20 commitments and for commercial reasons, since other jurisdictions have adopted similar legislation — I speak particularly about Dodd-Frank — for commercial reasons, they have to be clearing their swaps now. I think that if they had a preference, they would always prefer to settle central bank money, but on a daily basis they transact billions and billions of dollars through other commercial arrangements. Therefore, this would not be entirely untoward for the banks.

The Deputy Chair: Could you define the risk? Is the risk related to the currency? You mentioned in your presentation the Canadian dollar. At least it is quite a strong currency. Does the euro or any U.S. denomination going up and down make a difference for a user of the clearing house?

Mr. Goucher: It should not. The derivatives contracts we are speaking of are denominated in every currency. We are speaking only of the Canadian dollar-denominated derivatives market in this context, but it is unrelated to the value of the currency.

The Deputy Chair: That means that even if you talk about the Canadian dollar, these derivatives are not necessarily in Canadian dollars?

Mr. Goucher: We speak of the Canadian dollar because in Canada we only settle Canadian dollar.

The Deputy Chair: I think it is good to know.

Senator L. Smith: I want to ask about the ultimate control mechanism to ensure the integrity of the system for derivatives. We heard about the crash in 2008 and all the problems in the U.S. and throughout the world. What mechanism is the ultimate control lever, if you want, for the Canadian banks that are playing in this market?

Mr. Goucher: There is the banking oversight through OSFI, because there is a tie-in in terms of capital and charges for capital for the use of non-cleared versus cleared derivatives. That is a newer form that starts as well. The ultimate control rests with groups like the Financial Stability Board, globally, which sets those best practices conditions for the use of a CCP. The CCPs themselves are highly regulated entities.

Our ability to perform the systematically important function is subject to oversight by the Bank of Canada, as well as the securities regulators in our country. In other countries, they have similar oversight regimes.

Senator L. Smith: There seem to be some players involved in this process. Is the system going to be effective enough to ensure there will be no manipulation? I am sorry to be stupid, but I do not have the same sense of sophistication you guys have.

Mr. Goucher: It is the world we live in, and what you speak of is regulatory arbitrage. It is a bit off-topic, but it is a concern for all of us in terms of the changing regulatory regimes, globally, right now and the ability for participants to move their OTC business to one jurisdiction or another to perhaps avoid some higher oversight regime.

All the reforms that have been designed to date have been very tailored to ensure as much as possible that such a thing cannot happen. Home jurisdiction regulation is designed to ensure that business cannot move to less regulated jurisdictions.

Senator L. Smith: Within the system that exists as you see right now, will it be agile enough and responsive enough to oversee and assure the integrity of the system, or will that evolve over time?

Mr. Goucher: We are talking about global financial reform, and saying that would be agile is probably a bit of a stretch. I do believe that the commitment and effort is there to ensure harmonization of regulatory regimes to allow us to have that type of flexibility you are speaking about in the future.

Senator L. Smith: Or to make sure you do not play in areas that do not have that, correct?

Mr. Goucher: Regulatory arbitrage is a very focused part of any conversation that is going on in the reform process to ensure that this does not occur.

Senator Massicotte: I am curious: Who is looking to create these clearing houses? They must be subsidiaries of large, existing financial houses.

Mr. Goucher: Regarding the evolution of clearing houses, regulatory reform and change in general spawns, I would say, innovation. Prior to this reform, there existed many clearing houses, generally attached to exchange groups; the CME, Eurex, the New York Stock Exchange, NASDAQ all had clearing houses for different businesses, not for the OTC markets. However, in general, most countries and most exchange infrastructure had clearing capacity.

In every country, clearing houses are developing either as government-sponsored industry utilities or for-profit enterprises, subject to the same regulation, where they believe they offer some form of competitive advantage vis-à-vis their peers.

The market is evolving. Clearing, in general, is effectively the plumbing of our system. The nice thing about plumbing is you can add different pipes to the plumbing and it still works.

Senator Massicotte: I suspect it is a big back-room operation, and I suspect there must be economies of scales. I gather some other witnesses are saying maybe this will be an international group, not necessarily a Canadian group. Is it coming out that we have three or four persons offering the service worldwide?

Mr. Goucher: That is a fair comment. In general, this is evolving. There are two or three institutions that are offering effectively global services, and there are benefits to the Canadian participants for being in these global infrastructures.

These are competitive clearing houses in some instances for us. However, it is clear that they offer economies, because of these scale issues and the business they are doing, to our Canadian participants, which means there is some value for them to participate in this global infrastructure.

Senator Massicotte: Much of the role of those clearing houses is what I call a transparency accounting thing. They do not guarantee obligations of one insurance swap from one institution to another. They just assure full transparency of where we are at with net payments; is that accurate?

Mr. Goucher: No, that is not accurate. This is what we think about then we go to sleep every night. We do guarantee the payments through a process called novation. Every time a transaction is done and brought to the clearing house, it is a contract, especially in derivatives.

The buyer and seller, when the contract comes to the clearing house, are novated — or split in half — and the clearing house becomes the buyer to every seller and the seller to every buyer.

Senator Massicotte: It guarantees the obligation of every buyer to every seller.

Mr. Goucher: When we are talking about affecting settlements — getting back to where we are today from a clearing house perspective — the ability to ensure that you can make the payment through the process is why we are talking about this today. The CCP — the clearing house — is responsible for making all of the payments.

Senator Massicotte: If I look at your own exchange and so on, relative to the things that you are talking about, these are not huge entities with immense covenant. I presume that, before you assume the responsibility, you ensure that you have a proper match. If you are going to take on this responsibility, you ensure that the other contractor is such that it is like most investment houses; every night you come out to zero.

Mr. Goucher: Yes. The clearing house, by design, has a buyer and a seller. We would never accept a transaction that is half of a transaction. By design — and that is where the risk mitigation comes in at the clearing house — we have, as the central counterparty, both sides to every transaction. The risk we face is when one of those sides is in default and we have to fulfil their obligations vis-à-vis the other counterparties.

Senator Massicotte: When you close your books every day, I will not name a bank, but let us say a bank is a party to 40 swaps that day. You must ensure that, at the end of the day, your 40 swaps are close to zero because, if they are billions of dollars, you are exposed.

Mr. Goucher: No, we have a process. Vis-à-vis any bank, they would have risk with us. We collect margin, just like at the retail level when you are, perhaps, trading on margin. A clearing house does it at a much larger level. We would never expect any one clearing member to have zero risk. They all come with risk, which we margin, and we ensure that we have enough margin to cover their exposure to the clearing house.

Senator Massicotte: Margin includes physical collateral?

Mr. Goucher: Cash and treasury bills pledged in the name of the CCP. In the event of default, the CCP collects those assets. Again, thank you for not allowing CDIC to take those assets before the clearing house. That is the point of that.

Senator Ringuette: I am getting a clearer picture. When you say that you act as the balance, I am supposing that the derivatives that you are clearing are rated.

Mr. Goucher: No.

Senator Ringuette: They are not?

Mr. Goucher: No.

Senator Ringuette: The derivatives are not rated.

Mr. Goucher: No. The first line of protection for the CCP and my first line of defence in managing the system is to ensure that the participants in the system meet certain qualifications. In the case of a Canadian bank, we would do a credit check on the Canadian bank. We would look at their balance sheet and their eligibility to participate. We have control mechanisms inside the clearing house; if someone takes on more risk than is appropriate for the size of the institution, we extract more margin or stop them from participating. The instruments themselves, however, are not rated.

Senator Ringuette: That is no certainly no consolation prize with regard to the world banking system. Essentially, it was the poor rating of the derivatives that were swapped in 2008 and prior to that that caused the chaos. Now, you are saying that the derivatives are not rated.

Mr. Goucher: I will clarify that point as well.

Senator Ringuette: Please do. Reassure me.

Mr. Goucher: There is a broad range of derivatives. It is a term that is loosely used and often abused. The instruments that you are speaking to that were rated were actually structured products; they were not the derivatives themselves. There was some financial engineering that pooled together a bunch of financial instruments and created an asset. That asset was rated. The ratings were not properly understood, or there was some discussion about the way those ratings were done.

Senator Ringuette: You are very polite.

Mr. Goucher: I am very polite about the ratings process because it is a complicated process. I am not here to either defend or abuse the rating agencies for the work that they did; they would have a story to tell on that.

Senator Massicotte: A rating of that kind of instrument is irrelevant. You are talking about two large institutions trading with each other. They know each other's credit covenant. The full covenant of the bank is behind the contract. It is not sold to the public. There is no reason to have it rated.

Mr. Goucher: No. To be precise about central clearing of OTC derivatives, it is designed only for the most standardized and plain OTC derivatives. The derivative instruments or the packages that you are referring to would never come to a clearing house. They would be bilateral obligations between those counterparties.

Senator Ringuette: Give us an example of the derivatives that would be going.

Mr. Goucher: Generally speaking, the largest derivatives market in the world that is being cleared is called an interest rate swap. This is just, in its most basic form, a promise from one party to the other that one party is making a fixed payment on an obligation for a date. If it is for two years, one party is saying, ``I will pay you, at a fixed rate, 6 per cent a year for two years.'' The other party to that swap is saying, ``In return for that, I will pay you a floating rate of interest of whatever.'' The promise will be from the other party to make the commitment to meet those floating rate requirements. Generally speaking, there is a reason why someone would like to swap a fixed rate obligation and receive floating rate obligations. The two counterparties agree to that transaction. In its most basic form, that is the simplest of interest rate swaps. Those are going into clearing houses, and that is the large amount of —

Senator Ringuette: I am assuming that it is an interest rate that would also be attached to a fixed amount of —

Mr. Goucher: A fixed, notional amount. They would agree that, if the number was for $100 million, someone would pay 3 per cent interest on $100 million for that period, and someone would receive the floating equivalent on the same amount. There are many variations; that is the simplest version. However, that is effectively what it is.

Senator Ringuette: In that scenario, I could see that the only risk involved would be the potential insolvency of one of the partners.

Mr. Goucher: This is why those instruments are not rated. They have obligations to each other, and it is not an instrument that is being rated.

Senator Oliver: May I ask a quick question about that?

The Deputy Chair: Go ahead.

Senator Oliver: If there is a major swing in the interest rates in relation to the hypothetical that you gave us, say, in one week, a 3 per cent change in the rate up or down, will that not affect the transaction?

Mr. Goucher: It affects the value of the transaction. In its simplest form, let us assume that both sides are equal when they enter into that transaction. The next day, regardless of whether or not it is 3 per cent or some other thing, one of the participants will be a winner, and one will be a loser.

Senator Oliver: Well, the floating one will be.

Mr. Goucher: One way or the other. The clearing house is looking at the market-to-market value and collecting additional margin against the loser because that, when you are guaranteeing the payment, is what the clearing house does. When you talk about a 3 per cent shock, which is one of those extreme events, that is what the clearing house has to manage.

We look at extreme but plausible events and ask whether we have enough margin to ensure that, in the case where interest rates move substantively over a week, we will have enough resources to cover that risk. That is effectively how we risk manage those positions.

Senator Oliver: How does a rating agency, an underwriter or anyone else find out the total amount of an exposure of one of our banks? Is the information from the clearing house available publicly?

Mr. Goucher: This is another element of the financial reform. There were three pieces: transparency in execution; clearing, where appropriate; and the development of trade repositories. The trade repository piece goes to your question: Where do you get a central look at all of the activity of all of our participants? Those are being built now to deal with that particular concern.

Senator Oliver: Who would oversee that? Would it be OSFI and other regulators?

Mr. Goucher: OSFI looks at the balance sheets of the banks and their reported exposures individually on a bank-by- bank basis. On the regulatory framework, the Bank of Canada and the securities regulators are responsible for the oversight of the trade repository in that trade process.

The Deputy Chair: I thank all the witnesses who made an excellent presentation. We are more informed about this section of the bill. Perhaps Ms. Ascoli could work with you and propose some amendments to the bill that would reflect your desired direction. The committee has great staff, but you know best what would be needed to comply with the international rules that were adopted and that most advanced countries will respect. I do not think Canada would want to fall behind.

Mr. Goucher: They will not.

The Deputy Chair: Certainly, there is an interest. I sit on the Finance Committee as well, which will eventually look at this section. Within a reasonable time frame, later this week or the beginning of next week, perhaps you could propose an amendment that would comply with what you are recommending.

Thank you so much.

Senator Tkachuk: One moment, chair. We did not ask for any amendments. If you want to ask them for amendments, you can ask them after the meeting. The committee is not asking for amendments.

The Deputy Chair: He made a general proposal.

Senator Tkachuk: I know. If he has any, he can forward them to the clerk, absolutely.

The Deputy Chair: I am not asking on behalf of anyone. I am asking on my own. I am a member of this committee also.

Senator Tkachuk: There you go — much clearer.

The Deputy Chair: I do not feel that I have the credentials in law. Ms. Ascoli, who is a lawyer, could give us a sense of the desired direction, if the government and Parliament would like to go with what they are proposing, and how we could amend the bill.

On behalf of all the members, thank you for your presentation and assistance.

(The committee adjourned.)