Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 10 - Evidence - Meeting of November 2, 2006
OTTAWA, Thursday, November 2, 2006
The Standing Senate Committee on Banking, Trade and Commerce met this day at
10:45 a.m. to examine and report upon the present state of the domestic and
international financial system (study on hedge funds).
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
The Chairman: Good morning. I welcome our distinguished guests from
the Montreal Exchange, la Bourse de Montréal. Thank you for coming this morning
on such short notice.
The Standing Senate Committee on Banking, Trade and Commerce is resuming its
inquiry into hedge funds. When our committee was in New York early in October,
we discussed a number of issues within the committee's mandate, one of which was
hedge funds. Our American colleagues value this sector at approximately $1.5
trillion to $3 trillion a year in terms of exchange, although we do not know the
source for that number.
In our hearings yesterday, based on the 2004 numbers, we heard that the
sector here is worth Can. $28 billion, but we understand it is growing at the
rate of 30 per cent compounded over a year. It should be around $50 billion, if
our numbers are correct. We will have more precise numbers shortly, we hope.
Given the size and scope of our trading relationship with the United States
and the integrated nature of our economies, the priority must be given always to
North American as well as global financial stability. It is imperative that we
in Canada understand what is happening not only in Canada in this new growing
area of investment but also in the United States, because of our
During our discussions in New York with U.S. regulators and representatives
of the financial services sector, hedge funds emerged as a key issue. The
Americans were divided on the issue as to whether or not there should be
regulation. This committee is open-minded. We know there is a light form of
regulation in Canada on hedge funds. Is that appropriate or not? Should
regulation be looser or tighter? We are very open-minded on this matter but we
know that thousands of sophisticated investors, at both the wholesale and the
retail level, are using this financial tool. Our institutions — that is, banks,
pension funds, mutual funds — are all investing in this new form of activity,
which shows a higher yield at the outset than other forms of investment.
Obviously, that is why it is attracting increasingly large pools of funding.
We heard about hedge funds during our recent study on consumer issues in the
financial sector and we recommended that the government appoint an eminent
person to review appropriate regulatory oversight of hedge funds, but this has
not been done as yet. We hope it might be in addition to the study we are now
undertaking. Nevertheless, key questions remains the extent to which and how
these types of new financial products should be regulated or supervised, if at
all, in order to protect consumers and above all the stability of our domestic
and global financial markets.
We are delighted to welcome the two of you on our second day of hearings.
Léon Bitton, Vice-President, Research and Development, Montreal Exchange:
Honourable senators, thank you for your invitation and for your interest in
the development of my financial markets.
I am going to try, within the time provided, to explain to you the role of a
derivative's market, and particularly the Montreal Exchange, which is now a
specialized derivative's exchange. I will also focus on market's security.
My presentation will focus on the financial security of the market, and my
colleague, Jacques Tanguay, will deal with monitoring participants and general
To begin with, just a few words on the Montreal Exchange. Since the market
restructuring in 1999, there was an agreement between the Toronto and Montreal
exchanges. We are now the only financial derivative's exchange in Canada. We
work in a context of market globalization. So we obviously encounter stiff
In relation to the products we offer, we also provide a wide array of
financial derivatives, equity derivatives, index derivatives and interest rate
derivatives, which are Canadian in nature but also have an international reach.
A large number of the users of our markets are located not just in Canada, but
also all around the world.
Our daily volume for these various products, to put the size of our market in
perspective, is on average around $70 billion in notional terms; every day, that
is roughly the amount traded. Over the past five years, we have grown by
approximately 25 per cent per year on an annualized basis. From last year to
this year, we grew by 40 per cent. That growth, which is not unique to Canada,
is quite a clear reflection of the fact that derivatives have now become
indispensable tools for risk management and also for increased output on today's
financial landscape, be it the Canadian financial landscape or the international
one. These days, it is practically impossible and unthinkable to manage a
portfolio or a bank or company treasury without using derivatives. That is also
demonstrated by our market position.
Our market model, which is also a market model that meets international
standards, is based on features of transparency, expanded access and security.
Market transparency is essentially based on having an accessible electronic
trading platform, in our case, at almost 25,000 access points in Canada and
around the world, following recognition from regulatory authorities in foreign
countries like the United States. The CFTC, which is the authority there,
authorizes us to set up terminals that give American residences access to
Canadian products. Similarly, we also have access granted in Great-Britain and
in other countries around the world.
Among the services we provide, we have an electronic market with expanded
access all around the world. We also offer technological solutions to other
markets. We operate the Montreal Exchange Market with our own technology, but we
are also the technical operator and main shareholder of an options exchange in
the United States, the Boston Options Exchange. As a matter of fact, we are the
only foreign exchange to be recognized by the SEC — the Security Exchange
Commission — in order to operate an options market in the United States, which
reflects the high quality standards for the services we provide.
We also own a clearing house, which plays a central role in the financial
security of a derivative's market — and that is what I am mainly going to talk
about for the purposes of the study you are conducting.
Once again, I would like to stress the importance of this financial security
and to thank you, because in 2002, your committee and the Senate initiated Bill
S-40, which was subsequently approved by the House of Commons. That was an
amendment to the Payment Clearing and Settlement Act that protected the ability
of a clearing house to realize the collateral of a member in the event of the
member's financial insolvency. That amendment to the act, which was initiated
here and approved by the Senate and then submitted to the House of Commons,
increased the financial security of the Canadian market and thereby made it
possible for us to get a credit rating from Standard & Poor's. The CDCC clearing
house has an AA credit rating today, which shows how much financial security
this clearing house offers participants in the Canadian market.
What an Exchange offers is basically a trading and price exposure mechanism
in a regulated framework — and exchange operates in a regulated framework — and
this facilitates the transfer of risks, derivative instruments, options and
futures contracts traded on the Montreal Exchange and around the world. They are
instruments that facilitate this transfer of risks between those who are willing
to assume them and those who are interested in transferring them.
This involves an exchange, and organized market, but also a large number of
economic players who have totally different viewpoints and needs. Keep in mind
that the existence of an equilibrium price in a market is based on operators
with different expectations. In order for there to be a market, we need not only
investors with one view of risk management, who are seeking to ensure against a
risk, we also need people who can either arbitrate among various markets or
trade by anticipating market price fluctuations, who are commonly known as
So there is an equilibrium price in a market when various viewpoints come
together in the market place, hence the interest of the derivatives market in
the community of hedge funds, who are active participants in derivatives markets
and who, in that sense, play an important role in the operation of the markets.
I would like to introduce here an important notion, the fundamental
difference between derivatives traded on the exchange in a multilateral concept
supported by a clearing house and derivatives traded over the counter on a
bilateral contract basis. You have two market participants at the counter, who
agree on the terms of a derivative and conduct a transaction based on the credit
risk of the other party and put in place measures they agree on.
In an exchange market, there is reliance on a multilateral concept whereby
the financial performance guaranty is provided by the clearing house. What you
find in an exchange market is the concept of universal prices. In a transaction
on the Montreal Exchange, you may have, on one hand, a hedge fund represented by
its broker. I would like to point out to you that hedge funds do not have direct
access to the market. They have to go through a broker, with status as an
approved participant in the Montreal Exchange. So a hedge fund that is behind a
transaction could quite easily find itself with, on the other side, another
broker, representing a pension fund or an individual. Clearly, this multilateral
market concept is made possible by the fact that you have a clearing house
acting as an intermediary between the buyer and the seller, and guaranteeing the
transaction for both sides.
The Chairman: Mr. Bitton, may I interrupt for a moment? The Canadian
audience is listening. Some are sophisticated; others, like many of us, are not.
Before you continue, please describe a typical derivative transaction. We have
heard the words. Some of us believe we understand what they mean. When we talk
to others, they say something different. You mention your derivative marketplace
and your clearing house. Please give us an example of a derivative transaction
and then return to your text. It is important for our audience to understand
what we are talking about.
Senator Angus: As well, please tell us what you mean by guarantee.
The Chairman: Yes, that would be helpful as well.
Mr. Bitton: Fundamentally, a derivative has an economic basis. The
mean economic basis for a derivative is to provide the service of risk
management or risk transfer that I referred to. Basically, you are going to have
financial institutions, let us take a concrete example, providing their clients
mortgages and assuming an interest rate risk. The financial institution, a bank
in this case, can either decide to assume the risk in its portfolio, or decide
not to assume it. In that case, the institution could decide to transfer the
risk to another player who is willing to assume the risk, for example, a hedge
fund. You have here a typical case of two players: on the one hand, you have one
player who needs risk management for its portfolio or liabilities, and on the
other hand, a player who anticipates a market movement and is willing to acquire
In derivatives lingo, you actually have two types of deal; you have what is
called "futures contracts'' that is a type of differed trade. That means that
you can set the price today for something you are interested in buying or
selling at a later date. It is a differed method, and it is obviously a
price-setting mechanism that facilitates the transaction I just described.
A second type of instrument —
Senator Goldstein: What you just described, I assume that is what is
commonly called an interest rate swap?
Mr. Bitton: In OTC lingo, it is a "plain forward,'' which is based on
the interest rates. An interest rate swap is an instrument that is more often
found in the over-the-counter market place. In fact, an interest rate swap is a
series of forwards. It is someone who spreads a series of differed payments over
time. The person takes a series of forwards and makes up what is called an
interest rate swap. But in organized markets, the terminology that is used is
that there is a futures market and an options market. The main futures market is
predominantly institutional. So most of the players in a futures market for
financial instruments are institutional and professional. You see very little
retail activity on futures markets. They are markets used mostly by a
Another range of products is options, which come under the definition of
derivatives. Options are a flexible mechanism that enables you to manage risk
too, but with ceilings or floors that you can set. Here is a really simple
example: You have one share in your portfolio, just as today you tend to ensure
other goods like your car or your house, so you buy some insurance, the options
market allows you, among other things, to manage your portfolio risk, be it an
individual share or an index, and thereby provides your portfolio with this
price insurance. By buying, for example, an option to sell, you can insure the
value of your share. For example, say you bought a share for $50, you have a
long-term outlook in terms of that share and you want to keep it in your
portfolio, but you know the share could go through some momentary turbulence and
you want to insure the share price throughout that period of turbulence, say for
one year, you buy an option which entitles you to set the share price at $50. So
even if the market price of the share goes below $50, you reserve the right to
resell the share for $50, and then, obviously, just as in real estate insurance
or other insurance fields, you pay a premium for that commitment.
The advantage of options is that you can reduce the leveraging of the option,
that is, when you are the buyer, you pay a premium, your risk is limited to the
premium; when you are the seller, you can use that leveraging. When leveraging
is used in derivatives, it is mostly used in futures contract. Because futures
contract, whether you are the buyer or the seller, either way it is a
commitment, a performance requirement. The risk is certainly not limited.
Obviously, derivatives, like any other instrument you might use in other
fields, depend on how they are used. There are straightforward basic strategies
and other more complex strategies.
In the edge fund industry, there are specialized and professional players who
use derivatives to build more complex strategies with a view to producing better
The Chairman: Pause there. We will come back to this, but turn for a
moment to Senator Angus's point that we do a forward option, and the question is
what is the nature of the guarantee and how does somebody satisfy himself. Let
us take your example. Somebody buys a chunk of stock at $50. He wants a forward
guarantee that he will be able, if necessary, to sell that stock at no less than
$50. It is a downward hedge. It is out a year and he pays a particular premium.
What would be the typical premium on that? What percentage would it be, or is it
a wild number?
Mr. Bitton: The number could vary depending on the price you are
trying to insure. You can have insurance that fits precisely with the current
price of the stock, but you will be paying more. If you are looking for
insurance at a lower price than the current price of a stock, you will be paying
less of a premium.
Let us come back to that example and the idea of a guarantee. The clearing
house bases his guarantee on a margin deposit mechanism and a daily assessment
of the risk.
How does that work in practice? A clearing house stands between the two
parties to the transaction. The example we provided would not necessarily be a
good example for the purpose of the guarantee. I mentioned earlier that with the
guarantee, in the instance of purchasing an option, the risk is limited to the
premium you pay. It gives you the right to exercise this option, but you pay a
premium and then your risk is limited to that premium.
The Chairman: Let us follow this through. Again, this is a widely
traded stock of one of the larger companies. The investor buys it and guarantees
his downside with a premium.
Keeping in mind that when it goes through at the end of the day there are a
clearing house, risk takers and guarantors, how can an investor be satisfied
that he does a hedge or a protection for the downside of his stock based on the
guarantee? How does he see through the guarantee? What form is it? Is it on
behalf of the institution he is dealing with? For instance, if he is dealing
with an investment company or a bank, does the bank guarantee the downside or
does a third party? How is an astute investor satisfied that he has a firm
guarantee having paid the premium at the other end?
Turning to insurance, do you look at their insurance portfolio and balance
sheet and satisfy yourself that if something happens and you die, this company
will be able to sustain the payment of your insurance?
How does one look through these transactions to satisfy himself that there is
a security at the other end for this payment?
Mr. Bitton: The clearing house provides the guarantee in terms, first,
of the monetary settlement — monetary settlement implies that you are buying the
The Chairman: What stands behind the clearing house?
Mr. Bitton: That is the direction I am headed in my answer.
There are two facets to the insurance-monetary settlement guarantee. For
holders of derivative positions with a commitment, and obligation, the clearing
house demands margin deposits. It requires collateral or an acceptable form of
margin deposit to be posted with the clearing house. It is all done trough the
broker, who is a member of the clearing house.
The client has requirements to meet in relation to the broker, but the broker
has to post the margin with the clearing house. So the clearing house has that
margin, that is the first part of the guarantee, and it has the collateral on
The clearing house also follows continuously, from day to day, and even over
the course of the day, the evolution in the price of the instrument. The margin
is generally determined according to risk assessment methods based on an
historical analysis of volatility and also on stress testing, in an attempt to
cover periods of extreme volatility in the past; the clearing house sets the
amount of the margin based on that historical volatility and stress testing. The
clearing house sets the amount and then requires the broker to put up sufficient
collateral to cover that guarantee.
However, the process does not stop there. Once the margin has been deposited,
there is monitoring, constant monitoring of the evolution of the market, and
this could lead the clearing house to act. If at any time there is a price
fluctuation beyond historical norms, such that the margin has to be greater than
one was required, the clearing house can act and require, in the course of the
day, the broker to provide additional margin to cover the commitment it made.
The Chairman: I will return to that, but it is important to understand
At the end of the day, there is a guarantee, there is surveillance of the
guarantee, there is a clearing house daily look; but is it all based on a
Mr. Bitton: Not necessarily, no. It is based on a historic pattern,
stress testing and an ongoing risk management process.
The Chairman: What happens if the unpredictable occurs, a collapse in
the marketplace? I am not talking about a modest collapse of 50 points or 70
points. I mean 500 points or 600 points. We have seen in our lifetime a number
of serious market collapses, one just four or five years ago in the tech market.
What happens if there is a precipitous collapse? Can one be satisfied at the
bottom of this that with stress analysis and so on the investor will still be
protected if a very steep downturn in the marketplace occurs?
Mr. Bitton: History is the best proof that the system works. If there
is a failure of a participant, then the clearing house will use the margin on
deposit to try to meet the obligation or the financial amount resulting from
that failure. If that is not sufficient, as a second step we require each
clearing house member to deposit with the clearing house what we call guaranteed
funds or a clearing fund. That is a reserve fund that is maintained and used
only if there is a failure.
Normally the first step is to look at the margin. The margin deposit, with
the mechanisms I explained, is based on historical volatility, stress testing
and ongoing risk management monitoring and should be sufficient to cover the
If not, we look at the reserve fund. The clearing members, who are basically
the credit ring of the system, have an obligation to contribute an additional
100 per cent of what they have in that clearing fund, if there is a failure.
The Chairman: What is the amount of the original coverage? Is it 5 per
cent or 10 per cent?
Mr. Bitton: The coverage varies depending on the volatility. For a
very volatile futures contract based on an underlying interest, obviously the
margin will be at the higher level.
The Chairman: Give us an example of that level.
Mr. Bitton: Currently, for SXF, our stock index futures contract, we
charge approximately 7 per cent of the value of the contract.
The Chairman: Let us use that as an example, to follow this through.
We are concerned about the extent of the downside risk.
If somebody does a futures contract, puts up cash for 7 per cent and the
market falls 500 points — not unreasonable as we have seen precipitous falls
greater than that — the 7 per cent would not cover that, even if it were doubled
to 14 per cent. Is that right? Please clarify this for us.
Jacques Tanguay, vice-president, Regulatory Division, Montreal Exchange:
Mr. Chairman, one of the things the clearing house can do is this: in the course
of the day, if it sees that the market is taking a dive, it can issue
"intraday'' margin calls.
I should point out that the calculations of the margin and collateral
required by the clearing house are done based on the worst case scenario. For
example, the clearing house examines what would happen if there was another
situation like Black Monday in the 1980's, or Russia defaulting on its debt.
Those are the factors it takes into account in examining the worst case
scenario. The calculation methods determine with 99.5 per cent certainty that
the margins and collateral required are adequate.
So the clearing house is comfortable enough with the fact that what it
requires of his members on a daily basis is sufficient to cover the worst case
scenarios with a 99.5 per cent confidence level. In addition, as Mr. Bitton
said, there is the clearing fund, which is a separate fund; its purpose is to
cover potential situations of insufficient collateral. There are many mechanisms
that limit the risk of defaulting on the guarantee.
Mr. Bitton: What we are advocating here today is that, as demonstrated
around the world, the clearing and guarantee mechanism operated by the clearing
house in organized derivatives markets should be the industry's mechanism of
choice. I did attempt in my remarks to explain how over the contract deals are
different; there are only two parties and the mechanism we have described to you
is lacking. Over the contract deals really depend on the credit wordiness of the
other side. That is increasingly taking into consideration, but in over the
contract dealings, although there is an increasing "collateralization'' of these
dealings, with collateral being put up more and more often, you do not have the
ongoing risk management function that is performed by a clearing house. That
means a clearing house is in a more dynamic reactive or preventive mode. It has
and hold assets covering obligations with 99.8 per cent confidence certainty and
has more than one way of taking into account historic volatility, including
periods of increased volatility, which are called stresses.
The systemic risks resulting from default by a participant in the organized
derivatives market are limited by the presence and role of a clearing house.
Furthermore, and this should reassure committee members about what I have just
said, there is the Basel I Accord, which governs financial institutions and
includes capital requirements to cover credit risk in the exchange market; under
that agreement, if the parties to an over the counter transaction take that
transaction and post it with an exchange or clearing house, the capital
requirement will be reduced from what would have been required on the over the
counter market. So that is one thing we at the Montreal Exchange found
encouraging. The clearing house, the CDCC, now provides clearing services to the
Mr. Bitton: The Canadian Derivatives Clearing Corporation now offers
over-the-counter or OTC clearing services to participants of the OTC market that
could benefit from this financial market security.
The Chairman: What is the size of the clearing house?
Mr. Bitton: We have margin on deposit of approximately $1.5 billion.
The clearing fund is approximately $300 million and can get up to another $300
million in case of failure. That is more or less the current size, although
these figures vary over time. It depends on the positions held by participants
in the market.
The Chairman: The overall hedge fund market is approaching somewhere
between $40 billion and $50 billion in Canada. This would be a small portion of
that; it is an item within the overall hedge fund market.
Mr. Bitton: We have just described the size of the funds that are
The position held in the market by participants based on the notional
underlying value is currently close to $600 billion. If you want to use a
comparative figure, the Montreal Exchange currently has positions based on
notional value of approximately $600 billion. On a daily basis we trade an
average of $70 billion of notional value. That is the market scope right now.
Senator Angus: That includes only the transactions that go through the
Bourse de Montréal; the over-the-counter transactions are not included in that.
Do you know how much trading there is in the OTC market?
Mr. Bitton: Some statistical figures are provided, for example, by the
Bank of Canada. We have recent figures of maybe 40 per cent of the market in the
interest rate field and 30 per cent in the equity derivative field. The rest is
over the counter.
In terms of volume traded or transactions generated, we have the majority of
the activity. In terms of notional value, because this is the nature of the OTC
market, the hedging activity is large. In notional value terms, this is our
Senator Angus: If I understood you, all the transactions that go
through the exchange are protected by the clearing house. However, for OTC
transactions, you offer investors the service of a clearing house but they do
not have to use it. Most of the over-the-counter transactions are not so
protected. Am I right on that?
Mr. Bitton: We recently started offering this service for OTC business
and we anticipate seeing a lot of activity coming to the clearing house. Also,
we expect to see institutions looking to reduce the capital required on the
credit risk. As mentioned earlier, if you move an OTC activity into a clearing
house, you benefit.
We think that we will see more of the OTC activity moving to an exchange. I
would not say an exchange. Let us remember, an exchange provides a price
discovery facility based on standardized terms.
What we see mostly in the OTC market are derivative products tailored to
specific needs. I am specifically referring to the ability to provide those
tailored derivative transactions to be cleared by the clearing house for the
benefit of the risk-management facility.
This is a good question. The two markets are complementary in a sense because
we see a lot of the activity generated on the exchange, and that is basically
activity done by OTC derivative traders. Let us say if you are swap traders in
the OTC market you are taking a risk because you are meeting the risk of your
customers, and that risk is transferred to another participant via the exchange.
There is a lot of complementary activity between the two.
The Chairman: I think we understand that. The numbers you gave us were
for the Montreal Exchange. Do you know how big the market would be nationwide?
Mr. Bitton: The figures I just gave you strictly refer to activity on
the Montreal Exchange.
The Chairman: You were the quasi-exclusive traders of the derivative
Mr. Bitton: That is right.
The Chairman: Is there anyone else across Canada doing this work?
Mr. Bitton: Following the restructuring deal in 1999, there is an
exclusivity arrangement until 2009. That makes us the only financial derivative
exchange. There is the Winnipeg Commodity Exchange, which deals in canola.
The Chairman: That is more commodities-driven.
Mr. Bitton: That is right. We are the only Canadian derivative
financial exchange. As I mentioned earlier in my remarks, we are exposed to
international competition because our competitors are all the global futures
The Chairman: Like Chicago?
Mr. Bitton: Yes, among others. We obviously look at some type of
products. We are not in a situation where we have no competing force; we in a
At this point, unless there are any other questions on financial security,
let us move on to the second component of protection. I said at the beginning of
my remarks that financial security was the first component of our market
The second component of protection is what is called "monitoring participants
and market security.'' I am going to ask Mr. Tanguay to talk to you about market
security, which is provided by the Montreal Exchange.
Mr. Tanguay: Hedge funds do not have direct access to our market. As a
matter of fact, there is currently no exchange anywhere in the world that allows
hedge funds to participate directly in their market. In order to become a
participant with direct access to the Montreal Exchange, the participant has to
be registered as a broker with a provincial securities commission or regulator
or in the case of our foreign participants, with a foreign regulator.
By the way, we currently have 90 brokers who are approved by participants, 60
of whom are Canadian and 30 foreign. Of the foreign brokers, 25 are American and
In addition to the requirement that brokers be registered with a regulator,
they also must be members of a recognized self-regulating body. In Canada, the
recognized self-regulating body for the purposes of monitoring capital and
managing client accounts is the Investment Dealers' Association of Canada.
Brokers must also be members of the Canadian Investor Protection Fund. That fund
protects investors in the event of broker insolvency. There is currently $250
million in the fund, not counting available lines of credit. That covers clients
in the event that their broker should go bankrupt.
Brokerage staff are also required to have the necessary skills to deal in the
products listed on the Montreal Exchange. This means that dealers of these
products have to have taken the courses prescribed by regulators on issuing
options and futures contracts. Among other things, we also look at whether the
broker has the required capital and what systems and procedures are in place,
particularly with respect to dealing in derivatives in our market.
Finally, brokers who want to become approved participants in the Montreal
Exchange have to submit a business plan setting out, over a spend of three to
five years, what their intentions are in terms of activity on the exchange's
Brokers have to go through this approval process before becoming what we call
"approved participants'' with direct access to our market. In all of this, hedge
funds ultimately end up as clients of these brokers. They must go through a
broker approved by the exchange.
One of our main goals is to ensure market integrity and prevent any
manipulation and avoid any distortion in the price discovery mechanisms. That is
our main regulatory goal. To this end, we have put in place a number of tools to
allow us to reach those goals.
The main tool we have is what we call "position reports.'' Once a participant
in the exchange or one of his or her clients holds over a certain number of
futures or options contracts, the approved participant and the client are
required to report to the exchange on the positions they hold. For options, they
are required to report to us weekly on the positions they hold. It is a very
detailed report that describes the instrument, the expiry date and in the case
of options, the exercise price. Together with this information, we also have all
of the client identification information. We would know that Mr. so and so holds
300 options on such and such a share.
The Chairman: We understand that. We heard some of the parallel
testimony yesterday with Mr. Wilson about the regulatory oversight you have in
terms of the investment managers and so on. Is there something more you want to
add? I do want to get to questions.
Mr. Tanguay: By requiring periodic position reports, we can, first of
all, identify the major players in our market, including hedge funds. We can
also do cross-referencing, because in many cases, clients, especially
institutional and hedge fund clients, have accounts with a number of brokers.
The reports we get enable us to cross-reference and identify the overall
position held by an institution or hedge fund under a specific contract.
The Chairman: You aggregate the various reports from the various
managers or funds so that you can identify if they were overindulging in one
particular sector or one particular stock and the risk therefore is greater.
Senator Angus: In the Emirates, would you have seen the guy who stayed
too long in the gas stock or gas futures at that price?
The Chairman: From your reports, can you tell that the portfolio is
unbalanced and the risk is not properly balanced?
Mr. Tanguay: For options, it is once a week, and for futures
contracts, it is twice a week. One of the goals is to avoid any particular
individual or entity holding and overly heavy position. One of the objectives is
to identify situations of concentration. That is why we have what are known as
position limits. There are thresholds that cannot be exceeded.
The Chairman: How can you determine whether someone is going beyond a
limit? What powers do you have to say to a licensed member that his portfolio is
tilted? We heard from Mr. Wilson yesterday that they can take a look at
something that is apparently wrong, but they do not necessarily survey the hedge
Mr. Tanguay: It is in our regulations. It is provided for in the
exchange's regulations. As a matter of fact, that goes for all derivatives
The Chairman: Your exchange regulations are more intense in that sense
than those of the Toronto Stock Exchange.
Mr. Tanguay: Definitely.
The Chairman: I am talking about it as it applies to directors.
Senator Goldstein: Can you refuse transactions if someone has reached
Mr. Tanguay: Yes. In fact, when someone has reached the limit, there
are two possible scenarios: if the positions are held for purely speculative
purposes, no permission will be given to exceed the limit; if, however, the
positions are held to cover or protect a portfolio, the position limit can be
extended. But the applicant has to prove to us that coverage is really what he
or she is looking for.
Senator Goldstein: So it is on a case by case basis.
Mr. Tanguay: Yes, it is case by case.
The Chairman: We are trying to understand this very complicated area.
Is there anything you would like to add before we turn to Senator Harb for some
Mr. Tanguay: I am just going to leave it at position reports and
position limits, because I think that is our main tool for managing the risks
associated with transactions on our market.
Senator Harb: You stated that, on average, the Canadian Derivatives
Clearing Corporation processes about $70 billion a day. Would you see that as
being a large-volume payment system or a low-volume payment system, as compared
to, for example, the Canadian Payments Association, which deals with large-value
transfer systems, averaging daily about 18,000 transactions, valued at $145
billion? Where does your organization fit in?
Mr. Bitton: First, we have to clarify the $70-billion figure. When you
deal in futures contracts, the futures can be based on banker acceptance. Each
contract is $1 million. If you trade 10 contracts, you trade a notional value of
$10 million, but the actual exchange of funds that results from taking a
position in the futures market is what I described before, variation margin.
Basically, the funds that are exchanged on a day-to-day basis correspond to
the price fluctuation of the futures contract from one day to the next. These
amounts are much smaller than the notional value. The notional value is the
absolute risk. If you come to delivery, so you are at the end of the futures
contract, you know that there is an exchange of funds.
Another important point is that in the futures world there are two types of
instruments. There are physically delivered futures contracts and there are
financial contracts, which are basically cash-settled contracts. In other words,
at the end of a period, rather than delivering the actual, let us say, $100,000
of bonds, you basically just exchange money differential between the actual
value of the bonds at expiry and your futures contract. That is to say that in
fact the money being exchanged on a daily basis is much smaller in scope.
Senator Harb: On October 4, 2006, a task force released a report
entitled Canada Steps Up. You are probably aware of it. They made a
number of recommendations. They asked for full disclosure of all performance,
management, administrative, referral and other fees, including the compensation
of the investment adviser and manager, in relation to hedge funds. That is
outside the scope of what you are dealing with, because the hedge funds do not
come to you; they go to a brokerage of sorts.
It seems to me that every clearing house is a large-value transfer system,
which is managed by the Canadian Payments Association; or a cleared and settled
security transaction system, which is also overseen by the Canadian Payments
Association and run by the Canadian Depository for Securities Limited; or an
automatic clearing settlement system. Each one of these systems has some
oversight, either through the Bank of Canada or through the Department of
It seems to me that your organization is the only one that is on its own. Do
you see any need for coordinating with those other agencies and organizations?
Do you see a role, for example, for you and the Bank of Canada or the Department
of Finance to have some sort of information exchange on a regular basis? Both
the chair and the vice-chair raised a number of questions about transparency in
the transaction, the ability of people to know what is really going on. Is there
any plan in the works, or are you already doing that?
Mr. Tanguay: I should point out that the clearing corporation, the
CDCC, is a self regulating body recognized by the Autorité des marchés
financiers du Québec. The Autorité des marchés financiers overseas the CDCC. The
Autorité des marchés financiers also oversees financial institutions in Quebec.
I cannot tell you whether, through that, there may be any communication or
transfer of information between our clearing house and other clearing houses.
Senator Goldstein: Thank you, gentlemen, for coming and for both of
your very clear and very helpful presentations. Your presentations raise a
number of questions, not because they were not clear, on the contrary, but
because this is a field that for most people, is a little obscure, in that it is
not very well understood.
You mentioned earlier, Mr. Bitton, some figures, including a $70-billion
figure. Are you able to divide that figure into those who are truly covering
their business risks, on one hand, and those who are purely speculating, on the
For example, if I am a chocolate bar maker, and I need orange juice for my
product and I know I am going to have to produce a huge amount of chocolate for
Christmas, I might want to establish the price of my orange juice right away, so
I am going to buy "futures'' or perhaps options, but more likely "futures'' so I
can establish my production cost. I see that as "normal'' commercial
transaction. On the one hand, that is commercially useful and not purely
speculative. On the other and, there are speculators who are going to buy orange
juice, for future delivery, for speculative purposes, and to them, it is a
purely financial instrument.
To what extent is the $70 billion speculative and to what extent is it
Mr. Bitton: There are two components to that. We told you about the
Clearing House component and the Exchange component. In terms of the Clearing
House, you have to remember one important thing: the idea of universality. The
Clearing House does not attempt to determine the nature, be it commercial or
speculative, of the transaction. All it tries to do is take a position, assess
the risk of the position; it requires guarantees and follows the position to
ensure that it continues to meet its standards for guarantees and margin
deposits. In other words, it is completely indifferent to the perspective of the
party on the transaction.
Now, at the Exchange, the regulations of the Exchange have a position limits
system, which was mentioned. There are strict position limits for speculators.
Currently, a speculator can never exceed the prescribed position limits.
However, there is a mechanism to allow those with commercial transactions to
apply for an increase in their market position, and the Exchange then requires
that institution to demonstrate the nature of the coverage and decides whether
or not to allow the increase. That means that in our world, there is no need to
identify the motive.
Senator Goldstein: The figure given was $70 billion in transactions.
Speculators account for how much of that?
Mr. Tanguay: Mr. Bitton gave a figure of $70 billion, but those are
transactions in a single day. On the regulatory side, what we look at are
positions held at a specific point in time. Based on the reports we get, I would
say approximately 95 per cent of futures contract positions reported to us are
positions held for coverage purposes, for protection.
One of the unique features of speculators in the futures market is that
usually, they do not keep any position at the end of the trading session, or if
they do, it is going to be very small. They prefer to get in and out quickly. So
the positions at the Clearing House at the end of the day, for futures
contracts, are mainly coverage positions.
On the options side, it is harder to identify because the options market,
unlike the futures market, is used heavily by retail clients. The futures market
is basically an institutional market, whereas the options market sees a fairly
substantial use by individuals. Obviously, when the positions reported to us are
relatively modest, we do not systematically check whether it is a speculative
position or not. That would get to be too much.
Senator Goldstein: You seem to use the terms "participant'' and
"member'' interchangeably. Is there any distinction?
Mr. Tanguay: Until the Exchange was demutualized in October 2000, we
had members. When the Montreal Exchange became a business corporation, in
October 2000, the term was changed to "approved participant.'' It means the same
Senator Goldstein: The terms are synonymous.
Mr. Tanguay: Yes, they are basically synonymous.
Senator Goldstein: You mentioned that occasionally there are
"intraday'' margin calls. When there is this type of margin call, is it settled
immediately or is there a delay?
Mr. Tanguay: It is usually settled in the following hour. It very
rarely happens with Clearing Houses; to my knowledge, in the past 10 years, I
think it happened once in 1998, when the CDCC issued a margin call at noon and
the funds had to be forwarded by one o'clock. One of the CDCC's requirements is
for each of its members to have a pre- established line of credit with a major
bank, and then the CDCC can get the money straight from the line of credit
provided by the bank to the broker.
Senator Goldstein: It is pre-authorized? They are contracts between
the Exchange or the Clearing House, on the one hand, and the participant or
member, on the other hand, that allow the Exchange or Clearing House to go
straight to the bank, I assume, that has given one of your members the line of
credit, to get the money immediately.
Mr. Tanguay: This mechanism works every day because one of the unique
features of the derivative instruments market is that all gains and losses have
to be settled daily. Before the markets open, every morning, if there are any
losses to be settled by the broker, CDCC goes and takes the amount owing from
the participant's bank account and vice versa, if there are any gains, CDCC
makes a direct deposit. All of this is done virtually in real time.
Senator Goldstein: So it is the same system, for all intents and
purposes, as the clearing that takes place with the Clearing House for the
banks? In other words, in the evening, when the banks are closed, the
calculations are done in order to arrive at a balance.
Mr. Tanguay: Yes.
Senator Goldstein: You mentioned earlier a 99.8 per cent degree of
certainty. That reassures us a bit, except what happens with the other 0.2 per
cent? What does that represent? Is it a historic percentage or something else?
Mr. Tanguay: Actually, it is a statistical formula used by CDCC. I do
not know whether you have ever heard of the concept of the bell curve, with its
degrees of confidence. It is pure and simple statistics.
Senator Goldstein: It is a study. It is not experience. It is a
Mr. Tanguay: Yes, but it is also based on the past. CDCC looks at what
has happened over the past 20 days, the past 90 days, the past 260 days, and
based on that historical data, it does a calculation using what is called a
worst-case scenario: what is the worst thing that could happen today? It is a
Senator Goldstein: You determine your level of certainty daily?
Mr. Tanguay: Yes, the CDCC does that daily. And on days where there
could be a lot of volatility on the market, it does it in real time to ensure
there is enough money in the margin fund and in the clearing fund to cover all
The Chairman: Senator Goldstein, you have been so patient with us, we
must be more than patient with you. You bring expertise and wisdom, particularly
because you come from Quebec and you understand these questions far better than
I, from Toronto.
Senator Goldstein: I do not know about that, but I agree with your
first two statements. I have been patient and you are being patient.
Senator Goldstein: It is of great relief to us to hear you say that
you do check daily or twice a week in one case, and once a week, in the other
case, to determine and make sure there is no undue concentration. But how would
you know whether someone with a hedge fund, who had reached the position limit
on your exchange, had not at the same time done deals on a number of other
exchanges, in order to ultimately achieve an overall concentration sufficient to
virtually corner the market? Are there any information exchanges between you and
the Chicago Exchange and other Exchanges?
Mr. Tanguay: There are information exchanges, but mostly when there
are problem situations. The Montreal Exchange is part of what is called the
"Intermarket Surveillance Group,'' a group of 35 North American and European
Exchanges. There are information exchanges.
Senator Goldstein: Theoretically, it is after the fact, after a crisis
Mr. Tanguay: Yes, it is after the fact. We certainly monitor positions
on our market. The other derivatives exchanges, for all intents and purposes,
have identical requirements. Each monitors its own market.
Senator Goldstein: If I bought orange juice "futures,'' to take a very
simple example, and I reached my limit on your exchange, I could also have hit
the limit on 22 or 23 other Exchanges and therefore have potential control over
Mr. Tanguay: We have products that are unique. So our products are not
what are known as fungible products, that is to say, you cannot buy them, for
example, on our market and sell them on another market or vice versa. In Canada,
we are the only derivatives Exchange.
If you take the United States, for example, there are six Options Exchanges
dealing in the same contracts, so you can buy an option on one exchange and sell
it on another. Under that system, information received by each exchange is
consolidated to identify situations of concentration.
Senator Goldstein: So there can be no arbitrage between Exchanges? Are
there any price differences?
Mr. Tanguay: In the United States, yes. In Canada, we do not have that
problem. In the United States, there may be price differences, at least among
Mr. Bitton: Arbitrage occasionally involves different products; there
may be two products with some similarities and for which there are two separate
markets. More often than not, within a single market, a hedge fund may have
strategies in terms of its relative value forecast, for example, the 30-day
interest rate versus the 10-year interest rate. When that occurs within our
range of products, we have full control. When that occurs between two products
on different markets, each market is responsible for its management. Still,
there are information exchange mechanisms among different markets. Obviously, we
are talking about organized markets.
If part of the transaction originates on the over the counter market, for
example, and the other part, on the regulated market, it gets a bit trickier.
The difficulty may lie on that level.
Mr. Tanguay: Another difficulty that may crop up in Mr. Bitton's
example is that, if you have a hedge fund taking positions in futures contracts
on the Montreal Exchange and in futures contracts on the Chicago Mercantile
Exchange, it will not necessarily go through the same broker. A Canadian broker
could be used for the Montreal transactions and an American broker for the
American transactions. In that case, there is absolutely no way of checking.
Senator Goldstein: So that is a weakness in the system that could lead
to more situations like the one with Amaranth and Long Term Capital Management
and so on?
Mr. Bitton: But, if you take the recent example, we have shown an
ability to manage counterparty risk well. Counterpart risks are well managed.
Clearly, the weakness is ultimately the weakness in terms of the knowledge the
investor has to have of an instrument on offer and the degree of risk. But what
has in fact been shown to date is that the management of counterpart risks has
actually been handled well by the market, both domestically and internationally.
Senator Goldstein: And that has been proven.
Mr. Bitton: Absolutely. And in other matters.
Senator Angus: As you know, we are studying hedge funds. In your
testimony you are talking about this specialized exchange that you run for the
trading of various structured products by regular funds, individuals, brokers,
and it is not all hedge funds.
Mr. Bitton: What we have been presenting to you today is basically a
market model of any organized derivative exchange. The model we presented
applies to Canada, and you will find it also in Chicago, London, Frankfurt and
so on. We have presented the value of an organized market in terms of its
ability to manage credit risk.
We have tried to highlight that we are totally indifferent in that model as
to whether you are a hedge fund or a retail investor or a mutual fund. We manage
risk, and as such we adopt an objective view on that and we put in place a
quantitative measure to manage risk.
We also stated that we are not referring here to the activity in the OTC
market, which is of a different nature. In many instances, hedge funds might use
a lag that is a cash lag, an OTC derivative lag, or an exchange credit lag.
The Exchange has to operate in an environment that minimizes ambiguity. That
is clear. This means that if participants loose confidence in the integrity of
the Exchange, that impacts on our operations, on our activity. So we are
extremely interested in seeing to it that operations are managed with integrity
and also that those dealing on our markets do not default on other markets
because ultimately that same player could have an impact on our market. That is
where our interest lies. The monitoring measures are specific to our market, but
in terms of information exchanges among various authorities, that is where the
rubber really hits the road.
Senator Angus: I wanted to make it clear that you run a highly
specialized market and you have been very successful. I think the Montreal
structured products exchange that you run is a world-class facility and I am
proud to be from Montreal.
As experts in the field of financial transactions, be they structured or
otherwise, do you have any ideas or comments that you could leave with this
committee as to whether or not hedge funds are high-risk vehicles that need
closer and stricter regulatory oversight?
Mr. Bitton: We would not be in a position to comment on the regulation
of hedge funds. However, we can comment on the contribution of the hedge fund to
our market. They play an important role. Studies have demonstrated that hedge
funds provide the liquidity that helps reduce price volatility. If you have
hedge funds on the long side of the market and you want to reduce volatility, in
many instances you find hedge funds on the other side of the trade. Hedge funds
have a beneficial impact on the market.
We must evolve, and that is a goal in our own environment. We must evolve in
an environment where a delicate balance must be established between regulations
and market efficiency and free markets. We come from a regulated environment and
at the same time we encourage innovation and we encourage participation for the
stability of the financial system.
Senator Angus: You do that very well.
Regarding the over-the-counter trading that you described, I got the
impression from what you said that most of the hedge funds do their trading
outside the exchange, in the over-the-counter world.
Mr. Bitton: It is hard to qualify. Hedge funds are not too
transparent, because part of the hedge fund model is being able to protect the
property rights related to the strategy. That is how they bring value and added
value to the investors. They have trading rights under the strategy.
Having said that, we know that hedge funds are active users of futures
markets, including our markets. We do not know their share of market
exchange-related products versus OTC, but we know that they play an important
role in the exchange market, whether ours or any other futures markets around
Senator Angus: To the extent that they use your exchange, even though
a hedge fund has to operate through a broker to deal with you, they are subject
to the registration. Or is it only the broker who has to be registered?
Mr. Tanguay: Only the broker is subject to registration.
Senator Angus: His client could be anybody.
Mr. Tanguay: He has a duty to monitor and know what his client does.
The onus is on the broker to check his client.
Senator Angus: We are quite preoccupied by the extent to which hedge
funds are now being invested in by retail clients, as opposed to institutional
and genuinely sophisticated investors. We have heard a lot about principal
protected notes, PPNs. Are they vehicles of trading or are they simply
Mr. Tanguay: Principal protected notes are very complicated
instruments. We have raised the point several times that some of these products
are very complex. They involve a cash part, an option part, a futures part or
whatever, and they are distributed by sales representatives who sometimes do not
have the proficiency or the knowledge to explain the product to their clients.
Securities representatives should be required at least to take a course so that
they properly understand what they are selling to their clients. Lack of
knowledge on the part of the sales representatives may actually be the main
drawback or weakness of the hedge fund products.
The Chairman: Thank you very much. We found this fascinating. We want
to commend you on your very intensive examination of the question for us. We are
trying to learn to understand your business, which is very complex. At the same
time, we are trying to educate the public. We all appreciate your contribution.
If there is anything else you can contribute to our examination in writing,
please feel free to do so. We are still waiting for the public to react and we
will take their contributions in hand as well.
We will continue our inquiry into hedge funds in Canada. We are delighted
that our next witness is Mr. Gary P. Selke, President of Front Street Capital.
We heard evidence yesterday from the Toronto Stock Exchange that the numbers
in Canada in 2004 were about $28 billion, but it is growing at a compound rate
of over 30 per cent. We are in a fast and burgeoning area of activity for
financial services. We are concerned about the risks to the economy and the fair
risks that should be undertaken by individual consumers and investors.
Senator Angus: We are delighted to see you. We know you were in the
room for the previous witnesses so you have that background, as well. You know
we are interested in selling chocolate bars short and dealing in those kinds of
Gary P. Selke, President, Front Street Capital: I was most interested
in orange juice.
It is an honour to appear before the committee and I am delighted to be here.
If there are any questions the committee might have, now or in the future, I
would be happy to respond.
One concern that exists is transparency. I would like to assure the committee
that we are completely transparent with respect to our activities — certainly
with all of our service providers, as well as our clients. Hopefully, this will
be a helpful discussion.
The Chairman: One moment, Mr. Selke. Would you be related to one of
the great Montrealers of all time?
Mr. Selke: I am proud to be the father of Frank Selke, who turned 20
yesterday; and I am the son and grandson of Frank Selke.
We are originally from Toronto, but I was able to sit at the Montreal-Toronto
game on Saturday night at centre ice, because my grandfather was the general
manager of both Toronto and Montreal. When it was appropriate to lean to the
left, I went that way; when I had to go to the right, I did that also.
The Chairman: We, in Toronto, feel that we know your Toronto roots. We
knew your grandfather's Toronto roots very well. We were delighted when he was
in Toronto and were aghast that he would go to Montreal. However, we understand
because hockey is our national past time and we ultimately are patriots.
Thank you for telling us about this history, because your family has been
part of Canada.
Mr. Selke: Thank you very much. I appreciate that.
I am President and Chief Executive Officer of Front Street Capital, which is
a Canadian investment and hedge firm. We run approximately $2.3 billion in the
hedge fund space. We run three essential strategies: a diversified and
opportunistic strategy; a sector-specific strategy, involving energy and mining;
and, a topic currently on various headlines, long-short income trusts. We did
very well yesterday, thank you very much. It is something to think about.
Mr. Chairman, if I may, I will leave with you a magazine report that came out
in September 2006, called "A Hedge Fund Market in Focus.'' It is a 30-page study
written by an internationally recognized group. We had nothing to do with the
commissioning of it. It attempts to explain the state of the hedge fund market
in Canada. We have extra copies that we would be delighted to share with the
committee. It is a good overview for committee members to peruse.
I am a chartered accountant by profession and, having realized the limits of
that skill set, I became involved in the investment business 25 years ago. I
have been involved in the investment business as an investment banker for 15
years. Ten years ago I left RBC Dominion Securities and formed the predecessor
firm to Front Street Capital with one of my current colleagues. I have been in
the investment counselling money management business for the last 10 years.
I will give the committee a quick overview of what we believe to be the
market in Canada. We would concur with the earlier testimony or views that it is
about $20 billion, of which approximately 50 per cent or $10 billion would be
essentially hedge fund product backed by principal protected notes. About 20 per
cent or $4 billion would be backed by fund of fund product and about 30 per cent
or $6 billion in stand-alone hedge fund product.
That would involve single-manager activities. There are about 100 stand-alone
managers in Canada. To give you an order of magnitude, however, and this is
interesting in terms of understanding the scope of the market, there are
approximately 15 firms in Canada that manage in excess of $100 million. There
are only two firms that manage in excess of $1 billion. Our firm happens to be
one of the two.
Generally speaking, all members in Canada, as the chair suggested at the
outset, are regulated by provincial security regulators. We must be registered
there. Our firm makes an application. The relevant securities body tests to
determine whether we are proficient in the area and have the expertise to
provide advice to the public. They examine our records and, depending upon the
results of our records and capabilities, they licence us and we report to those
bodies. Currently, Front Street Capital is registered with and regulated by the
Ontario Securities Commission, the British Columbia Securities Commission, the
Investment Dealers Association, and the Canadian Investor Protection Fund. We
are also registered with the U.S. Securities and Exchange Commission.
Senator Angus: As a securities dealer?
Mr. Selke: No, as an investment adviser to a long-short hedge fund.
We welcome increased transparency and oversight. As an editorial comment, I
am puzzled by the commotion existing in the United States with respect to the
reluctance of the community to submit themselves to regulatory oversight. There
is nothing wrong with regulation. It provides credibility, transparency and
trust-worthiness, and my partners and I at our firm welcome it with open arms.
I will explain the particular positions that we run for the firm. We have
daily oversight through triple reconciliations with our service providers, prime
brokers, custodian and valuation and we back it up against our own. We do that
three times a day to ensure that positions do not get out of order.
Concerns have been expressed here at the committee or in the public generally
that there is a lack of oversight and a lack of compliance. In our firm we have
a registered chief compliance officer and, like many firms, we have general
counsel, all charged with the overview of ensuring that the relevant funds stay
within their investment guidelines. The investment restrictions in which each
fund operates are pre-determined and set up on a computer monitoring system such
that if we happen inadvertently to go over a limit, which does not happen often,
it is be recognized and flagged, an exception report is produced and the error
is corrected the next trading day.
In the event that the relevant portfolio manager wants to keep that position,
that person loses control of the position, which reverts back to the chief
compliance officer and is put back on side. It is important that controls exist.
Investors with a position in Amaranth would be groups such as pension funds,
insurance companies, banks and funds of funds. Our firm runs its own money, so
we have pension funds and international banks and high net worth individuals as
investors in the fund products that we manage. We would not have had any
exposure to Amaranth other than through the social networking that occurs within
the community; and we know the fellows well.
From a distance, it would appear that there was just a walk away from the
risk management and that risk management was ignored. Had risk management been
applied as it was written down, there would have been no problem.
Senator Angus: We were told during our recent trip to New York that
because of the depth of the kinds of investors in that fund, the market was able
to absorb it. It came and went and there was no run on it like there was on Long
Term Capital Management in 1998.
Mr. Selke: That is correct. The funny-sad thing is here we are, six
weeks after the event. Had they had sufficient capital to carry it through, they
would be solvent today because the market has returned to exactly where it was
August 1, when the natural gas market was at roughly $7 per metric cubic foot
and fell to about $4.50 per metric cubic foot mid-September. That was the straw
that broke the camel's back. Today, it is back to $7 per metric cubic foot.
The Chairman: We were curious about the fact that the market was able
to absorb the loss with no real impact on the marketplace, although many people
lost a great deal of money. One of the managers in that fund was able to set up
a new fund in short order and accumulate about $800 million. You are regulated
in the sense that you as a fund administrator and portfolio manager are
regulated at the top, not at the bottom. Had that situation happened in Canada,
would that person have been able to set up a fund the day after and accumulate
that much capital so quickly? Obviously, people trusted him because he was able
to attract the money; we are being curious, not critical. Could that have
happened here? You said that it occurred because of a fault in risk management
of the fund.
Mr. Selke: That is correct. The individual responsible for that trade,
Mr. Hunter, from Calgary, was not the person who received the backing to which
you just referred. It was the Toronto-based equity group that received U.S. $800
million from Moore Capital in the United States.
The Chairman: We were privileged to speak to one of the chief officers
of Moore Capital in New York, but we did not have an opportunity to ask him this
question. He did have some serious insights into the hedge fund.
Senator Angus: You need extremely deep pockets.
Mr. Selke: Yes, it is a $10-billion fund. To make members of the
committee smile, on ebay, should one wish to bid, the business card for the risk
manager of Amaranth is now up for auction. You could put it beside your Bre-X
The Chairman: If our cards were out in the marketplace, we would
probably be seriously undercutting the marketplace.
Mr. Selke: Our firm handles about $2.5 billion. We have been very
successful in that respect. We started with 11 individuals. We have grown to 30
people based in Toronto. The partners have in excess of $200 million invested in
the funds that we manage. That is a very important aspect of goal congruence. We
pay the same fees and bear the same risks. We have the same chance of profit and
risk of loss as our investors have. That is an important statement to make, and
it is an important marketing plus.
Most investment firms in this country cannot make such statements. That would
typically be true of most of my peer group and competitors in the hedge fund
side of things. Long only managers do it on an agency basis. We take the
position that we are principals in the business. If we are providing advice on
funds, we should be invested in all of those funds. If we do not have the
conviction to put our money in alongside our investors', we do not manage that
In 1999 we began to run a long-short Canadian equity strategy. By the way, we
only manage Canadian assets. We do not trade in derivatives. Notwithstanding the
elucidating testimony from the earlier group, we do not trade derivatives
because we do not understand them. We try to stay to the very narrow area that
we are involved with, which is Canadian equity long-short, energy shares in
Canada long-short, mining shares in Canada long-short and income trusts
Since 1999, which is when our investment mandate began, we have compounded in
excess of 20 per cent versus the Toronto Stock Exchange index rate of about 5.5
per cent. We have provided excess returns to our client base with less than
The hedge funds are sellers of risk if they do their job properly. Hedge
funds are not meant to provide excess returns. Hedge funds are meant to sell
risk. Sometimes people forget they are in the risk management business. I made
sure to bring my little book here today entitled Managing Risk, because
that is what a hedge fund does. A hedge fund attempts to minimize risk. That is
very important to consider.
A hedge fund is not someone standing in the financial market rolling the
dice. That is a speculator. We as a firm, and we in terms of the funds we
manage, do not take speculative positions; we manage risk.
This is very important. In the context of the investment world, it is a risk
return trade-off. One can have excessive returns if one takes excess risk. In
our view, one of the better things to do is sell risk. That is why we have been
Our energy-specific and mining mandates have done very well. We are at 28 per
cent on our energy mandates. Our mining mandates since inception have been
roughly 24 per cent, 33 per cent and 47 per cent.
Senator Angus: Is that on both the long and the short side?
Mr. Selke: That is the net number after all fees. Every number that I
have given you is after all fees, all expenses and all costs.
Senator Angus: I am running out to phone your firm.
The Chairman: What exactly are your fees?
Mr. Selke: We charge a 2 per cent management fee and a 20 per cent
performance fee, which is relatively standard.
The Chairman: Is the performance fee after a certain return to the
investors or is that a flat rate?
Mr. Selke: In our case, once we hit a certain threshold, we set the
The Chairman: What is the bar?
Mr. Selke: The bar would be 8 per cent gross.
The Chairman: If an investor puts in $1 million with you and you
charge a 2 per cent commission on an annual basis —
Mr. Selke: That is a 2 per cent management fee.
The Chairman: Yes. What type of return does the $1 million have to
earn before your 20 per cent performance fee kicks in?
Mr. Selke: It would be fund specific. As an example, if we attained an
8 per cent return net of all expenses, we would then be in what we characterize
as performance territory. From that point on, there would be a daily accrual and
the independent evaluator would make a provision in the asset value of the fund
for the performance fee payable.
The Chairman: The 8 per cent would be net of your 2 per cent
Mr. Selke: Yes, in that particular example.
The Chairman: Essentially, it would be 8 per cent after all fees, and
then your 20 per cent of the overage would kick in?
Mr. Selke: Yes, that is one example.
Senator Tkachuk: Is that standard for the industry?
Mr. Selke: No, that would be considered low. In the United States,
generally speaking, there are no hurdles or thresholds. One of the more
prominent managers there would charge a 3 per cent management fee and 25 per
cent of all profits from zero.
There are a number of other examples in the United States where the fees are
much higher. The Canadian fees I have just mentioned vary depending on the
particular negotiating skills when the fund is set up or just relevant to the
underlying strategy. Different managers have different fund structures. Some
managers may charge less and some may charge more. Someone said earlier that it
is a free market. No one is forced to allocate money to the particular strategy.
If people wish to do so, they can.
Senator Goldstein: In your operation, if in a given year the fund
suffers a loss, do you have to get back to the threshold from which you took the
loss in order to start participating with respect to your 20 per cent?
Mr. Selke: That is known as a high watermark, and the answer is
In a case where you went from $10 to $20 with 100 per cent return, you would
do very well. In the next year, if you went from $20 to $15, you would have to
make up for it before going into the next calculation.
Senator Massicotte: Is it a cumulative 8 per cent return?
Mr. Selke: Yes.
The Chairman: Let us return to your earlier comment about regulation.
You support regulation. We had intensive discussions in the United States
several weeks ago with officials from the Federal Reserve Bank of New York, the
New York Stock Exchange and major banks, and they were divided on the question.
They had been lightly regulated with registrations. Then the Goldstein
decision came in, and after 18 months it is back to free form with no
We do have a form of what I call "regulation light,'' by which I mean the
brokers, the administrators and the portfolio managers are, in effect, licensed,
but the fund itself is not licensed, based on what we heard yesterday from Mr.
What do you mean when you say that you are prepared to invite more
regulation? Please give us some specifics. We are very conscious of not wanting
to recommend anything that will affect the workings of the marketplace.
Mr. Selke: Perhaps I can come back to that question.
The Chairman: Yes, please do.
I will ask Senator Goldstein to chair this meeting at this time because I
have to leave in five minutes to present evidence at a committee of the House of
Commons. If you could return to that question for the purpose of the record, I
would appreciate that.
Mr. Selke: The strategies we would typically employ that are relevant
to hedge funds in general include arbitrage, that is, selling a weak company in
an industry and buying a strong company in the same industry. That is pairs
trading. We do short selling, where you identify a weak company on its own.
There are large-capitalization trades and small- capitalization trades.
Generally, the large-capitalization companies are slow and lumbering and the
smaller ones move a little faster, and capital is allocated accordingly.
Convertible arbitrage, warrant arbitrage and merger arbitrage are standard
I will not get into the specifics of the different strategies. Suffice to say
they are in the offering documents that are put out to the investment community.
They are written in plain English, so they are understandable and not confusing.
They are very clear statements. The investment strategy is articulated just as I
have set out here.
Our firm writes our offering memorandums with prospectus-like disclosure. If
we had the ability to file them as prospectuses, we would. We have filed four
long-short strategies with the regulators in Canada. We currently have two
long-short strategies listed and trading on the Toronto Stock Exchange — the
Front Street Performance Fund, which is a long-short Canadian equity, and a
Front Street long-short income trust fund.
These funds are fully regulated and fully transparent. We are completely
compliant with all securities regulations that exist in the country. We would
encourage the development of that compliance. We are likely the only Canadian
firm that has gone this far.
The investment community in Canada, the underwriting community that knows our
firm, knows the principal well. When we sign certificates that state that the
disclosure is full, true and plain and the underwriter has done the appropriate
amount of due diligence on the strategy and on the disclosure that is in the
offering document, they are prepared to sign. I am happy to say that we have had
support from the Canadian investment community, which would be the members of
the Investment Dealers Association, who are typically subsidiaries of the
various large financial institutions in the country. We have been supported
wonderfully well by that community.
I will be speaking on this topic next week at a hedge fund conference in
Toronto. There are concerns with respect to the so-called "retailization'' of
hedge funds. We believe that one of the issues associated with that is full,
true and plain disclosure, that it is very important for all investors, in any
investment product, to have the ability to understand, which in our system is
the duty of the broker or financial adviser who is selling or marketing the
particular product. That is very important, and we are completely in agreement
with that. The know-your-client rule and the suitability of the particular
investment are absolutely paramount.
We do not liaise with individual investors. I know that you will all rush up
to me after the meeting and wish to allocate money. The good news is that I will
not take it, because we do not deal with the Canadian public. We create product
that is then distributed, and it is the duty of the investment adviser or the
financial representative to find out whether that product is suitable, given the
knowledge level, the means and the financial situation of the client, and to
comply with what is known as the know-your-client rule. That is the key aspect.
We are completely and totally in sync with respect to transparency.
The Chairman: Senator Goldstein will assume the chair. He has only a
short term here. It is important that he indicate his great talents as a
chairman. Senator Meighen, a long-serving member of the committee on the
Conservative side, will be the temporary vice-chairman.
I apologize. I am due at another committee on the other side to present
evidence on one of our reports. You will be in capable hands with Senator
Goldstein and Senator Meighen.
Mr. Selke: Thank you.
Senator Yoine Goldstein (Acting Chairman) in the chair.
The Acting Chairman: Please continue.
Mr. Selke: Our view is that the hedge funds can reach the so-called
retail market, the moms and pops of the world, in Canada through only two
avenues. One is that you wrap a hedge fund product around something known as a
principal protected note. In security law terms, the product ceases to become a
hedge fund and is now wrapped by the institution that is issuing the principal
protected note. The other method, of course, is to issue an offering memorandum
to accredited investors, which takes it out of the retail level and moves it up
to people who are thought to have knowledge because they have money in their
pockets. The two do not necessarily go hand in hand, as we have found out.
Senator Meighen: Are you in favour of mom and pop, in other words,
unsophisticated investors, being able to purchase hedge funds directly?
Mr. Selke: At the present time, investors can purchase funds through
this mechanism of the principal protected note.
Senator Meighen: I am leaving that one aside, because we had evidence
yesterday that that is possible, but it also perhaps cries out for some sort of
Mr. Selke: It is challenging because it does not fall within the
purview of the Canadian security regulator. They are challenged in terms of the
requirement to have full, true and plain disclosure. Any financial instrument
should have full, true and plain disclosure. If the strategies employed are
properly disclosed and vetted by a provincial securities regulator, it is hard
to imagine why the risk increases.
For example, during the tech boom, the provincial securities regulators
suspended the so-called prudent-man rule, which had been in existence since
1847, and allowed mutual funds to have investments in a particular company —
Nortel — well in excess of what was prudent. They were able to take it up to a
level of 35 per cent of the particular fund because that was the market weight
at the time for that particular company. As we all know, that particular company
fell on hard times and went from more than $100 a share to about $2 a share, and
suddenly that was not prudent.
They have never suspended the law of supply and demand, nor the law of
gravity, nor the need for common sense. Common sense goes a long way in this
We are very much in support of full disclosure and running things with proper
limits in the prudent-man world, which is how we run our funds. We cannot
overload positions, we cannot have high levels of illiquidity, and we cannot
have one position greater than 10 per cent. These restrictions are completely
defined in the offering documents. In our particular case, they would be
completely lifted from the mutual fund rules that exist at the present time.
Our funds are identical to Canadian mutual funds, with two exceptions.
Canadian mutual funds prima facie cannot short-sell securities. We are allowed
to do that. Also, Canadian mutual funds are not allowed to borrow. In our case,
we can borrow, but it is subject to strict guidelines that are governed on a
daily basis by the Investment Dealers Association.
With the current accounting and valuation systems in existence, there is no
reason that the necessary valuation procedures cannot be put in place across the
financial system today. All the controls are there today; it is just not
something that wins many votes. However, from a financial efficiency
perspective, it improves the efficiency and liquidity of markets.
Senator Meighen: I am perhaps being thick on this. If I am a retail
investor rather than a sophisticated investor and I say to my broker, "I have
heard about these Front Street Capital funds. I would like you to buy one,''
you, Front Street Capital, have no obligation to ascertain whether I should be
buying it. That is up to the broker; is that correct?
Mr. Selke: Yes.
Senator Meighen: The burden is on the broker to say I should not be
investing in this or I should be.
Mr. Selke: That is correct.
Senator Meighen: The ordinary retail purchaser has full access to your
long-short income funds.
Mr. Selke: Yes. We are in support of choice.
Senator Meighen: You are also in support of regulation.
Mr. Selke: Yes, regulation and transparency.
Senator Meighen: To what extent do you have to be transparent?
Mr. Selke: What would you like to know?
Senator Meighen: I gather your transparency comes about when you tell
the investing world, probably through a broker, what your fund is all about,
what regulations it follows, what limits it self-imposes, et cetera.
Mr. Selke: We would be delighted to file such documents with the
relevant securities regulators and have done so for our two exchange-traded
Senator Meighen: You are not now required to do so?
Mr. Selke: No, because we cannot offer it that way. We would be
delighted to do that so that it is on the record and we would be subject to the
same rules as any mutual fund. In fact, long-only mutual funds are much riskier
than long- short hedge funds, hugely more risky.
The Chairman: If properly managed?
Mr. Selke: No, prima facie, they are riskier.
Senator Meighen: Then why do hedge funds have this bad reputation, Mr.
Mr. Selke: It is a wonderful mechanism to sell newspapers.
Senator Meighen: I know what you are talking about.
Mr. Selke: It is mentioned in here. For example, the Portus affair,
which was a great headline last year, had nothing to do with hedge funds and
everything to do with breaching the Securities Act; the wrong offering document
was being sold to the wrong people. It had nothing to do with hedge funds. You
could have been selling anything underneath it, pork bellies. It had nothing to
do with hedge funds but it was a wonderful headline and got a lot of press, a
lot of attention and, I dare say, sold a few more newspapers.
The Acting Chairman: It happened largely because of lack of oversight.
Mr. Selke: No, it happened because the individuals involved were bad
The Acting Chairman: But the oversight mechanisms did not catch them
as bad people.
Mr. Selke: One of the individuals leant his name, if you can believe
this, as a portfolio manager in exchange for a fee. These two bad guys then
borrowed his name and used that and then they ran amuck without him knowing
about it. It is like putting a blank cheque on your bank account. Why anyone
would be willing to do that to his or her name, which is the most important
thing you have, is beyond me. You cannot legislate stupidity.
Senator Meighen: Or honesty.
Mr. Selke: Yes, you cannot legislate it. You try to be open and ensure
you pre-screen. The pre-screening aspect is very important. Regarding the
proficiency aspects of it, all my colleagues in Canada that currently employ
hedge funds are all registered. We have all been approved as having met certain
proficiency standards — the same ones, I might add, that are utilized by all the
folks in the mutual fund business. It is the same proficiency standard; we just
have more tools and strategies. As a result, we have been able to generate
slightly higher returns with lower risk.
We are puzzled by the issue around transparency. It is our clients' money,
not ours. If our clients need to understand what it is that we are doing, we ask
them to sign a nondisclosure agreement and they get full access to our prime
broker, which is where the daily activity takes place. It is very important that
one treat one's clients with respect.
The Acting Chairman: Whom do you see as your client, the broker or me?
Mr. Selke: I do not see either of you as my client; the funds that we
create are the client. We have investors who subscribe to those funds. They are
not our clients but investors. I have 20 different fund products; those are my
clients. I do not deal with the public. I do not want to deal with the public. I
want people who are better suited, who have the appropriate compliance system,
the skill set and the level of knowledge to do that. They can do the suitability
aspect of it. They should do that; that is their strength. Let us do ours.
Restrict us to our activity, which is managing money. That is what we are good
Senator Massicotte: Who owns Front Street Capital? Are there any
financial institutions with an interest in it?
Mr. Selke: No. There are five partners in Front Street Capital. Three
partners, myself, Frank Mersch and Norm Lamarche, each own 30.25 per cent; my
chief operating officer, David Conway, owns 5 per cent; and our office manager,
Linda Hryma, owns 4.25 per cent.
Senator Massicotte: You have often said that at Front Street Capital
you disclose your practices. You are one of the two largest hedge fund managers
in Canada. Given your size, it is easier for you to comply and satisfy
investors' expectations. However, can you tell us about other hedge fund
managers? Tell us about the ones that are much smaller. In your mind, is the
disclosure adequate in those cases?
Mr. Selke: Likely not. It would only be suitable to the institutional
investor or to the accredited or high net worth investor because it is an easier
standard for them to attain with respect to disclosure. It is not that they are
not capable, but the cost of complying with the disclosure requirements that
would be required from a "public perspective'' would be too high and too costly.
Senator Massicotte: Therefore, they do it by the private placement
Mr. Selke: That is correct.
Senator Massicotte: Are investors in these cases adequately
knowledgeable and getting adequate information to understand the risks and
expectations they should have from these funds?
Mr. Selke: Yes; that would be my conclusion.
Senator Massicotte: People are not surprised. When they lose money
they do not say, "I did not understand. I did not know.'' You think there is
adequate information being afforded?
Mr. Selke: Yes; they understand.
Senator Massicotte: Is that the case for all funds?
Mr. Selke: I would put it very close to 100 per cent.
Senator Massicotte: People talk about conflicts in the industry where
a manager may own part of the distribution system. We see in the banking system
where they obviously push their own product and sometimes a sales person is not
as informed or as knowledgeable as possible because there is an orientation
motivation to sell your product. Is that the case in hedge funds? Do we see such
Mr. Selke: There are different conflicts. For example, your interest
might diverge from the interests of the investors in your fund product. One way
we have tried deal with that is that my partners, myself and the rest of our
staff do not buy and sell individual securities. When we have extra cash,
liquidity, we buy the same fund units that our clients buy. We are in the same
investment pool, so there is no ability for us to say, "I like stock A and I am
willing to really invest in it.'' If it is good enough for me, it is good enough
for the fund. The investor has to come first. We make that comment at every
presentation: The client must win first before the adviser wins. If you do not
do that, and it is not transparent and it is not auditable, there is the
potential for conflicts and poor behaviour.
We have a 25-page due diligence questionnaire that we table with our clients.
There are 200 questions. If 200 questions are not enough, they are allowed to go
to 201, and they should. When people say they do not know enough, that is up to
them, but they have to ask for this material.
Senator Massicotte: The key is alignment of interest.
Mr. Selke: Absolutely.
Senator Massicotte: Is your comfort level for conflicts similar to
that of other fund managers?
Mr. Selke: I am aware where there are conflicts that may or may not be
disclosed, but we would not have specific knowledge of them.
Senator Massicotte: One major conflict arises from the fact that you
share 20 per cent of the upside after a certain prior return, if you wish.
Therefore, many fund managers do not share the losses. That may not be so in
your case, but you may use debt to a significant degree because if you buy $1
million of security and you finance it for 80 per cent or 90 per cent, your
upside is more significant, and if you called the wrong shot, you lose money.
The fund manager does not share that loss. Is that a problem in Canada and is
debt used significantly by the hedge funds?
Mr. Selke: In our particular case, we use virtually no debt. That just
happens to be the way we run our different funds. Debt is typically not used a
great deal in Canada. It clearly was the straw that broke the camel's back, if
you wish, with the Amaranth situation, where they were levered up 10 or 11 to 1,
not quite like Long Term Capital Management, which was 200 to 1.
Senator Massicotte: Just to make sure, 200 to 1 means you are financed
at 98 per cent or 99 per cent?
Mr. Selke: Yes. They took a big bet with other peoples' money.
Generally speaking, the Canadian hedge fund community does not use an enormous
amount of leverage. That is not a strategy with which Canadian portfolio
managers are generally comfortable. You might be able to say, what about
so-and-so, as an exception, but, in general, Canadian portfolio managers, if
their assets are custodied at the various brokers in Canada, are subject to the
IDA margin rules. Those rules prevent you from significant leverage by
definition. Those margin ratios, safety ratios, are calculated on a daily basis.
Senator Massicotte: There is nothing wrong with that as long as
investors are aware.
Mr. Selke: Yes, it should be disclosed in any document.
Senator Massicotte: You think it is; do you think most investors of
hedge funds know?
Mr. Selke: Yes.
Senator Massicotte: Regarding the coincidence of people with hedge
funds going to mutual funds, a generic and wide definition of investments is
allowed; therefore, there is an immense discretion to the fund manager, and that
is the scary part.
Mr. Selke: Agreed. The committee might consider that there is nothing
wrong with making a suggestion that you apply the same types of rules that exist
within the mutual fund world. For example, in the mutual fund world one cannot
have an exposure greater than 10 per cent to any one name. That seems to me
pretty smart. That will limit your exposure. You should not have more than 10
per cent of your portfolio in illiquid securities. That seems smart, too.
Senator Massicotte: Would you use those rules for all hedge fund
managers or only those who go retail?
Mr. Selke: I would only use them for those who go retail. If someone
in a private contract to buy a fund wants to go 30 per cent into one name, that
is fine, as long as the person knows and has full, true, plain disclosure.
Senator Meighen: That is with a sophisticated investor.
Mr. Selke: That is with a sophisticated investor, absolutely. If you
are talking retail, the prudent-man rule was created for a reason, because
somebody was prudent a long time ago. It ran for 153 years before that rule was
suspended. It begs the question why that rule has not been reinstated. It was
prudent for 150 years.
Senator Massicotte: You mentioned earlier that you need more
regulations for retail. Why is that the case? If you go retail, you must follow
a prospectus. By its nature, there is full and plain disclosure. What more would
Mr. Selke: You would not need much more.
Senator Massicotte: You would not need more regulations, just the
application of the regulations.
Mr. Selke: We need the application of existing rules. One does not
need new rules to prevent bad behaviour. If people will misbehave, the presence
of the rule will not prevent them from misbehaving.
Senator Massicotte: Agreed.
Senator Meighen: Senator Massicotte was getting to the area that I
wanted to ask about. One thing that I retain as a suggestion of yours is that
some of those basic rules of mutual fund management behaviour could be applied
to the retail hedge fund.
Mr. Selke: I completely agree. A compliance regulatory system is
already in existence. There is the ability to do oversight. One can have all the
transparency one wishes because of the existence of the current application of
technology. All of that can be fed in. You can get instantaneous disclosure.
Nothing prevents it. That product, in and of itself, is lower risk than the
equivalent long-only product. No one can refute that.
Senator Meighen: No, but it flies in the face of popular belief.
Mr. Selke: That is correct. If I may be bold, it is up to us as
participants and the committee here as leaders to make recommendations to try to
reduce risk. For example, we had an announcement Tuesday night about the income
trusts. I am not here to chat about whether it is good or bad; it just is.
Yesterday, income trust in Canada fell 13 per cent. The energy trust portfolios
went down 15 per cent. They are down a further 4 per cent or 5 per cent this
morning, according to my recent information.
I am happy to report to honourable senators that investors in our long-short
income trust fund were down 6 per cent. Those were all retail investors in
Canada that bought pursuant to a prospectus filed with the securities regulators
across Canada, all members in that, and they suffered dramatically less as a
result of the hedging strategies and the ability for us to effectively protect
our client base from risks that we did not know existed. I am not trying to take
a position one way or the other. We do not know all the risks out there. That is
what we do; we try to sell risk.
Senator Meighen: I refer to evidence we heard yesterday from Mr.
St-Gelais and Mr. Wilson. They believe there is a need to regulate in some
fashion the principal protected notes. Do you subscribe to that?
Mr. Selke: Principal protected notes, or PPNs, are a confusing product
because they have enabled folks to make relatively large commissions. There are
hidden fees buried in that product because there are no disclosure requirements.
We share your committee's concern about the lack of disclosure. The inability of
the regulators to force full, true and plain disclosure in PPNs goes to the
heart of the issue of transparency. We would welcome full transparency in PPNs.
You must disclose what your costs are.
Senator Massicotte: The reason you are not getting full disclosure is
because the Bank Act does not require it and those selling PPNs are members of
banking institutions; is that correct?
Mr. Selke: You are absolutely correct. Technically speaking they are
not securities subject to the disclosure requirements of the provincial
regulators because they do not have the ability to comment on federal matters.
Here I am in Ottawa. I can assure you that members of my community would welcome
federal regulation in security matters. Forgetting the political world, I can
tell you that the investment community across the country wants a federal
regulator because at the end of the day we have the provincial costs and the
differing rules kill us. No other country has this.
I am getting political, which I am not allowed to do.
That would go to the heart of the matter because you get one rule and you
have full transparency all the way up.
I spoke at a conference last year where I called this regulatory arbitrage, a
term that Senator Massicotte used. Basically, if you regulate, you have
arbitrage between the regulators, and what good is that? That does not serve the
Senator Meighen: We were told yesterday that managers of hedge funds
in Canada are unregulated, unlike in the United States. We were told that the
administrators should be also be regulated. Do you have a problem with that?
Mr. Selke: No. I am puzzled by the statement because I would have
thought they were. Our administrators are either the Royal Bank of Canada or
Citigroup. They are subsidiaries of banks. We also use CIBC Mellon. All use the
normal custodian record-keeping groups. We do not want to deal with Fly-by-night
Administration Inc. It provides no confidence in our client base.
Senator Meighen: Mutual fund fees are lower in the United States than
in Canada, yet you told us that hedge fund fees, or long-short fund fees, are
lower in Canada than in the United States. How do you account for that?
Mr. Selke: That is a good question. There is a perception in the
United States that people are prepared to pay for value received. There are
low-end, mid-end and high-end stores. You can get fine cotton shirts at the high
end and cheap cotton ones at the low end. You get what you pay for. If people
want high-end value, there is nothing wrong with paying for it.
Senator Massicotte: Are you suggesting that your service is not as
good as that of the Americans?
Mr. Selke: Oh no. In fact, I welcomed Senator Grafstein's earlier
comment that there would be a 30 per cent to 40 per cent growth in the business.
I would like to capture some of that. I am doing everything I can to achieve
The Acting Chairman: We have two dominant interests. The first is to
recommend what we can to ensure financial stability in the market, and that
includes all kinds of things, including regulation. Many of us here are not
great admirers of regulation except to the extent that it is necessary. We have
different views of the extent or quantity of regulation with which we ought to
be prepared to live.
Our second concern is the protection of consumers who rely on a system they
do not, by and large, understand and on investments they may not understand as
well as they could or should.
I am concerned about the definition of "sophisticated investor.'' At the time
the concept was created, $150,000 was a fairly high threshold. For a retiree who
has $1 million in retirement funds, risking $150,000 as a sophisticated investor
is a very high risk.
The threshold in the United States and in the U.K. to determine who is a
sophisticated investor is significantly higher. What is your view as to the
appropriateness of the threshold we now have?
Mr. Selke: The definition of "sophisticated'' does not necessarily
equate to whether you have money. There are a number of bright young
whipper-snappers coming out of various schools who are extremely sophisticated
and who do not have money. As well, there are a number of retirees who might
have seven-figure nest eggs who are exceedingly unsophisticated.
I appreciate that as a bright-line test it is easy to say that if someone has
$1 million, they are sophisticated, and you can tick the box. Mr. Tanguay
suggested that investment advisers needed to take certain proficiency courses so
that they are competent in understanding the products they are marketing or
selling. It is one thing for the seller to know, but it is more important that
the buyer knows.
If the duty of this committee is to protect the consumer, should you not
prevent the consumer from doing something that is arguably, to be blunt, stupid?
You might want to consider making a recommending that before one can be defined
as accredited they must take some courses and learn about the risks involved.
In your example of investing $150,000, it is not that amount that is at risk;
it is, generally speaking, the profit or loss associated with that. It is the
allocation of it. It is my view that we need communication, transparency,
education and disclosure. You have to educate the investor. If the person does
not want to take the time to it, maybe they should not invest.
The Acting Chairman: We want to thank you for a fascinating and
informative presentation. We may have to ask you to come back again. If there is
anything that you believe we have not covered adequately, we would appreciate it
if you would contact us about it.
Mr. Selke: Thank you. It has been an honour to be here. I hope that I
have been of assistance.