Canadian capital markets 2024 regulatory outlook: Implications from the CSA’s 2023 Annual Report on ‎Capital Markets ‎

On February 15, 2024, the Canadian Securities Administrators (the “CSA”) published its Systemic Risk Committee’s (the “Committee”) 2023 Annual Report on Capital Markets (the “Report”). The Report provides an analysis of recent trends and key vulnerabilities in Canadian financial markets, and outlines the CSA’s efforts to mitigate those vulnerabilities and associated risks. This is the first time that the report has been made public.

The Report represents the Committee and the CSA staff’s observations regarding broad trends in capital markets that contribute to systemic risk. The Report is informative as it provides an indication as to the CSA’s areas of focus in the coming year. In this article, we will outline the main risks and vulnerabilities highlighted in the Report and comment on how these risks can impact participants in Canada’s capital markets.

Overview of main vulnerabilities

Benchmark transition

Since 2018, the Canadian Alternative Reference Rate Working Group has led Canada’s transition from the Canadian Dollar Offered Rate (“CDOR”) to the Canadian Overnight Repo Rate (“CORRA”). One of the most significant effects of the transition from CDOR to CORRA that was identified by the Report is the disappearance of Bankers’ Acceptances (“BA”) based loans. Comprising about 20 percent of the notional amount outstanding in the Canadian money market, BAs are the second largest money market instrument after treasury bills. BAs are expected to be replaced by a mix of existing financial products and new products yet to be developed. The Report notes that there is a potential need for exemptive relief from National Instrument 81-102 Investment Funds if capital market participants, notably money market funds, use alternative products to replace BAs. Capital market participants that are involved in money markets and the trading and/or issuance of BAs, may find it relevant to consider this issue and determine if seeking exemptive relief is appropriate.  

Crypto asset market

The Report signals that the crypto asset market remains volatile and unstable, however, the links between the crypto asset sector and the traditional finance sector appear limited. That said, the Report noted that the CSA will continue to work with regulators to examine any potential supervisory gaps and risks, especially related to value-referenced crypto assets (“VRCAs”), and signalled that further regulation can be expected in this area.

The Report also highlighted the Autorite des Marches Financiers and Ontario Securities Commission’s contribution to the International Organization of Securities Commission’s (“IOSCO”) Policy Recommendation for Crypto and Digital Asset Markets Final Report (the “IOSCO Recommendations”). The IOSCO Recommendations contain a number of policy recommendations in relation to VRCAs and the crypto asset market in general. One such example is the recommendation for crypto asset service providers to provide disclosure regarding the terms of VRCAs to purchasers, such as what the VRCA represents, including the reserve assets, how the VRCA is pegged and the reference asset for the peg (e.g. to a single fiat currency, a basket of currencies, etc.).  

The Report signalled that jurisdictions in Canada may begin implementing and adopting the recommendations contained within the IOSCO Recommendations in 2024. Issuers that are involved in the crypto asset space should follow these developments closely in the year ahead. 

Exchange-traded funds

The Report noted a few concerns in relation to exchange-traded funds (“ETFs”). First, the Report highlighted the growth of “active” ETFs. In an active ETF, portfolio managers work under a discretionary mandate to add or reduce positions in individual securities, in contrast to passive ETFs that replicate an index. The share of active ETFs has grown and now represents approximately 12% of the Canadian ETF market in terms of net assets. The Report highlighted concerns with the lack of disclosure of the positions of active ETFs on a daily basis, which could impact deviations from net-asset value and bid-ask spreads.

Second, the Report expressed concern with certain ETF’s market resilience, particularly those that invest in less liquid assets, such as fixed-income instruments that do not typically trade on centralized marketplaces. The concerns revolved around impaired liquidity in times of stress and the deviation of the trading price from the value of the fund’s underlying assets.

The Report signalled that the Committee will continue to monitor ETF resilience with a focus on active ETFs and ETFs that invest in less-liquid assets. In addition, the CSA launched a review of ETFs in 2023 to assess whether the current regulations applicable to ETFs remain appropriate. Capital market participants can expect increased regulatory scrutiny from the CSA regarding ETFs as these developments unfold. 

Marketplaces

The Report found that a major disruption to the TMX Group exchanges (the TSX, TSX-V and Alpha) could have a significant impact on market participants. The Report based this finding on an analysis of the TMX outage on November 1, 2022 and found that marketplace participants are extremely reliant on the TMX Group exchanges. This conclusion was based on the fact that instead of seeing an uptick in trading activity on other marketplaces that may have benefited from a TMX outage, there was a substantial decrease in trading activity in all but a few marketplaces as many market participants rely on TMX for access to information.

The Report noted that the IOSCO has been examining market outages in various jurisdictions to develop guidance to enhance market resilience. The Report signalled that this guidance, once released, will inform future CSA market policy considerations. 

Mutual funds

Overall, the Report found that risks posed by mutual funds to capital markets in Canada were relatively low. However, the Report signalled that the CSA may update its regulatory oversight of the liquidity of mutual fund units. The Report found that when faced with significant outflows, mutual fund managers may experience a liquidity mismatch. While regulation is currently in place through National Instrument 81-102 Investment Funds, the Report indicated that the CSA continues to examine the extent to which its regulatory approach aligns with international best practices, specifically, with respect to recently published IOSCO policies regarding vulnerabilities from liquidity mismatch in open-ended funds.

Over-the-counter derivatives

The Report began by conducting a review of the risks that over-the counter (“OTC”) derivatives have posed to the financial system in the past, notably, during the 2007-2008 financial crisis. While the Commission was of the view that regulatory developments in Canada have helped to mitigate this risk, OTC derivatives still pose threats to Canadian capital markets as they can facilitate the buildup of large exposures and create negative knock-on effects from the failure of a highly leveraged and interconnected entity.

As such, the Report identified the OTC derivatives market as an area that will continue to see regulatory developments. One such development was the adoption of Multilateral Instrument 93-101 Derivatives Business Conduct (“MI 93-101”). For a summary of MI 93-101, see our previous article. Additionally, the Report indicated that rules relating to the adoption of harmonized international derivative data standards, improvement in data quality validations at trade repositories, and new responsibilities of reporting counterparties for verification of the data they report, are expected to be finalized in the spring of 2024 and become effective one year thereafter.

Conclusion

Overall the report found that high inflation and interest rates have continued to weigh on the economy and financial markets in 2023. The future path of interest rates and the economic outlook remain highly uncertain and have created challenges for market participants. Nonetheless, the Committee was of the view that risks to financial stability in Canadian capital markets are well contained.

Despite this somewhat optimistic view, there are many areas we expect to see regulatory developments in throughout the year. Canadian capital market participants who may be impacted by any of these developments identified herein, are encouraged to contact a member of our Equity Capital Markets team for assistance.