Advisory panel urges caution on OTC derivatives

The panel has issued comments on proposed guidelines governing conduct

Advisory panel urges caution on OTC derivatives
The Ontario Securities Commission’s Investor Advisory Panel (IAP) has commented on a proposed national instrument concerning a financial product that could be risky for unsophisticated investors.

Issued in April, the Canadian Securities Administrators’ (CSA) proposed National Instrument 93-101 aims to govern the business conduct of advisors and dealers of over-the-counter (OTC) derivatives. These include contracts-for-difference and exchange-forward contracts, and are generally used for hedging and risk-management purposes.

“But derivatives can be complex, employ leverage, require margin, lack transparency, and include counterparty risk,” IAP Chair Letty Dewar said in a letter to the CSA. “As a result, derivatives are generally poorly understood by unsophisticated investors.”

Dewar said the IAP supports the instrument’s stated goals, which include helping investors, reducing risk, and improving transparency and accountability. She went on to outline the panel’s recommendations.

On the issue of suitability, Dewar said that “any recommendation involving derivatives is based not just on the suitability of a product, but also fits within the context of a client’s portfolio,” considering factors such as the purpose of including them in portfolios, the client’s risk profile, and their desired outcome.

The panel also recommended that sales OTC derivatives be used as a trigger for enhanced manager and compliance scrutiny. Licensing and training requirements should also be reviewed and enhanced for these products, it asserted, adding that firms should have “robust know-your-product processes.”

“Investors need enhanced plain-language risk disclosure including simple illustrations of the return profiles across a wide range of market environments,” Dewar said. She also reiterated the panel’s call to immediately enact a best-interest advice standard, which she said would essentially ensure that derivatives are used “to improve outcomes for investors.”

The panel also took issue with a provision allowing the requirements of the proposed instrument to be waived. “The panel is concerned that an investor’s ability to waive the applicability of the proposed instrument may result in abuse,” Dewar said.

Finally, she noted that most retail investors are exposed to derivatives, such as futures and options, through exchange-traded funds or mutual funds.

“These derivatives continue to be regulated under existing securities regulations and do not fall within the scope of the proposed instrument,” she said. “Given that derivatives are complex and often poorly understood, their use in any form should require the highest standard of care on the part of those who recommend them.”

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