The Canadian structured finance and Fintech space have seen a number of recent developments, including in the structured finance areas of residential mortgages, covered bonds and derivatives. Similarly, there have been a number of recent developments in the Fintech space, including Marketplace Lending and Blockchain. Below are specific comments on each of these areas which highlights recent developments.
Residential Mortgage Developments
There have been a number of initiatives by Canadian federal government bodies in the areas of Canadian residential mortgages. For instance, each of the Office of the Superintendent of Financial Institutions ("OSFI") and the Canada Mortgage Housing Corporation ("CMHC") have been taking steps to strengthen areas of the residential mortgage market in order to limit losses if economic conditions deteriorate or borrowers are unable to make payments under loans, such as due to rising interest rates following a period of persistently low interest rates, record levels of household indebtedness and rapid increases in housing prices in certain areas of Canada. It is these initiatives that are supporting the possible increase in the securitisation of uninsured mortgage loans to less credit-worthy borrowers ("alt-a mortgage loans") and potentially the re-emergence of a term ABS market for uninsured mortgages.
OSFI, the Canadian regulator of federal financial institutions, released on July 6, 2017 draft changes to Guideline B-20 – Residential Mortgage Underwriting Practices and Procedures ("Guideline B-20") for public consultation. Guideline B-20 sets out the expectations of OSFI for prudent residential mortgage loan underwriting, and is applicable to all federally-regulated financial institutions in Canada that are engaged in residential mortgage underwriting and/or the acquisition of residential loan assets. OSFI is seeking in the draft amendments to clarify and strengthen expectations of federal financial institutions in a number of specific areas, including requiring federally-regulated financial institutions to revisit their residential mortgage underwriting policies on a regulator basis1, requiring a qualifying stress test for all uninsured mortgages to ensure borrowers could afford their loans even if interest rates were two percentage points higher than the contractual mortgage rate being offered, requiring that loan-to-value measurements remain dynamic and adjust for local market conditions where they are used as a risk control, expressly prohibiting co-lending arrangements that are designed, or appear to be designed, to circumvent regulatory requirements, and introducing additional rigour around verification of a borrower's income.
In addition, Canadian federal regulations have been introduced to limit the securitization of private insured mortgage securitizations and to add requirements for mortgage loans to benefit from insurance, which further support the need for the development of financing alternatives for mortgage loans. For instance, in July 2016, regulations were introduced that restricted new private securitisation programs from including insured mortgages in their collateral pools and provided that existing private securitisation programs could only continue to include insured mortgages in their collateral pools during a transition period that ends on December 31, 2021. Also, in October 2016, the federal Department of Finance introduced requirements for lenders of insured mortgages to stress test a borrower's ability to make mortgage payments at a higher interest rate and also proposed a risk sharing regime that would require lenders of insured mortgages to bear a portion of the losses on mortgages that go into default.
Covered Bond Developments
In June 2017, CMHC, as administrator the Covered Bond Programme, introduced the updated 2017 Canadian Registered Covered Bond Guide (the "Guide") which included new requirements to be satisfied on or before January 1, 2018. Covered Bonds are one of the key funding vehicles for major Canadian financial institutions and are supported by collateral pools of uninsured residential mortgages. Issuances to date have been predominately in foreign markets and issued in the following currencies: Euro, Sterling, Swiss Franc, Australian dollar, U.S. dollar and Canadian dollar.
One of the new Guide requirements is the introduction of a regulatory overcollateralization minimum of 103% to complement and enhance the existing framework requirement and to align with global regulatory best practices. As part of the new requirements, minimum and maximum values for the asset percentages used to perform the asset coverage tests are required to be adopted. There are also added disclosure enhancements as part of the new revisions.
Under the revised cover pool sampling methodology, the sample is now required to be collected from newly added covered pool loans to improve the relevancy and timeliness of the data reviewed, which aligns with industry practice and better supports issuers' internal processes. The independent cover pool monitor will also be required to recalculate the cover pool's actual level of overcollateralization in accordance with the new regulatory overcollateralization minimum mentioned above.
OTC Derivatives and Captive Finance Companies
OSFI recently introduced prudential margin rules for non-centrally cleared derivatives ("Guideline E-22")2, with the first requirements under Guideline E-22 effective as of September 1, 2016, and the balance of the requirements phased in over a four-year period.3 Guideline E-22 is based on the framework jointly published by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions and is aimed at mitigating systemic risk in the financial sector and promoting the central clearing of derivatives.
Guideline E-22 applies to non-centrally cleared derivatives transactions between federally regulated financial institutions ("FRFIs"), such as banks and certain trust and insurance companies, and counterparties that are "financial entities", in each case, belonging to a consolidated group whose average month-end aggregate notional amount of non-centrally cleared derivatives for March, April and May of 2016 exceeded C$12 billion (each FRFI and financial counterparty exceeding such threshold, a "Covered Entity"). A "financial entity" is defined under Guideline E-22 as a legal entity whose main business includes, among other things, lending, factoring, leasing, the provision of credit enhancements and securitisation. Helpfully, Guideline E-22 expressly excludes from the definition of "financial entity" certain "special purpose entities" ("SPEs") that are established for the purpose of financing a specific pool or pools of assets or underwriting a specific set of risk exposures, in each case, by incurring indebtedness, as long as the indebtedness of the SPE is secured by the specific pool or pools of financed assets. However, unlike similar margin rules in the United States4 and Europe5, Guideline E-22 does not provide an exclusion for "captive finance companies", which are companies that provide financial products that promote and facilitate the sale or lease of products that are manufactured by the parent company.
In the absence of such an exclusion, a captive finance company that enters into a non-centrally cleared derivatives transaction with a Canadian bank that is also a Covered Entity, including a transaction to hedge interest rate or foreign currency risk, may be subject to the margin requirements under Guideline E-22. By contrast, a captive finance company will not be subject to margin requirements if its counterparty were a U.S. bank or, if such captive finance company is an NFC-, a European bank. This regulatory gap has presented concerns for a number of market participants. It should be noted that facing a U.S. or European bank is not an ideal solution as we understand that it is more expensive for a Canadian captive finance company to trade CAD derivatives with non-Canadian banks.
The Canadian Fintech industry has been rapidly growing over the last few years, similar to other jurisdictions globally. In particular, with respect to marketplace lending, a recent report issued by the Financial Stability Board found that the size of this market in Canada increased from US$8 million in 2013 to US$71 million in 2015.6 The report also identified 23 Fintech credit platforms in Canada in 2015. The number has continued to grow since then. Canada also has a thriving blockchain industry, with Ethereum being developed in Canada. A number of partnerships between established Canadian financial institutions and Canadian and foreign Fintech entities have also occurred, including by way of direct investments, co-branding and white label partnerships.
On the Fintech regulatory front, there have been a number of developments in Canada recently, some of which are in the starting phases and remain ongoing. The Competition Bureau launched a Fintech market study in 2016 in respect of the effects of the Fintech industry on the financial services industry as a whole, which remains ongoing. Canada has also been actively considering or, in some cases, implementing a "regulatory sandbox" concept, as put forward in certain other jurisdictions, such as the UK. The Ontario Securities Commission established an innovation hub, OSC LaunchPad, in 2016, dedicated to assisting Fintechs navigate securities requirements. Similarly, a regulatory sandbox initiative was adopted more broadly in 2017 by the Canadian Securities Administrators, representing securities commissions across Canada. The federal Department of Finance is undergoing a number of consultations relating to the Fintech industry, including with respect to the establishment of a national retail payments framework, and consultations in respect of the federal financial sector framework. In particular, the consultation paper in respect of the federal financial sector framework raises a number of regulatory issues relevant to the Fintech industry, including the concept of open banking. These consultations will likely lead to the development of legislation affecting the Fintech industry in Canada in the future. Therefore, both the Fintech industry and the related regulatory regime remain very much in flux in Canada.
- A residential mortgage underwriting policy is required under Guideline B-20 and sets out limits regarding the level of risk that the lender is willing to accept with respect to residential mortgages.
- See Guideline E-22, Margin Requirements for Non-Centrally Cleared Derivatives, available at http://www.osfi-bsif.gc.ca/Eng/fi-if/rorg-/gdn-ort/gl-ld/Pages/e22.aspx.
- The start date to exchange variation margin under Guideline E-22 was March 1, 2017 for the vast majority of Covered Entities; however, OSFI provided Covered Entities with an additional six months to finalize margin documentation.
- See 81 FR 636, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, available at: https://www.federalregister.gov/documents/2016/01/06/2015-32320/margin-requirements-for-uncleared-swaps-for-swap-dealers-and-major-swap-participants. See also 80 FR 74839, Margin and Capital Requirements for Covered Swap Entities, available at https://www.federalregister.gov/documents/2015/11/30/2015-28671/margin-and-capital-requirements-for-covered-swap-entities.
- See Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R2251&from=EN.
- "FinTech credit: Market Structure, Business Models and Financial Stability Implications", available at http://www.bis.org/publ/cgfs_fsb1.htm