Since 2008, Canada has acquired a new lustre in the eyes of international investors, as the market that remained resilient when global financial markets fell off the cliff. The usual explanation is Canadians’ general financial conservatism, including a much more cautious approach to credit and risk.

With a lot less leverage in the system, there was much less to unravel. The Royal Bank of Canada, Bank of Nova Scotia, Toronto Dominion Bank, Bank of Montreal, and Canadian Imperial Bank of Commerce, Canada’s five large banks, came out with barely a feather ruffled, and are newly prominent around the world.

“But this does not translate into Canada being a hotspot for the derivatives industry,” says Aaron Fennell (pictured), senior market strategist and portfolio manager at Lind-Waldock, a division of MF Global Canada.

Regulatory barriers that deter foreign firms from moving in, and even make things difficult within Canada, are partly to blame – as is that conservatism.

Many in the market would like to see reforms, but all agree that, with or without them, Canada is still a derivatives market with vast tracts of unexploited potential.

Montreal on a roll

It’s been a good year for the two Canadian derivatives exchanges. The minnow of the pair, Winnipeg’s ICE Futures Canada, offers canola and barley derivatives (see box).

About 2,400km to the east is Montréal Exchange, dominated by interest rate and equity derivatives and owned by TMX Group, which also runs the Toronto Stock Exchange.

First half volume on the exchange is up 32% – a sure sign that something is going right. MX may even recapture by December its record annual trading volume – set with 42.7m contracts in 2007.

Boosted mainly by foreign investors, interest rate derivatives have picked up dramatically, with 13.6m contracts traded this year, 70% ahead of the same time last year. Further growth came from equity derivatives.

MX’s three big products are Three Month Canadian Bankers’ Acceptances Futures, which can get through more than 1m contracts a month in good times; Ten Year Government of Canada Bond Futures, about 70% as active as the short term interest rate contract; and equity options.

There is plenty of potential here – 1m equity options contracts a month is little compared to the third of a billion that flows through US markets.

But still more underdeveloped looks the equity index segment. Futures on the S&P Canada 60 Index get about 400,000 trades a month, while those on the iShares ETF tracking the same benchmark add another 200,000 or so.

Together, they make up less than a sixth of the exchange’s volume. There should be plenty of room for this to grow, especially taking into account the overall performance of Canadian equities.

“The interest Canada has been attracting wasn’t just from fixed income participants,” explains Alain Miquelon, president of the Montréal Exchange and group head of derivatives at TMX Group. “Generally, a lot of foreign capital has flooded into Canada in the last two years. This was further underlined by Canada’s equity indices outperforming US indices due to Canada’s strong mining and raw materials sector. This increase in liquidity has helped the derivatives markets.”

Striking oil

Despite its recent records, Montréal Exchange remains unsatisfied. “While our market share has grown and a lot of our products have good liquidity, there are still challenges for us,” Miquelon says. “The retail sector is underdeveloped in Canada, and we are focusing on attracting more international players to drive more liquidity on to the exchange.”

To do this, MX is diversifying. In mid-June, it launched a cash-settled futures contract on Canadian Heavy Crude Oil. This is based on the price of Western Canadian Select (WCS), the benchmark blend for heavy crude in Canada.

There is certainly a disconnect between the importance of Canada as an oil producer – among the top 10 producers in the world, and the US’s main source of imported oil – and the weight of oil derivatives on its bourse.

With heavy crude production expected to double by 2020, MX hopes to skim off some of the expected growth in trading that would otherwise go to the US exchanges and the OTC market. But can MX compete with the huge liquidity at Nymex?

“We launched Canadian oil futures in June and are trying to build up that product as well as other energy products,” says Miquelon. But he admits: “While we have further energy products in the pipeline, this is largely a diversification opportunity for us. Our core business is in interest rate and equity derivatives, where we are seeing attractive growth and have a unique competitive advantage, as we have the market very much penetrated. There would be a lot more scope in indices, and futures are also broadly underdeveloped. There is a much less active retail market in futures, which is a reflection of the past, as investors here are more conservative and are not enough supported.”

The secret of Montréal Exchange’s success? Like ICE Futures Canada, MX has claimed its niche and fully owns it. Its products are suited to the domestic market – which means MX does not have to go toe-to-toe with its big competitors in Chicago and New York.

As Miquelon puts it: “We’re developing products that are focused on a very segmented market. These markets are not being targeted by anybody else, and CME might not step into such a niche as it would not be profitable for them.”

Exporting expertise

Vital to any successful exchange nowadays is technology, and here TMX Group has gone from strength to strength.

At the end of last year, the Investment Industry Association of Canada chose TMX’s Canadian Derivatives Clearing Corporation to develop the infrastructure for a central counterparty facility for the fixed income market.

CDCC has been the issuer, clearing house and guarantor of exchange-traded derivatives in Canada since its inception in 1975. It has been Montréal Exchange’s exclusive clearer since 1999.

The new multilateral, centralised clearing house for fixed income products is meant to enhance the Canadian capital markets and make them more attractive to domestic and foreign participants.

TMX Group’s Sola clearing platform, launched in June 2009, “has both the flexibility and the horsepower to meet this challenge”, according to the company.

As European traders know well, last year TMX won the mandate from LSE Group to provide its new trading platform. Under the multiphase contract, Sola is now in use at LSE’s EDX London market, while the Italian Derivatives Exchange Market should follow by the end of October.

Miquelon says the systems held up very well during May’s high volatility and record volumes.

Divided by regulation

With Canada set up well for future growth and success, there remain formidable challenges, and perhaps the biggest is the legal framework.

“The Canadian regulatory landscape provides a very confusing picture when it comes to derivatives regulation,” explains Greg McNab, partner in Baker & McKenzie’s corporate and securities practice group in Toronto. “There are a lot of inconsistencies and gaps in the existing regimen. While other jurisdictions tend to treat different types of derivatives consistently, Canadian jurisdictions treat certain types differently.”

One of the main problems is that Canada doesn’t have a national securities regulator, nor a single securities act regulating the industry. Instead, each province has its own slightly different laws and system of oversight. Market participants must register separately in each province.

Provincial regulators have acknowledged that they are applying some principles inconsistently and are working on a national regime. But industry experts do not predict fast progress.

“I don’t anticipate Canadian regulation to change all that much any time soon,” says Levente Mady (pictured), managing director, derivatives at Canadian broker Union Securities. “Firstly, it is not a high priority of regulators to change. Secondly, the attitude is ‘let’s wait and see what they do abroad first, then adapt what works for us’.”

Regulatory initiatives are in the works. In September 2009, a new registration regime was introduced, intended to standardise licensing for securities firms.

“We had hoped that this would also regulate how derivatives are treated,” says McNab. “However, due to the complexity of the area, reform of derivatives-related licensing did not form part of the reform project. So, right now, there hasn’t been any progress on regulating derivatives.”

In Canada the devil is, indeed, in the details. “I would estimate that about 90% of securities regulation is the same across Canadian provinces and territories, but the remaining 10% can vary significantly,” McNab says. “In that 10%, it depends very much on which type of security you are talking about. While the Canadian regulators all broadly agree on regulatory questions for, example, mutual funds, the opposite is true for derivatives, an area in where there is a lot of inconsistencies on how you regulate them.”

And not only is there fragmentation – the individual provincial regimes can also be complex. The crucial province of Ontario, with 38% of the population, is one of the most troublesome. “It has four or five different pieces of legislation that impact the creation and distribution of derivatives, which at times compete with each other,” argues McNab.

The industry is divided on the effects of this fragmentation. Some feel that it has shielded Canada from some of the fallout of the global financial crisis. Others believe that what trouble came to Canada occurred specifically because of that fragmentation. A third group is neutral.

“While the situation was not ideal, it could also have been much worse. While the situation was dealt with eventually, I’m not sure that the solution can be attributed to our sound financial and regulatory system,” McNab concedes.

His fondest wish is for a uniform national regime of regulation and legislation – one that might remove some of the frustrations and inefficiencies he encounters.

Clients, he says, “have to do a separate analysis for every province, and while they might get approval in three provinces, a fourth takes them to task over something that the other three had had no issues with. Yes, we’re good at navigating that system, but we’re not particularly proud that we have to do it this way.”

If it ain’t broke...

Industry professionals agree that there is little impetus for reform in Canada today.

“In terms of regulation, Canada has been a laggard rather than a leader,” says Mady – perhaps no bad thing when many supposedly more forward-looking countries’ financial systems have come close to collapse.

Yet the minority Conservative government lacks support from the financial industry, beyond the big banks. “There is no political will to streamline regulation or grow the exchange-traded derivatives industry in Canada,” says Fennell at Lind-Waldock.

In McNab’s view, the attitude seems to be ‘if it’s not broken, don’t fix it’. “My sense is that the feeling is the players in the market are all sophisticated and knowledgeable enough, which means they don’t need the same protection as, say, a retail investor that might be misled. There also is nowhere near the same populistic clout to gain as in Europe, so there’s very little pressure to do something about the current structure.

“We’ve talked about reforms to securities regulation for 30-odd years, but it’s only in the last two or three years that this has gained any traction,” the Toronto-based lawyer adds.

Drawing attention

Despite these obstacles, Canada’s promising market is attracting attention from investors and international financial services providers.

“The pattern over the last years was like this: international firms came into the market, some of which were successful,” explains Rod Wilmer (pictured), new CEO of Newedge Canada. “The ones that weren’t, were very quick to leave the market. So all the big investment banks were here, but they left in droves 10 years ago after a bad year or two. The same pattern was repeated two years ago.”

In exchange-traded derivatives, the community of players is described as ‘very small’ and ‘clubby’. Everybody knows everybody else. Some blame offputting regulation for this insularity, yet domestic players see the advantages in barriers that make it hard for newcomers to break in.

“The regulatory environment is difficult,” says Fennell. “This is, of course, good for the specialised players that are already in the market and are familiar with the futures industry environment.”

Compared with other countries, Wilmer says, “Canada has much higher capital requirements and technical trading obstacles such as fees. Generally, the cost to clear a listed derivative is higher than in comparable markets, and clearing is relatively slow. There is also a certain resistance to foreigners trading, but these are becoming less formidable over time.”

“I wouldn’t want to use the term ‘protectionist’, but that is what it feels like at times,” says one insider at a brokerage.

McNab disagrees. “I would have agreed that the Canadian securities regime could have been seen to be protectionist 10 years ago,” he says. “A strong push started of US electronic trading platforms and brokers entering the market, that could have caused a race for prices and speed. Canadian policymakers were slow to allow those platforms access to Canadian markets, in some cases on the basis that they had to fully understand the models before granting access. This was sometimes seen as a way for the Canadian regulator to protect its own industry.”

Now, he believes, market access for foreigners is a lot more straightforward.

Unfair competition

Others want more protection – or at least, the establishment of rules that are taken for granted in the US. Some Canadian brokers complain that US rivals are encroaching on their territory to serve Canadian clients accessing US or global markets.

“I’m not even sure if that is legal – but they are doing it anyway,” says Fennell. “The CFTC would be on me in an instant if I did the same for US clients, but there seems to be nobody to enforcme the rules against US brokers. We’ve been fighting this for as long as I can remember without much progress.”

Adopting similar rules and especially similar enforcement could make competition fairer, he believes: “I don’t mind competing with US brokers, but this isn’t really competition if there are two different sets of rules for US brokers and Canadian brokers. This is simply no level playing field and has nothing to do with healthy competition.”

Exchanges, of course, welcome any increase in trading. “US investment banks have been very successful in franchising into Canada, especially in the futures space,” says Miquelon. “From our perspective, they not only create a larger demand for derivatives products, but they are also aiding to educate investors on the products and opportunities, which in turn helps develop the market, which we can only welcome.”

Sources of growth

At present, the ‘big five’ and vast pension funds are prime users of Canadian derivatives, but there is a lot of potential for smaller and non-bank investors. Participation by retail investors and hedge funds is low, even though activity from hedge funds is growing.

And usage patterns of investors that do use derivatives are markedly different from those of foreign peers.

“Market participants, whether portfolio managers or asset managers, use derivatives a lot less than their counterparts in the US,” says Mady.

And the bulk of the flow, Canadian brokers agree, goes to exchanges south of the border. Yet they also agree that prospects for the market are bright.

“While the Canadian business is only a small part of our business, it is growing,” says Mady of Union Securities, which does 95% of its futures trading on US exchanges such as CBOE or ICE. “The US is where the liquidity is. Especially in terms of gold futures, there is no other market to trade than the US.” Fennell at Lind-Waldock gives a similar 95% estimate.

Daniel Cutts, co-head of institutional sales and trading at Newedge Canada, says: “There is a robust business of taking Canadian clients to international markets – what we call ‘outbound business’. In addition, the business of taking international clients into Canada is growing nicely.”

In Fennell’s view, “the dominance of the US in Canadian derivatives is not only because the US exchanges have the most liquidity, there is also a structural element to it. The Canadian financial sector is fairly small and lacks the critical mass to properly develop new futures markets.”

Yet interest in Canada as a financial marketplace is growing, not just from the US or even European clients, but increasingly from Asia, says Cutts, who adds that it is now seen overseas as a more mature market than a few years ago.

“Despite the attractiveness of Canada, however, it is still underdeveloped as far as investments go,” Wilmer contends. “Markets like these have consistently more margins. There is an attractive business spreading Canadian pair trades versus other markets. But there is more room to expand into.”

He describes Canada as “opportunity rich, but liquidity poor”, and certainly not as liquid as other futures markets.

“If we look at open interest, the financial crisis cut that in half,” Wilmer points out. “By now, only half of that lost volume has come back, as a lot of international banks have pulled back. The Canadian banks are holding the majority of positions, especially when it comes to interest rate products. We think the market itself can handle a lot more players.”