The Ontario Securities Commission (“OSC”) recently published OSC Staff Notice 81-735 Cash Collateral Use for Delayed Basket Securities in ETF Subscriptions (the “Staff Notice”) regarding the use of cash collateral for ETF in-kind subscriptions where one or more securities from a basket of securities comprising payment (“Basket Securities”) cannot be delivered on the settlement date. OSC staff (“Staff”) are of the view that this practice is permitted under National Instrument 81-102 Investment Funds (“NI 81-102”), provided that certain conditions are met.
Background
Staff note that the use of cash collateral to facilitate ETF in-kind subscriptions is a practice employed in some jurisdictions, including the United States, to reduce failed trades and disruptions in the capital markets. Without cash collateral, a purchaser (i.e., a designated broker or authorized participant) will postpone delivery until they have collected all of the Basket Securities, typically delivering them at the end of the day, because if one security is missing, the ETF units cannot be issued.
Occasionally, a purchaser may be unable to deliver the Basket Securities by the settlement date. Delays may be the result of a mismatch between settlement cycles or of other delays in deliveries from transactions or corporate action events where a security has been submitted to a tender process and cannot be released.
Staff understand that market participants have diverged in their interpretations of whether the use of cash collateral is permitted to facilitate the issuance of ETF units when the delivery of Basket Securities is delayed under section 9.4 of NI 81-102. Market participants who have taken the position that this practice is permitted rely on a cash collateral process to temporarily satisfy the payment obligation and deliver the ETF units to the purchaser on the settlement date.
Staff’s Position
Staff agree that the use of cash collateral in such situations is permitted under NI 81-102. They indicate that delivery risks to the ETF should not be increased and the ETF should benefit from the settlement risk being reduced. To minimize delivery risks, the ETF should ensure that the use of cash collateral is consistent with certain requirements applicable to securities lending arrangements under subsection 2.12(1) of NI 81-102, including that the cash collateral is:
- at least 102% of the market value of the delayed Basket Securities;
- provided under a written agreement between the purchaser and the ETF, which sets out the terms of the cash collateral, including those described in these bullets;
- transferred by the purchaser to the ETF and immediately available for good delivery;
- received by the ETF either before or at the same time as it delivers the ETF units to the purchaser;
- marked to market on each business day, and the amount of collateral in the possession of the ETF is adjusted on each business day to ensure that the market value of collateral maintained by the ETF in connection with the transaction is at least 102% of the market value of the delayed Basket Securities; and
- held by the custodian of the ETF in the name of the ETF.
Staff add that the ETF should be entitled to realize on the cash collateral in good faith at any time and that the cash collateral should not be held for more than 10 business days.
[View source.]
