In response to inquiries from federally regulated financial institutions (“FRFIs”), the Office of the Superintendent of Financial Institutions (“OSFI”) has published Advisory 2013-01, Business and Powers – Ownership Interest in Commodities. The Advisory sets out principles relevant to determining whether a transaction that involves an FRFI taking an ownership interest in commodities generally appertains to the business of providing financial services and would, therefore, be permitted by FRFI statutes. The Advisory also lists minimum prudential standards for FRFIs engaging in activities involving such ownership interests.
FRFI statutes generally prohibit a FRFI from dealing in goods such as commodities. This includes a prohibition on buying and selling commodities for a commercial purpose. However, the prohibition would not apply where the FRFI takes an ownership interest in commodities in connection with activities otherwise authorized by the applicable FRFI statute. For example, in the case of the Bank Act, a federally regulated bank may take an ownership interest in commodities where it does so in the context of the “business of banking” (which includes the provision of any financial service) or business which generally appertains to such business of banking.
In 2004, OSFI ruled on a commodity swap arrangement involving natural gas entered into by a federally regulated foreign bank. In the ruling, OSFI concluded that an FRFI that engages in physically settled commodity trading is providing a “financial service” (and, therefore, is engaged in the business of banking), provided that the FRFI:
enters into such transactions only with customers who are producers or end users in the context of financial risk management services to those customers, or with other market intermediaries to manage its exposure to the relevant commodity; and
takes title to the commodity only on a “transitory” basis and only in connection with, or for the purpose of facilitating, the settlement of such transaction.
In the new Advisory, OSFI acknowledges that the scope of transactions in which an FRFI might take an ownership interest in a commodity extends beyond transactions entered into for credit enhancement purposes, as was the case transaction considered in the 2004 ruling. For example, OSFI noted that the transactions might include an ownership interest in a commodity for time periods that extend beyond “transitory” periods or transactions in the nature of inventory financing. As a result, OSFI has set out the following principles for determining whether a transaction in which an FRFI takes an ownership interest in commodities generally appertains to the business of providing a financial service:
Purpose of transaction: The ownership interest in commodities should arise from a transaction that the FRFI has entered into as an alternative to providing a traditional financial service to the customer (e.g., inventory financing, guarantee, letter of credit or risk management service).
Duration of ownership: The FRFI should only retain ownership interests in commodities for a commercially reasonable period of time, having regard to the nature of the financial service that the transaction is intended to provide.
Exposure: The FRFI should not, in the normal course of its business, be exposed to fluctuations in the price of the commodity as a result of the transaction. The FRFI’s exposure in this regard should not be fundamentally different in nature and degree from such exposures that arise from the provision of comparable traditional forms of financial services. On this basis, OSFI expects FRFIs to enter into an agreement to dispose of their ownership interest in commodities promptly after agreeing to acquire that ownership interest.
Return: The return that is generated by a transaction that is an alternative to a traditional financial service and that involves a FRFI taking an ownership interest in commodities should not be based on fluctuations in the price of commodities but should rather have a close correlation to the return that would normally be generated by the comparable traditional financial service.
These principles would not apply to ownership interests in precious metals (which OSFI has acknowledged should be considered in a different light given the historical special status afforded to precious metals) or ownership interests resulting from realization of a security interest in collateral under a secured financing arrangement (which ownership interest, OSFI has noted, is incidental to the provision of the financial service).
OSFI has also set out minimum prudential standards for FRFIs engaging in activities that fall within the scope of the Advisory.