Exchange fund account

Management of Canadian dollar cash balances

In addition to managing risks associated with domestic debt, the government must also manage risks related to the investment of domestic cash balances. In managing the cash position, the objective is to ensure that adequate liquidity is maintained at a reasonable cost.

Deposit auctions used to invest cash balances were conducted on an uncollateralised basis until 2002, and only a limited number of large Canadian financial institutions were allowed to participate. As a result, the unsecured credit exposure to individual institutions was occasionally quite significant.

A new collateralised framework for the investment of cash balances was implemented in 2002. The new framework strengthens the management of the credit risks involved in the investment of cash balances through the use of credit ratings, credit lines and collateral agreements, and increases competition in the auction of cash balances by opening auctions to a wider range of participants.

In addition, two types of forward-looking techniques, namely “stress test scenario analysis” and “sensitivity stress testing”, are conducted. Stress test scenario analysis is based on a potential market event, such as a stock market crash. Sensitivity stress testing is based on standardised moves in closely-linked market risk factors, such as a parallel yield curve shift. These scenarios are explicitly defined and reported. This analysis helps reserve managers assess the performance of the EFA (i.e.potential market value loss) under different scenarios, and determine whether changes in the structure of the portfolio are necessary.

Credit risk

Credit risk is managed by diversifying the EFA asset portfolio, with appropriate use of credit ratings and counterparty limits imposed by investment and credit guidelines approved by the Minister of Finance and released publicly (Annex 9.A), as well as through other measures such as netting agreements and collateral support agreements. To control credit risk, FRO currently uses an approach based on the BIS 1998 Basel Accord and subsequent amendments, whereby all exposures are risk-weighted according to entity type. In addition, the BIS Accord “add on” approach has been adopted to calculate potential exposures for derivative transactions.

The investment and credit guidelines, which encompass all lines of business, limit the EFA’s credit exposure and call for diversification of assets and counterparties. The guidelines, which are reviewed regularly, impose tight limits on exposures to credit risk. For instance, there are tight individual and global limits on financial institution exposures based on the nature of transaction and the quality of credit ratings.

Furthermore, the guidelines allow the EFA to invest only in highly liquid, and high quality securities, such as bonds and bills issued by a sovereign, an agency of a sovereign or an international financial institution. It can also invest in US dollar deposits with eligible financial institutions or in US dollar repos. At the end of 2003, most of the EFA was invested in securities issued by sovereigns and agencies (Figure 9.3). To be eligible for investment, an entity must have a credit rating of at least A-. (See Annex 9.A for details.) Currently, most investments are in the AAA category (Figure 9.4).

In addition, there are rules governing the maximum maturity of reserve assets and concentration limits.

Collateral management frameworks have been recently introduced in reserve management operations to manage credit risk to financial institution counterparties associated with derivatives and US-dollar deposits (i.e.repos).

Under the collateral framework for swaps, high-quality collateral (e.g.cash and high-grade securities) is posted to the EFA when credit risk to financial

institution counterparties exceeds specified limits. In addition, a large proportion of uncollateralised short-term US dollar deposit investments have also been shifted into tri-party collateralised repurchase agreements. Firms have been recruited to manage posted collateral. Formal agreements are signed between Canada and the external managers. The external managers must then follow the policies and guidelines provided by the government. To manage the risks, there are restrictions as to eligible collateral, minimum rating requirements, minimum outstanding amount requirements, etc. The external managers are required to submit daily reports on the collateral posted.

Liquidity risk

High liquidity standards have also been defined in the guidelines to limit refunding and liquidity risks. For example, to ensure that reserves are invested in liquid securities, the outstanding amount of securities must be at least US$500 million, and must be issued by eligible issuers. To limit liquidity risks, the

Figure 9.3. Composition of EFA assets

Figure 9.4. EFA assets by credit rating Supranationals 15%

Deposits and repos 5%

Sovereigns and Agencies 80%

AA +5%

84%AAA

AA7%

AA -4%

guidelines also require that securities issued by any one counterparty cannot exceed 10 per cent of EFA liquid assets, except for bonds issued by sovereign governments and their direct agencies issued in their domestic currency.

To limit rollover risk, EFA-related liabilities maturing within 12 months cannot exceed one third of EFA assets. Figure 9.5 summarises the instruments used to fund the EFA. Other means of raising liquidity also include a short-term US dollar commercial paper program (Canada Bills), and holdings of highly liquid Euro and Yen securities.

Operational risk

Sound operational risk management requires adequate management information systems and qualified staffs. In the case of the EFA, the FRO analyses operational processes and establishes controls that are regularly reviewed.

Operational risk associated with the management of the EFA was significantly reduced in 2003 following the introduction of a new integrated straight-through-processing trading system. This new system allows for a more integrated operating process for the front, middle, and back offices, and includes trading limits for individual counterparties. These trading limits have been hard-coded into the system so that they can be enforced on a real-time basis. In addition, operational risk issues associated with staffing are mitigated through human resource policies in each institution that clarify responsibilities for each position, and promote competitive compensation with abundant training and learning opportunities.

Legal risk

Canada’s foreign reserves are governed by the Currency Act, which serves as the legal framework for EFA asset management and investment operations.

Figure 9.5. EFA funding composition

Swapped domestic issues 55%

Global Bonds 30%

Canada Bills 5%

Canada Notes 3%

Euro medium term notes 7%

The Minister of Finance approves policies for managing the EFA, mainly through a set of investment guidelines. The liabilities that fund the EFA are governed by the Financial Administration Act.

The federal government’s Department of Justice has the responsibility for advising on legal risk, and preparing (as required) a legal risk report for the Risk Committee. The report identifies any potential legal risk issues with respect to existing documentation. In addition, formal agreements such as ISDA (International Swap Dealers Association) Master Agreements and CSA (Collateral Support Agreements) are signed between the Government and swap counterparties to manage legal risk.

Reporting on risk exposures

Reporting on the EFA’s investment performance and risk exposures in a regular and timely manner is also a key element of risk management. The Minister of Finance provides an Annual Report to Parliament on the operations of the EFA for each calendar year within five months after the expiration of that calendar year,² and this report is available publicly at www.fin.gc.ca. The EFA Annual Report also includes the result of annual audit of the EFA conducted by the Auditor General of Canada.

FRO provides daily reports on EFA counterparty exposures to trading staff. In addition, detailed reports on EFA market and credit risk exposures are prepared for the Risk Committee and other officials at the Bank of Canada and Department of Finance responsible for funds management activities.