- International Monetary Fund
- Published Date:
- April 2005
288. In Canada, foreign reserves are owned by the government and managed by both the Bank of Canada and the Department of Finance. As of December 31, 2001, Canada held about US$34 billion in total international reserves. Of that amount, about US$30 billion (89 percent of total reserves) was held in liquid assets.19
289. These liquid reserves are held in a special account called the Exchange Fund Account (EFA) under the Minister of Finance’s name at the Bank of Canada. The EFA is financed with foreign-currency-denominated liabilities issued by the Government of Canada. Liquid reserves and gold are actively managed by the Bank unlike other components of the reserves such as Special Drawing Rights (SDRs) and the reserve position at the IMF. This report will focus on the liquid assets of the reserves.
Governance and Institutional Framework
Reserve management objectives and scope
290. The objectives of reserve management are:
to provide general foreign-currency liquidity for the government; and
to provide funds to help promote orderly conditions in the Canadian dollar in the foreign exchange market.
291. The management of reserves has changed over the past 25 years, reflecting developments in financial markets. The government has increased the level of foreign reserves in recent years to reflect increased flows in foreign exchange markets and to bring its level of reserves more in line with other comparable sovereigns. This increase in turn has required the reserve managers to focus on asset-liability and risk management, and on reducing the cost-of-carry of these reserves while maintaining a high degree of liquidity and capital safety.
292. In order to meet these objectives, the liquid reserves are subdivided:
A proportion of reserves is held in highly liquid U.S. dollar-denominated assets to fund immediate foreign currency liquidity requirements and intervention activity.
The remainder is held in a diversified portfolio of high-quality assets, denominated in U.S. dollars, euros, and yen.
293. Reserve management activities consist of the management of foreign currency assets and liabilities, which includes the use of derivative financial instruments. Reserve management follows a well-coordinated Asset-Liability Management framework described later in the paper, while at the same time focusing on cost-of-carry minimization.
294. Canada’s reserve assets are governed by the Currency Act, which serves as the legal framework for EFA asset management and investment operations. 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.
295. The responsibility for the management of the EFA is jointly shared by the Department of Finance and the Bank of Canada while the management policies are set by the Minister of Finance. The Bank of Canada, acting as a fiscal agent, administers and effects transactions for the Account on behalf of the Minister of Finance.
296. The Director of the Financial Markets Division at the Department of Finance and the Chief of the Financial Markets Department at the Bank of Canada are responsible for the ongoing management of the EFA. A Policy Committee, which is composed of senior officials from the Department of Finance and the Bank of Canada, meets semiannually to review developments and major policy initiatives, and provide guidance and accountability on the management of the Account. The Risk Management Committee (RMC), which consists of managers from the Department of Finance and the Bank of Canada, including two members with no connection to the operations of the EFA, meets quarterly to advise on the management of risk related to the government’s debt program, including the foreign exchange reserves.
297. The responsibilities for the day-to-day portfolio management and strategy implementation of the EFA rests with the staff of the Foreign Reserves Management Team at the Bank. The Risk Management Unit (RMU) at the Bank oversees and manages the risks associated with the EFA.
Transparency and accountability of reserve management and benchmarking
298. Reporting in a regular and timely manner is a key element of Canada’s reserve management policy. The Minister of Finance provides an Annual Report20 to Parliament on the operations of the EFA for each calendar year within five months after the expiration of that calendar year, and this report is available publicly. The EFA Annual Report also includes the result of annual audit of the EFA conducted by the Auditor General of Canada. In addition, periodic review by external third-party experts is undertaken, and the results of such reviews are shared with the government.
299. The EFA’s current asset management benchmark, in the context of asset-liability management detailed later in the paper, is the government’s foreign currency liabilities. The cost-of-carry is currently used as a performance measure for the EFA, and is disclosed in the EFA Annual Report. Additional benchmarking approaches are also currently under study.
300. Internally, the RMU provides daily reports on the EFA risk position to trading staff, and monthly and quarterly reports to the RMC and the Bank’s senior management.
301. Since July 1999, Canada has reported its disaggregated reserves position on a weekly basis.21 This disclosure of reserve positions is achieved by means of the Bank’s website on the first business day following the 8th, 15th, and 23rd of each month. On the third business day following month-end, a more comprehensive breakdown of Canada’s reserve position is published by the Department of Finance.
302. In addition, documentation of the chain of authority, decision making, and delegation in reserve management has been made public through Bank of Canada Review articles.22
Establishing a Capacity to Assess and Manage Risk
303. The goal of risk management is to balance risk and return. In 1997, the Bank and the Department of Finance jointly established an RMU to oversee the risk position of the government of Canada.
Strategy for managing risks
304. The EFA is exposed to various types of risk, such as credit risk, market risk, liquidity risk, operational risk, and legal risk. The government’s risk management strategy is to recognize, measure, and manage each type of risk individually as well as collectively.
305. The RMU manages EFA risk in three steps:
Identifies, analyzes, evaluates, and models the risks;
Advises on guidelines to limit the risks; and
Ensures day-to-day adherence to the guidelines, while periodically proposing new risk control mechanisms.
306. To control credit risk, the RMU currently uses an approach based on the BIS 1988 Basel Accord and subsequent amendments, whereby all exposures are risk-weighted according to entity type. In addition, the RMU has adopted the BIS Accord “add on” approach to calculating potential exposure on derivative transactions. Credit risk is managed through diversification of the EFA asset portfolio, with appropriate use of credit ratings, counterparty limits, netting agreements, and collateral support.
307. To limit market risk, the government follows an asset-liability management framework whereby foreign reserves are managed so that assets match liabilities in currency and duration. Over the long run, EFA assets and liabilities are expected to be held in approximately equal market values, thus keeping the account balanced. Assets match liabilities for the euro- and Japanese yendenominated reserves. At present, U.S. dollar liabilities exceed U.S. dollar assets, largely due to foreign exchange intervention and commitments made to the IMF in 1998. This imbalance has been reduced through a program of U.S. dollar acquisition in foreign exchange markets, and the plan is to eliminate the mismatch over the next year. In order to minimize the impact of any mismatches, the “excess” U.S. dollar liabilities are concentrated at the short end of the yield curve.
308. 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 standardized moves in closely linked market risk factors, such as a parallel yield curve shift.23 These scenarios are explicitly defined and reported on a monthly basis.
309. Various policies are implemented to limit liquidity risks. These policies require that no more than 10 percent of any single issue be held in the EFA, and that the issue size be a minimum of US$500 million. Furthermore, the securities of any one issuer cannot exceed 10 percent of EFA liquid assets, except for “home currency” bonds issued by AAA sovereigns and their directly guaranteed agencies. As well, no more than 15 percent of the EFA’s liquid assets can be in investments that cannot be sold or redeemed prior to maturity (i.e., non-marketable securities and fixed-term deposits).
310. In addition, to limit rollover risk, EFA liabilities that mature within any 12-month period cannot exceed one-third of EFA assets. Finally, other means of raising liquidity include a short-term U.S. dollar commercial paper program (Canada Bills) and holdings of highly liquid U.S. dollar, euro, and yen securities.
311. To control operational risk, the RMU uses a “bottom-up” method that is consistent with the concept of total quality management. It starts from examining the different aspects of operations performed by the organization and then maps the process.
312. Sound operational risk management also requires qualified staff and adequate management information systems. In the case of the EFA, the RMU analyzes operational processes and establishes controls that are regularly reviewed. Although the RMU is not directly involved in personnel management, the bank has a human resources strategy to maintain a competitive compensation structure with abundant training and learning opportunities. It also offers various flexible working hour agreements. The Bank is also currently improving its operational processes and implementing relevant technological applications such as a new integrated straight-through processing system.
313. The government’s Department of Justice has the responsibility of advising on legal risk, and the preparation of an annual legal risk report for the Risk Management Committee and senior management. The report identifies any potential legal risk issues with respect to existing documentation.
Currency composition and eligible investment instruments
314. There are restrictions on the EFA’s currency composition and the types of eligible investment instruments to control overall risk. The EFA’s eligible currencies are the U.S. dollar, euro, and yen. The EFA portfolio must be composed of a minimum of 50 percent U.S. dollars with the rest allocated in euros, and Japanese yen, according to the funding and investment opportunities in each currency. This currency composition reflects the important role of the U.S. dollar as a reserve currency, and the fact that intervention in support of the Canadian dollar has been historically undertaken through the U.S. dollar.
315. The Currency Act allows the EFA to transact in foreign exchange on a spot and forward basis, and to invest in deposits of supranational organizations and financial institutions, and in securities issued by sovereigns and their agencies. It also allows the EFA to lend any of the eligible instruments, and enter into derivative transactions based on any of the eligible instruments. In addition, the government is moving toward more extensive use of collateral in its reserve management operations to protect against current and potential credit exposure.
Use of derivatives
316. Among the eligible derivatives mentioned earlier, the government of Canada has made extensive use of long-term interest rate and currency swaps since 1984–85. The government uses these swap agreements to obtain cost-effective financing, to fund the foreign exchange reserves, and to permit flexibility in managing liabilities. For example, cross-currency swaps are currently used to convert Canadian-dollar-denominated fixed-rate debt into euro and U.S. dollar fixed-rate liabilities. In addition, short-term currency forwards and gold options have been used by the EFA.
317. The government uses external securities lending managers to manage a securities lending program for a portion of its U.S. dollar-denominated securities. Formal agreements are signed between Canada and the external managers. The external managers must follow the policies and guidelines provided by the government. To manage the risks, there are restrictions as to the securities allowed to be lent, the types of borrowers, eligible collateral, and investment of cash collateral. The external managers are required to submit reports, on a monthly basis and upon request, describing details of the loans and investments. Currently, there are two external managers.
Recent trend with respect to reserve management
318. Consistent with best practices in risk management in recent years, the government has been moving toward making more extensive use of collateral to reduce credit risk exposure in its foreign reserve operations.
319. This year, the government has put in place a collateral management framework for the government’s derivative counterparties. Canada’s collateral management system requires counterparties to put up collateral to the government when credit exposure on swaps and forwards exceeds given levels. An external firm is being used to manage securities posted as collateral to the government. In 2002, the government will also be moving a large proportion of its uncollateralized short-term U.S. dollar deposit investments to collateralized repurchase agreements.
Reserve Management Operations in Deep and Liquid Markets
320. Canada’s reserve management operations are undertaken in the most efficient and liquid markets in the world, i.e., the U.S., Japanese, and European markets. Foreign currency borrowing that finances the EFA’s reserves is also conducted so as to maintain Canada’s reputation as a “successful borrower” in international capital markets.
321. Continued access to these capital markets is facilitated by ensuring that Canada has the necessary legal documentation in place to allow reserve managers to raise funds in a variety of markets and jurisdictions.