Derivatives is one of the various forms of securities; thus, derivatives may be compared with the other forms of security, such as debts, equities, and hybrid securities. These forms of securities are also commonly called the “primary forms of securities” since these are the securities which derivates “derive” their value from, making it appear as if derivates is a “secondary form of securities”.
Additionally, there are different forms of derivatives, such as options, futures, forwards, and swaps. Though they are generally a derivative, each form also has its own advantages and disadvantages compared to the other forms.
Securities vs. Derivatives
Although there are only two general forms of securities – equity and debt – a combination of both forms creates a hybrid security. The difference of derivatives among other forms of securities may be in the:
- manner of payment of investments, returns, or dividends;
- the effects of bankruptcy of the issuer; and
- tax treatments for derivatives vs. securities
(1) Payments or Returns
Securities and derivatives in Canada may be primarily distinguished according to the manner of their payment or return of investments, which also affects the tax treatments of securities and derivatives.
Regular payments of income are the strength of debt securities – where the owner or holder is entitled to the payback of their principal amount, including its interest. This is according to the parties’ securities contract entered, which may also stipulate any other payments that the owner or holder is entitled to.
Another feature of payments under debt securities is that the securities holder or owner would have to be paid regardless of the financial performance of the issuer in the market or whether the security has increased its value or not.
In an equity, a “payment” of an owner’s or holder’s capital comes differently than in the other forms of securities. Owners or holders of equities become stockholders or shareholders of the corporation or company (the issuer) whose equity they have bought. Being stockholders and shareholders, they would now be subject to the rights and obligations afforded to such, according to Canadian laws, such as the Canada Business Corporations Act and other provincial laws on corporations. Additionally, payments in equities also occur when securities have been sold, after its increase in value.
Payment of investors in derivatives, on the other hand, operate in a similar way with debt securities. In derivatives, investors would generally be paid through a trustee account, where the income or cash flows from the derivatives would be put up, subject to the parties’ derivative contract which may stipulate whether payment is either in a fixed rate or at a floating rate. Also, payments or returns for investors under a derivative may also depend on its nature – whether it’s an asset-based security (ABS), or a mortgage-backed security (MBS). If it’s an ABS, it would then also depend on which specific asset is it “derived” from. The types of ABS include:
- Collateralized Debt Obligations (CDOs)
- Home Equity ABS
- Auto Loan or Car Loan ABS
- Credit Card ABS
- Student Loan ABS
For the best advice on how this works, seek out a lawyer in your province as laws can vary from one province to the next. For instance, those in Ontario should hire a derivatives instruments lawyer based in Ontario.
(2) Bankruptcy
When the issuer becomes bankrupt, the effect on securities and derivates in Canada are also different from each other.
For equities, the issuer (the corporation or company) may be subject to the provisions of Canada’s Bankruptcy and Insolvency Act on corporate or commercial bankruptcy. In here, the owners or holders of equities may only receive the net proceeds of their investments, only after winding down the company and payment of the issuer's debts according to the laws on creditor preferences and liens. Thus, it would mean that there’s a chance that the equity holder or owner may either receive their whole principal investment plus some dividends or may receive only the remaining portion thereof.
This is different with debt securities, since a secured creditor may be prioritized over unsecured creditors. However, a secured creditor under a debt security may be less prioritized over other forms of credits, such as trust claims, taxes, wages or salary claims, and liens. As such, while debt securities may either be secured or unsecured, it is of great importance that it must be backed by collateral, especially when the financial risk of bankruptcy is imminent on the invested issuer.
(3) Taxation
Taxation or tax treatments for securities and derivatives in Canada may generally depend on the type of distribution of the investment’s return or income.
- If investment income is distributed as an interest, it will be fully taxed similarly with the tax rate as that of an income tax, such as in a debt security and in a derivate contract that is a hedging transaction.
- For an equity, which typically distributes its income as dividends, preferential tax treatments for individuals may apply through dividend tax credits, but depending on the nature of the issuer or the corporation, and according to the guidelines set by Canada Revenue Agency.
- When a security is sold, as in the case of a debt security, it may be distributed as a capital gains where preferential tax treatments also apply, since only 50% of a capital gain is taxable.
- Since a hedging derivative contract’s income tax is dependent on the transaction, asset, or liability it is “hedged” upon, a speculative derivative contract’s income tax will be held by a taxpayer on the other hand.
Can you trade derivatives in Canada?
In Canada, trading derivatives, especially futures, is generally governed by the Canadian Derivatives Clearing Corporation (CDCC), which is the central clearinghouse mainly for exchange traded derivatives (ETDs).
The CDCC also cover some “over-the-counter" derivatives (OTCs), such as fixed income securities and foreign exchange securities. Although, OTCs are also documented through the International Swaps and Derivatives Association, by its standard-form contracts introduced in its 2002 Master Agreement.
Who regulates securities and derivatives in Canada?
Securities and derivatives in Canada are primarily governed by the provincial and territorial governments, since Canada does not have a federal authority regulating security.
Common law, through the landmark decision of Reference Re Securities Act (2011 SCC 66), dictates that regulation of securities are within the ambit of the provinces and territories, who has power to oversee the "day-to-day regulation of issuers and other participants in the securities market", respecting the federal relationship between the national government and the provincial and territorial governments, allowing both governments to decide on matters within and affecting its respective jurisdiction. This decision was again upheld in the most recent case of Reference re Pan‑Canadian Securities Regulation (2018 SCC 48).
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