Canada’s securities regulators have taken two additional steps towards implementing a comprehensive regulatory framework for over-the-counter derivatives (OTC Derivatives) and satisfying Canada’s G20 commitments in respect of mandatory trading and central counterparty clearing of standardized OTC Derivatives. The most recent regulatory notices discuss the basis on which certain standardized OTC derivatives will be required to be traded over organized marketplaces and provide a proposed rule regarding mandatory clearing of certain OTC Derivatives through regulated clearing agencies (referred to as “central counterparties” or “CCPs”). This bulletin discusses these developments and the proposed timeline for their implementation.
PROPOSED MANDATORY DERIVATIVES CLEARING RULE
On February 12, 2015, the Canadian Securities Administrators (CSA) published for comment Proposed National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (Proposed Clearing Rule). If adopted, the Proposed Clearing Rule will require that certain OTC Derivatives entered into by Canadian local counterparties be submitted to a recognized or exempt CCP for clearing, except in the limited circumstances described below. The Proposed Clearing Rule generally follows the approach set out in the draft model rule published by the CSA Derivatives Committee in December 2013 and, to ensure consistency, is proposed to be adopted in all Canadian provinces and territories in the form of a single National Instrument.
The primary objectives of requiring clearing of OTC Derivatives are to improve transparency in the derivatives market and to reduce the systemic risk to national and international credit markets that the default of a significant market participant could cause by triggering a cascade of defaults by other market participants. Central counterparty clearing interposes a central counterparty with a robust credit structure in what would otherwise be a private, bilateral contractual arrangement. When a CCP accepts a bilateral OTC Derivative contract for clearing, the CCP becomes the counterparty to each contracting party under a pair of new off-setting but independent transactions, thereby eliminating the direct credit link between the contracting parties while preserving the economic terms of the original transaction.
The CSA’s methodology for identifying which OTC Derivatives are subject to mandatory clearing, together with the limited exemptions from the clearing requirements, will determine whether particular OTC Derivatives transactions will be caught by the new mandatory clearing regime.
The CSA’s goal is to have the Proposed Clearing Rule come into force in the fourth quarter of 2015 or the first quarter of 2016, but clearing obligations will not apply until the CSA takes additional steps to designate specific classes of OTC Derivatives as being subject to mandatory clearing. It is expected that the CSA will also issue in the next month a revised version of the companion rule regarding Derivatives Customer Clearing and Protection of Customer Positions and Collateral, which was initially published as a model rule in January 2014.
Comments regarding the Proposed Clearing Rule may be submitted to the CSA until May 13, 2015.
Designation of Specific Classes of OTC Derivatives as Mandatorily Clearable Derivatives
Under the Proposed Clearing Rule, the CSA will, from time to time, designate specific classes of OTC Derivatives that will be subject to the mandatory clearing requirement (Mandatorily Clearable Derivatives). There will be no designated Mandatorily Clearable Derivatives at the time the Proposed Clearing Rule comes into force. Instead, CCPs operating in Canada will be required to submit to the CSA information regarding the classes of OTC Derivatives that they clear, including applicable Canadian and international clearing volumes. The CSA will evaluate whether a particular class of OTC Derivatives should be subject to mandatory clearing based on various factors, including its degree of standardization, risk profile, liquidity and other market characteristics. The CSA’s goal is to harmonize the determination process in Canada with the relevant international standards on clearing determinations. As part of the final step of the designation process, the CSA will publish for comment a description of the proposed class of Mandatorily Clearable Derivatives.
In connection with each designation of a new class of Mandatorily Clearable Derivatives, the CSA will specify an effective date on which the class of Mandatorily Clearable Derivatives will become subject to the clearing requirement (Relevant Effective Date). Only new Mandatorily Clearable Derivatives transactions entered into or materially amended on or after the Relevant Effective Date applicable for the relevant class of OTC Derivatives will be required to be cleared.
Application of the Clearing Requirement to Transactions Involving “Local Counterparties”
Under the Proposed Clearing Rule, a clearing requirement will apply to Mandatorily Clearable Derivatives for which either or both of the contracting parties is a “local counterparty” in a Canadian province or territory (jurisdiction). A local counterparty in a jurisdiction is a legal entity incorporated or organized in, or with a head office or principal place of business in, the jurisdiction. In addition, if a local counterparty is generally responsible for all of the liabilities of an affiliate, such as a general partner which is responsible for the liabilities of a partnership, then the affiliate is also deemed to be a local counterparty in the relevant jurisdiction.
Exemptions from the Clearing Requirement
It is contemplated that there will be three primary exemptions from the clearing requirement:
End-User Exemption – An exemption will be available if a party to a Mandatorily Clearable Derivatives transaction is not a financial entity and enters into the transaction for the purpose of hedging or mitigating commercial risk as such phrase is defined in the Proposed Clearing Rule. Commercial risks include risks related to the prices, values or rates of commodities, products or liabilities used, produced or incurred by the party in the normal course of its business, including those arising indirectly from fluctuations in interest rates and foreign exchange rates or from credit exposures. The exemption will not apply to transactions entered into for speculative purposes. The exemption will extend in certain circumstances to a party that is acting on behalf of an affiliated non-financial entity for the purpose of hedging or mitigating commercial risk.
The term “financial entity” is defined in the Proposed Clearing Rule to include not only regulated financial institutions, but also pension funds, publicly offered mutual funds and investment funds, and any company that is registered, or subject to or exempted from a registration requirement, under securities laws.
Intragroup Exemption – An exemption will be available for transactions between affiliated counterparties if the financial statements of the two affiliates are prepared on a consolidated basis in accordance with specified accounting standards or the two affiliates are prudentially supervised on a consolidated basis, provided the transaction meets certain requirements such as being subject to centralized risk evaluation and controls reasonably designed to identify and manage risk and provided that a prescribed form describing reliance on the exemption is filed with applicable CSA members.
Government-Entity Exemption – Transactions with Canadian or foreign governments and with certain Crown corporations and entities wholly owned by a Canadian or foreign government, as well as transactions with a national central bank or the Bank for International Settlements, will not be subject to the clearing requirement.
It will also be possible to apply to applicable provincial regulators for a discretionary order exempting the applicant from clearing requirements on agreed terms and conditions.
Phase-In of Clearing Obligations Based on Counterparty Type
The CSA proposes that for each class of Mandatorily Clearable Derivatives, the implementation of the clearing requirement will be delayed for certain local counterparties for 6, 12 or 18 months beyond the applicable Relevant Effective Date, depending on the classes of local counterparties that are party to the transaction. In particular, local counterparties that are not “financial entities” will not be required to clear Mandatorily Clearable Derivatives entered into within 18 months of the applicable Relevant Effective Date for the relevant class of OTC Derivatives, and financial entities that are not clearing members of a relevant CCP will not be required to clear a Mandatorily Clearable Derivatives if the transaction is entered into prior to 6 or 12 months following the applicable Relevant Effective Date. The distinction between the 6-month and 12-month phase-in period for financial entities will be based on thresholds to be determined by the CSA.
CONSULTATION PAPER REGARDING DERIVATIVES TRADING FACILITIES AND MANDATORY DTF TRADING REQUIREMENTS
On January 29, 2015, the CSA Derivatives Committee published Consultation Paper 92-401 Derivatives Trading Facilities (Consultation Paper). The Consultation Paper discusses the development of a regulatory framework for OTC derivatives trading platforms, to be referred to in Canada as “derivatives trading facilities” or “DTFs” (comparable to “swap execution facilities” or “SEFs” in the United States). The Consultation Paper also discusses the proposed approach for requiring market participants to use DTFs to enter into certain classes of OTC Derivatives. This initiative is in furtherance of Canada’s G20 commitment to require standardized OTC Derivatives to be traded over exchanges or electronic platforms where appropriate. The Consultation Paper notes that the primary objective of imposing DTF trading obligations in respect of particular classes of OTC Derivatives (Mandatory DTF Trading Requirement) is to enhance the transparency and efficiency of OTC Derivatives markets for the benefit of all market participants.
The Consultation Paper requests feedback from market participants on a number of specific questions regarding various aspects of the contemplated DTF regulatory framework and the proposed approach to imposing specific Mandatory DTF Trading Requirements. The Consultation Paper comment period ends on March 31, 2015.
Proposed Regulation of Derivatives Trading Facilities
The proposed definition of “derivatives trading facility” includes any facility or market that brings together the orders of multiple buyers and multiple sellers of OTC Derivatives and that uses methods under which the orders interact and the buyers and sellers agree to the terms of trades. This definition is intentionally broad and captures various multilateral execution venues but is not intended to catch bilateral platforms, one-to-many platforms or facilities, or processes where no actual trade execution or matching takes place (such as bulletin boards used solely to advertise buying and selling interests).
The Consultation Paper proposes that all DTFs, regardless of whether the DTF permits trading of OTC Derivatives that are subject to a Mandatory DTF Trading Requirement, will be required to obtain authorization from Canadian regulators to provide direct access to market participants in a Canadian jurisdiction unless the DTF is exempted from this authorization requirement. DTFs would be subject to basic organizational requirements comparable to those that currently apply to marketplaces under National Instrument 21-101 Marketplace Operation and National Instrument 23-101 Trading Rules, including requirements related to transparency, record-keeping, fair access to trade and price information, reasonable access to trading, systems requirements, financial and personnel resources, conflicts of interest rules, and regulatory reporting.
Marketplace participants have been specifically requested to provide input on pre-trade and post-trade transparency requirements that should be imposed on DTFs, including how these requirements should be varied based on whether or not the relevant OTC Derivatives are subject to Mandatory DTF Trading Requirements. The Consultation Paper also asks whether DTFs should only be permitted to allow specific execution methods for OTC Derivatives that are subject to Mandatory DTF Trading Requirements, such as limiting execution to an order book or a request-for-quote system offered in conjunction with an order book.
Exemptions from the DTF Authorization Requirement
The Consultation Paper does not support a blanket substitute compliance exemption for non-Canadian exchanges and trading platforms. Instead, the recommendation is that all DTFs that provide Canadian participants with direct access to their trading platforms should be subject to the requirements of the proposed Canadian DTF regulatory regime, with discretionary exemptions to be considered on a case-by-case basis. For example, an application for a discretionary exemption could be submitted by a DTF based and regulated in the United States or the European Union on the basis that the regulation and oversight in such DTF’s home jurisdiction is substantively comparable to that which would apply under the Canadian DTF regime. Under this approach, non-Canadian DTFs would be subject to obligations to report to Canadian securities regulators with respect to services provided to local participants and CSA members would rely on the DTF’s home regulator with respect to day-to-day regulatory oversight.
As part of the comment process, market participants may make the case, based on efficiency and access considerations, that the parameters of a preordained substitute compliance exemption should be expressly incorporated into the DTF regime in order to permit Canadian market participants to continue to have access to non-Canadian trading platforms operating within those parameters.
Identification of OTC Derivatives Subject to a Mandatory DTF Trading Requirement
The Consultation Paper indicates that following consultation with other Canadian authorities and the public, the CSA will determine from time to time whether to impose a Mandatory DTF Trading Requirement in respect of particular classes of derivatives. The Consultation Paper contemplates that in any such evaluation consideration should be given to a number of factors, including whether the class of derivatives is subject to mandatory clearing obligations, its trading liquidity and the number of regularly participating market participants that trade the class of derivatives, and whether an exchange-trading mandate applies to the derivatives in other countries or the derivatives are otherwise already voluntarily being traded through regulated exchanges and platforms.
Exemptions from the Mandatory DTF Trading Requirement
The Consultation Paper invites input on whether exemptions from Mandatory DTF Trading Requirements should apply in particular situations or for any particular category of market participants, and specific questions are posed regarding size thresholds and appropriate exemptions for large block trades and quotes. The Consultation Paper also considers whether bespoke or illiquid contracts will be excluded from Mandatory DTF Trading Requirements given that a minimum level of standardization and liquidity should be a precondition to imposing Mandatory DTF Trading Requirements.
We expect that exemptions applicable in the context of mandatory clearing may be included in the DTF rules. For example, exemptions based on the end-user exemption and the intragroup exemption described above in the context of mandatory clearing may be included when draft DTF rules are introduced, although these exemptions are not referred to in the Consultation Paper. Similarly, a phase-in period for particular Mandatory DTF Trading Requirements may be included on a basis comparable to the proposed six- to 18-month phase-in period applicable to mandatory clearing obligations.
We wish to acknowledge the contribution of Paul Rand to this publication