OTC Derivatives Regulation
Though the Canadian over-the-counter derivatives market is small when compared to the global OTC derivatives market, OTC derivatives play an important role in Canadian financial markets. As a result, reform of the Canadian OTC derivatives market is seen as a significant means of reducing systemic risk, improving market efficiency and integrity, and enhancing investor protection.
At the G-20 meeting in Pittsburgh in 2009, G-20 leaders made the following commitment:
"All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."
Reform of the Canadian OTC derivatives market is necessary for Canada to meet its G-20 commitments. During the latter half of 2010, discussion papers aimed at articulating how (or seeking input from the marketplace as to how) Canada should implement its G-20 commitments were published. We also saw the passage of Ontario legislation implementing a derivatives regulatory framework. This article will highlight the salient points from these discussion papers and Ontario legislation.
Canadian OTC Derivatives Working Group
The Canadian OTC Derivatives Working Group is an inter-agency group, formed in December 2009, to co-ordinate efforts directed towards meeting Canada’s G-20 commitments. The Working Group is chaired by the Bank of Canada and is comprised of representatives from the Alberta Securities Commission, the Autorité des marchés financiers du Québec, the Department of Finance, the Office of the Superintendent of Financial Institutions and the Ontario Securities Commission (OSC). The specific focus of the Working Group is to "ensure that any structural change is contemplated and undertaken in a manner that is appropriate for the ongoing stability and vibrancy of the Canadian financial system and that the timetable for initiatives is consistent with the "end-2012" commitment."
The Working Group published a discussion paper entitled "Reform of Over-the-Counter (OTC) Derivatives Markets in Canada: Discussion Paper from the Canadian OTC Derivatives Working Group," dated October 26, 2010. The Working Group offered recommendations across five key areas of reform:
- Capital incentives and standards — New capital standards should encourage the use of standardized, centrally cleared transactions, and Canada should coordinate implementation of these standards with other jurisdictions.
- Standardization — There should be a concerted effort in Canada to increase standardization of OTC derivatives contracts for all asset classes with a view to harmonizing standardization internationally based on guidance provided by international standard setters.
- Central counterparties and risk management — The derivatives industry should thoroughly assess all possible solutions for obtaining access to safe and efficient central clearing services, including the merits of (i) building a Canadian-based central clearing counterparty (CCP) with proper risk-proofed links to international CCPs and (ii) direct access to global CCPs.
- Trade repositories — All OTC derivatives trades involving a Canadian counterparty should be required to be reported to a trade repository to which Canadian authorities have appropriate access. In addition, Canadian authorities should have appropriate access to OTC derivatives trade information on underlying Canadian entities, regardless of where the counterparties are located geographically.
- Trading venues — To promote transparency and market efficiency, domestic authorities should encourage the migration of standardized OTC derivatives transactions to electronic trading platforms or exchanges, where appropriate. Canadian authorities will be assessing models and suggestions from the industry to ensure appropriate transparency for those transactions not executed on a public trading venue. In addition, all market participants should have the ability to be aware of prevailing levels of activity and valuations of OTC derivatives transactions.
The Canadian Securities Administrators
The Canadian Securities Administrators released an OTC Derivatives Consultation Paper dated November 2, 2010 (CSA Paper). The purpose of the CSA Paper is to set out various recommendations geared toward strengthening our financial markets, managing specific risks relating to OTC derivatives and implementing the G-20 commitments made in Pittsburgh in 2009 and confirmed in Toronto in June 2010. The CSA Derivatives Committee (Committee) also poses specific questions for which it sought input from the financial industry and the public relating to the following specific proposals:
- Clearing — Clearing of OTC derivatives that are determined to be "appropriate for clearing and capable of being cleared" (i.e. standardized) will be mandatory, however, not all participants (such as non-financial corporate and end-users) would be subject to mandatory clearing. Further input and study is required relating to the type of CCP and the location, including whether to have a Canadian solution or use an international CCP.
- Trade Repositories — Provincial securities laws should be amended to mandate the reporting of all derivative transactions by Canadian counterparties to a trade repository. For derivative transactions between a financial intermediary and a non-financial intermediary, it is recommended that the financial intermediaries be required to report the transaction (unless it is cleared, in which case the relevant CCP will either report the transaction or act as a trade repository for the information). For transactions between two financial intermediaries that are not cleared, both financial intermediaries should be required to report the transaction. Further study is required relating to the ownership of data in the repository, safeguards when sharing information with parties in potential conflicts, publication of data (if any) and preservation of sensitive/proprietary information/strategies.
- Electronic Trading — Provincial securities regulators should mandate electronic trading of OTC derivative products, but only those products that are capable of being traded on an organized trading platform (i.e. standardized and sufficiently liquid) and which pose a systemic risk to the market.
- Capital and Collateral — Higher capital and collateral requirements should be implemented for non-centrally cleared bilateral arrangements as compared to transactions involving a CCP. This, however, would be subject to certain exceptions, such as end-users whose use of OTC derivatives is restricted to hedging risks related to the end-user's business activities and does not increase systemic risk to the market. The Committee recognizes that it will be challenging to provide clarity regarding the concept of hedging and whether a person's use of OTC derivatives results in an increased systemic risk to the market.
- Enforcement — Provincial regulators should be granted the authority to conduct surveillance on OTC derivatives markets, develop robust market conduct standards and investigate and enforce against abusive practices.
Proposed Ontario Regulatory Framework for Derivatives
As we indicate in our related article, on December 8, 2010, the Helping Ontario Families and Managing Responsibility Act, 2010 (Ontario) (Bill 135) was granted Royal Assent. Schedule 18 to Bill 135 amended the Ontario Securities Act to address five different matters that included the establishment of a regulatory framework for the trading of derivatives in Ontario (the Derivative Framework). All of the Bill 135 amendments became effective on December 8, 2010 other than the amendments that will establish the Derivative Framework. The amendments to establish the Derivative Framework will not become effective until the date on which they are proclaimed in force by the Lieutenant Governor of Ontario.
Like the regulatory framework that governs the trading of securities, the Derivative Framework will comprise a dealer registration requirement, an adviser registration requirement and a disclosure document requirement. The dealer and adviser registration requirements will require any person or company that engages in, or holds himself, herself or itself out as engaging in, the business of trading in derivatives, or providing advice with respect to the buying or selling of derivatives, to become registered in an appropriate category of dealer or adviser registration, respectively, unless the trading or advisory activity can be conducted in reliance upon an exemption from such requirements. The Derivative Framework contemplates an exemption from the dealer registration requirement for persons or companies trading such classes of derivatives as may be prescribed by regulation.
The disclosure document requirement will prohibit any person or company from trading a designated derivative unless a prescribed form of disclosure document has been filed and accepted by the OSC and then delivered in accordance with regulations that have not yet been promulgated.
For purposes of the Derivative Framework, the term "derivative" has been broadly defined to mean an option, swap, futures contract, forward contract or other financial or commodity contract or instrument whose market price, value, delivery obligations, payment obligations or settlement obligations are derived from, referenced to or based on an underlying interest, including a value, price, rate, variable, index, event, probability or thing. Expressly excluded from the definition of "derivative" are exchange traded commodity futures contracts and options that are subject to the Commodity Futures Act (Ontario). For purposes of the Derivative Framework’s disclosure document requirement, the term "designated derivative" is defined to mean a derivative that,
- by reason of an order of the OSC, is a designated derivative, or
- belongs to a class of derivatives prescribed by the regulations.
Given the recent publication of the CSA Paper and the request by the Committee to respond with comments by January 14, 2011, the timing of Bill 135 (as it relates to the regulation of OTC derivatives) is quite surprising. However, as the amendments relating to the establishment of the Derivative Framework are not as yet in force, there is still time for the financial industry and regulators to consider the issues not only in Canada but also globally to ensure that efforts are co-ordinated among the G-20 countries.
Current Regulation of Derivatives
The Quebec Derivatives Act, which came into force on February 1, 2009, provides a regulatory framework for offering derivatives and trading and advising in respect of derivatives which is distinct from the Quebec Securities Act but administered by the same regulator, the Autorité des marchés financiers. The QDA provides for an exemption from its disclosure and registration requirements for the institutional OTC derivatives market by exempting the offering of derivatives to or trading or advising in respect of derivatives with "accredited counterparties."
Derivatives are included in the definition of "securities" in the securities legislation of several provinces including British Columbia, Alberta and Manitoba (Western Provinces) and, as a result, are regulated as securities under provincial securities legislation. Like Quebec, the Western Provinces have chosen not to regulate OTC derivative transactions in the institutional market by providing a blanket order from dealer registration and prospectus requirements if the transactions are entered into between "qualified parties."
See our November 2008 article, "Québec Adopts Derivatives Act, Publishes Draft Companion Regulation" and our August 2009 Legal Update which discusses the Québec Derivatives Act in part, for further information..