CSA Proposes Registration Regime for OTC Derivatives Market in Canada

Introduction

On April 19, 2018, the Canadian Securities Administrators (the “CSA”) published for comment Proposed National Instrument 93-102 Derivatives: Registration and Proposed Companion Policy 93-102 Derivatives: Registration (collectively, the “Proposed Registration Rules”), which set out a comprehensive framework for the registration of participants in the over‑the‑counter (“OTC”) derivatives markets in Canada.

The release of the Proposed Registration Rules follows the publication of Proposed National Instrument 91-101 Derivatives: Business Conduct and Proposed Companion Policy 93-101 Derivatives: Business Conduct (collectively, the “Proposed Business Conduct Rules”) in April 2017, which proposed a variety of business conduct requirements for participants in the OTC derivatives markets in Canada, covering such matters as fair dealing, conflicts of interest, know‑your‑client, suitability, safeguarding of counterparty assets, mandatory disclosure and reporting to counterparties, record keeping and compliance. For further information on the Proposed Business Conduct Rules, please refer to our previous article.

Together, the Proposed Registration Rules and the Proposed Business Conduct Rules are intended to establish a robust investor protection regime that the CSA expects will promote transparency and accountability in the OTC derivatives markets in Canada. The CSA noted that the regulatory approach under the Proposed Registration Rules is consistent with the regulatory approach taken by most members of the International Organization of Securities Commissions that have active OTC derivatives markets, including the regime under the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States.

Registration Requirement under the Proposed Registration Rules

The central feature of the Proposed Registration Rules is a requirement for participants in the OTC derivatives markets to register with the securities regulatory authorities of the provinces and territories.

Business Trigger

The requirement to register applies to any person or company that engages in, or holds itself out as engaged in:

  • the business of trading in derivatives as principal or agent; or
  • the business of advising in derivatives,

unless an exclusion or exemption from the requirement to register is available.

Similar to the securities dealer and adviser registration regime under National Instrument 31‑103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31‑103”), the requirement to register is based on a business trigger, which means that only persons and companies who are engaged in, or hold themselves out as engaged in, the business of trading or advising in derivatives will be subject to the requirement to register.

The Proposed Registration Rules contain a non-exhaustive list of activities that are indicative of being in the business of trading, which triggers the requirement to register as a derivatives dealer, or being in the business of advising in derivatives, which triggers the requirement to register as a derivatives adviser. For a derivatives dealer, these activities include such things as acting as a market maker and facilitating or intermediating transactions for others and soliciting directly or indirectly in relation to transactions.

Subject to the availability of an exclusion or an exemption, the requirement to register applies to a person or company that is in the business of trading or advising in respect of any type of OTC derivative, except for certain specified derivatives that are excluded from OTC derivatives regulations under applicable provincial product determination rules.

Additional Triggers – Derivatives Dealer

The Proposed Registration Rules also require a person or company that does not satisfy the derivatives dealer business trigger, but nevertheless carries on certain activities, to register as a derivatives dealer with the securities regulatory authorities.

The additional triggers for the requirement to register are as follows:

  • the person or company transacts with, for or on behalf of a non-eligible derivatives party;
  • the person or company solicits or initiates contact with a non-eligible derivatives party for the purpose of encouraging that person or company to transact in a derivative or to offer a service relating to a transaction or transactions; or
  • the person or company, on behalf of another person or company, other than an affiliated entity, facilitates the clearing of one or more derivatives through a clearing agency or a clearing house.

These additional triggers represent a departure from the CSA’s approach under NI 31-103, as the requirement to register as a securities dealer is based on a business trigger alone.

The concept of a “non-eligible derivatives party” is central to the first two additional triggers for the requirement to register as a derivatives dealer and also to certain exemptions from the requirement to register as discussed below.

A “non-eligible derivatives party” is defined under the Proposed Registration Rules as a derivatives party that is not an “eligible derivatives party”. An “eligible derivatives party” is a person or company that the CSA does not consider to require the full set of protections afforded to retail customers or investors, either because such person or company can reasonably be considered to be sophisticated, or because such person or company has sufficient financial resources to obtain professional advice or otherwise protect themselves through contractual negotiation.

The list of “eligible derivatives parties” includes, like the lists of “permitted clients” under NI 31‑103 and “accredited counterparties” under the Derivatives Act (Quebec), Canadian financial institutions, certain trust companies, certain pension funds and certain investment funds. However, the list of eligible derivatives parties diverges in significant ways from those other lists. For example, the list includes a person or company that is a “commercial hedger”, which is generally a person or company (other than an individual) that carries on a business and that transacts in derivatives in order to hedge certain specified risks relating to such business. In order to qualify as a “commercial hedger”, a person or company must satisfy a number of criteria set forth in the Proposed Registration Rules, including, in certain cases, a minimum net asset test.

Under the Proposed Registration Rules, a derivatives dealer is prohibited from transacting with an individual that is a non-eligible derivatives party, unless that derivatives dealer is a member of the Investment Industry Regulatory Organization of Canada (“IIROC”).

Categories of Registration

If a person or company satisfies any of the triggers for registration discussed above, then it will be required to register with the securities regulatory authorities under one of several registration categories, unless an exclusion or exemption from registration is available.

The following registration categories are available for firms that are subject to a registration requirement (such firms, “registered derivatives firms”):

  • a “derivatives dealer”;
  • a “restricted derivatives dealer”;
  • a “derivatives adviser”; and
  • a “restricted derivatives adviser”.

Firms that are registered as a “derivatives dealer” or a “derivatives adviser” are permitted to trade or advise, respectively, in any type of derivative. By contrast, firms that are registered as a “restricted derivatives dealer” or a “restricted derivatives adviser” are only permitted to trade or advise, respectively, in specific derivatives authorized by the securities regulatory authorities under the terms of their registrations.

The following registration categories are available for individuals that are subject to a registration requirement (such individuals, “registered derivatives individuals”):

  • a “derivatives dealing representative”;
  • a “derivatives advising representative”;
  • a “derivatives ultimate designated person” (“UDP”);
  • a “derivatives chief compliance officer” (“CCO”); and
  • a “derivatives chief risk officer” (“CRO”).

Individuals that are registered as a “derivatives dealing representative” or a “derivatives advising representative” are permitted to trade or advise, respectively, in any type of derivatives that their sponsoring firm is permitted to trade or advise in. Although there are no restricted variations of the “derivatives dealing representative” or “derivatives advising representative” registration categories, individuals may nevertheless face restrictions on the types of derivatives that they are permitted to trade or advise in, as a consequence of their sponsoring firms being a “restricted derivatives dealer” or a “restricted derivatives adviser”.

The Proposed Registration Rules provide that individuals will be exempt from the requirement to register as a “derivatives dealing representative” or a “derivatives advising representative” if their activity is limited to trading or advising either (i) an affiliated entity (other than an affiliated entity that is an investment fund), or (ii) an eligible derivatives party that, in the case of a derivatives advising representative, is not a managed account of any derivatives party.

Specific Requirements under the Proposed Registration Rules

In addition to the requirement to register, the Proposed Registration Rules contemplate a number of specific requirements for both registered derivatives firms and registered derivatives individuals.

Specific Requirements for Registered Derivatives Firms

Subject to the availability of certain exemptions, registered derivatives firms must:

  • designate an individual to act as a UDP, a CCO and a CRO;
  • satisfy certain minimum capital requirements;
  • conduct audits at the direction of the securities regulatory authorities;
  • deliver annual and interim financial statements to the securities regulatory authorities including certain specified information;
  • establish, maintain and apply policies and procedures designed to ensure that the firm, and each individual working on its behalf, complies with securities legislation;
  • adopt written risk management policies and procedures that will allow the firm to monitor and manage risks associated with its business;
  • satisfy certain standards for risk mitigation, including standards relating to (i) the confirmation of material terms of derivatives transactions, (ii) the existence of a written agreement for determining the value of derivatives transactions, and (iii) the existence of a written agreement establishing a process for resolving disputes;
  • establish and maintain business continuity and disaster recovery plans;
  • establish and maintain policies and procedures to terminate offsetting derivatives and to conduct portfolio compression exercises; and
  • keep complete records of derivatives, derivatives transactions and advice provided in relation to derivatives.

Specific Requirements for Registered Derivatives Individuals

Registered derivatives individuals are subject to a general proficiency requirement designed to ensure that such individuals have the necessary education, training and experience to perform their jobs competently, including an understanding of the structure, features and risks of each derivative that the individual trades or recommends. This general proficiency requirement is applicable to all registered derivatives individuals, irrespective of their registration category.

In addition, derivatives dealing representatives must have successfully completed certain derivatives examinations while derivatives advising representatives must either have the CFA Charter designation or have successfully completed certain derivatives examinations and have a minimum period of relevant work experience. There are also specific proficiency requirements applicable to individuals in other registration categories. Individuals that are registered as a CCO or a CRO, for example, must have obtained certain professional designations, must have completed certain examinations, and must have a minimum period of relevant work experience.

Beyond proficiency, the Proposed Registration Rules include further requirements applicable to CCOs, CROs and UDPs. For example, there is a requirement for a CCO and a CRO to escalate certain issues to the UDP, and also to submit annual reports to the board of directors, which reports may be reviewed from time to time by, and at the request of the securities regulatory authorities. Similarly, there is a requirement for a UDP to escalate issues to the board of directors and, in specified circumstances, report instances of non-compliance with the Proposed Registration Rules and other securities legislation to the securities regulatory authorities.

Exclusions and Exemptions under the Proposed Registration Rules

A variety of exclusions and exemptions are available under the Proposed Registration Rules. Some of these provisions provide relief from the requirement to register, while others provide relief from specific requirements under the Proposed Registration Rules.

Exclusions from the Proposed Registration Rules

The following governmental and supranational entities are categorically excluded from the scope of the Proposed Registration Rules and are not subject to any requirements thereunder, including the requirement to register:

  • the Government of Canada or any province thereof or the government of a foreign jurisdiction;
  • the Bank of Canada or a central bank of a foreign jurisdiction;
  • crown corporations or agencies of the Government of Canada or any province thereof; and
  • the Bank for International Settlements and the International Monetary Fund.

Although the foregoing entities will not be subject to any requirements under the Proposed Registration Rules, persons and companies that trade with such entities may still be subject to these requirements, unless they are eligible for another exemption.

Exemptions from the Requirement to Register under the Proposed Registration Rules

While not excluded from the Proposed Registration Rules, the following persons or companies may be exempt from the requirement to register under the Proposed Registration Rules, provided they comply with the conditions attaching to an exemption:

  • End-users. A person or company that trades derivatives for its own account for commercial purposes is not required to register as a derivatives dealer. A person that frequently transacts in derivatives to hedge business risk, for example, may qualify for this exemption. This exemption is only available where a person or company does not (i) solicit or transact with, or on behalf of, a derivatives party that is a non-eligible derivatives party, (ii) advise non-eligible derivative parties in respect of any derivative or transaction, other than to provide general advice, (iii) regularly make or offer to make a market in a derivative with a derivatives party, (iv) regularly facilitate or otherwise intermediate transactions for another person or company, and (v) facilitate clearing of a derivative through the facilities of a qualifying clearing agency for another person or company, other than an affiliate.
  • Limited notional amount of derivatives activity. Persons or companies that deal in derivatives (other than commodity derivatives only) that have an aggregate month-end gross notional amount of less than or equal to $250 million in each of the preceding 24 months are not required to register as a derivatives dealer. Similarly, persons or companies that deal in commodity derivatives only that have an aggregate month-end gross notional amount of less than or equal to $1 billion in each of the preceding 24 months are not required to register as a derivatives dealer. Gross notional amounts are to be determined on a consolidated basis using one of two proposed methodologies as discussed below. This exemption only applies where a person or company does not (i) solicit or transact with, or on behalf of, a derivatives party that is a non-eligible derivatives party, and (ii) advise non-eligible derivative parties in respect of any derivative or transaction, other than to provide general advice.
  • Advising generally. Persons or companies that provide advice that is general in nature and that is not tailored to the needs of the recipient are not required to register as a derivatives adviser. General advice could include advice delivered through newsletters, articles, newspapers or magazines, websites, e-mail, television or radio, or conferences, so long as that advice is not presented as being tailored to the needs and circumstances of the recipient.
  • Foreign dealers and advisers. Persons or companies that have their head office or principal place of business in certain jurisdictions outside of Canada that are specified in Appendices D and G of the Proposed Registration Rules (which are currently blank) and that are subject to regulatory requirements that the CSA considers to be equivalent to those under the Proposed Registration Rules are not required to register as a derivatives dealer or derivatives adviser. This exemption will only be available where a person or company (i) does not solicit or transact a derivative with a person or company that is a non-eligible derivatives party, (ii) is authorized to deal in derivatives in the jurisdiction where its head office or principal place of business is located, and (iii) complies with all of the equivalent requirements. If a person or company is relying on this exemption, it must provide certain disclosures to its counterparties relating to its status as a foreign entity, submit to the jurisdiction of Canadian securities regulatory authorities and appoint an agent for service, and also undertake to provide Canadian securities regulatory authorities with prompt access to its books and records upon request.
  • Trading or advising affiliated entities. Persons or companies that trade or advise affiliated entities alone and not any third parties are not required to register as a derivatives dealer or a derivatives adviser. This exemption will only be available where a person or company is not trading with or advising an investment fund.
  • Financial Institutions in the Province of Ontario. In the Province of Ontario only, certain financial institutions specified under section 35.1 of the Securities Act (Ontario) are exempt from registration requirements under provincial securities laws, and accordingly will not be required to register in Ontario under the Proposed Registration Rules. The list of specified financial institutions includes banks listed under Schedules I, II or III to the Bank Act (Canada), as well as credit unions, trust companies and caisse populaires that are authorized by a federal statute of Canada or of the Province of Ontario to carry on business in Canada or in the Province of Ontario, respectively.

Exemptions from Specific Requirements under the Proposed Registration Rules

In addition to exemptions from the requirement to register, the Proposed Registration Rules also include exemptions from specific requirements.

In particular, the Proposed Registration Rules contemplate that persons or companies that are (i) Canadian financial institutions, (ii) members of IIROC, or (iii) foreign dealers or advisers that have their head office or principal place of business in certain jurisdictions outside of Canada that are specified in column 1 of Appendices D and H of the Proposed Registration Rules (which are currently blank) will be exempt from specific requirements under the Proposed Registration Rules, provided that such persons or companies are complying with equivalent requirements that are specified, respectively, in Appendices F, E, and column 2 of Appendices D and H of the Proposed Registration Rules (which, except for Appendix F, are currently blank).

For example, Canadian financial institutions that are regulated by the Office of the Superintendent of Financial Institutions (OSFI) will be exempted from a variety of specific requirements under the Proposed Registration Rules, including in respect of minimum capital, risk management, business continuity and disaster recovery, portfolio reconciliation and portfolio compression, provided they are complying with certain equivalent requirements imposed under OSFI Guidelines.

Outstanding Provisions of the Proposed Registration Rules

A number of provisions of the Proposed Registration Rules remain outstanding and will be developed in a subsequent publication of such rules. Some of the most significant provisions that have yet to be addressed include the following:

  • Large derivatives participants. The Proposed Registration Rules do not currently include a registration requirement for persons and companies that have a large gross notional amount of derivatives activity, but that do not otherwise satisfy the triggers for registration discussed above. The CSA indicated that it may include such a requirement in a future version of the Proposed Registration Rules, after the CSA has completed additional analysis relating to the Canadian OTC derivatives markets.
  • Notional thresholds. As discussed above, the Proposed Registration Rules provide an exemption from the requirement to register for persons or companies that have a limited amount of notional derivatives activity. The CSA is considering two alternative methods for calculating notional amounts, and indicated that it may revise the thresholds for such exemption depending on the methodology that is employed. The selected methodology will be published for comment in Appendix A of a future version of the Proposed Registration Rules.
  • Minimum capital requirements. The Proposed Registration Rules contemplate that derivatives dealers will be subject to minimum capital requirements, but the CSA has yet to determine the nature of such requirements. The CSA indicated that it expects the minimum capital requirements under the Proposed Registration Rules will be consistent with the capital requirements proposed by regulatory authorities in other jurisdictions, including the United States. The CSA intends to publish for comment the minimum capital requirements in Appendix C of a future version of the Proposed Registration Rules in due course.
  • Other Incomplete Appendices. In addition to completing Appendices A and C as noted above, the CSA must also complete Appendices B, D, E, G and H, which set forth the nature and scope of the exemptions that are available for persons or companies that are members of IIROC or foreign dealers or advisers. The CSA intends to publish for comment full versions of Appendixes B, D, E, G and H, in a future version of the Proposed Registration Rules.

Comments on the Proposed Registration Rules

The CSA has requested general feedback on all aspects of the Proposed Registration Rules, as well as on twelve specific questions relating to the Proposed Registration Rules. The deadline for submitting comments to the CSA is September 17, 2018.

The CSA indicated that it expects to re-publish the Proposed Business Conduct Rules for a second comment period shortly after the publication of the Proposed Registration Rules, in order to allow commenters to consider both the Proposed Registration Rules and the Proposed Business Conduct Rules together when formulating their comments on the Proposed Registration Rules.

For further information on the Proposed Registration Rules, please contact a member of our Derivatives Group.

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