Originally published in Blakes Bulletin on Securities Regulation, December 2010
Ontario has taken important steps towards implementing Canada's G20 undertakings by amending the Securities Act (Ontario) (the Act) to adopt a broad regulatory framework for over-the-counter (OTC) derivatives.
The landmark changes to the Act were enacted in December 2010. Some of the amendments came into force immediately (the Initial Changes), while the more comprehensive changes (the Pending Changes) will be effective when proclaimed in force by the Ontario government. When the Pending Changes are proclaimed, the Ontario Securities Commission (OSC) will take on very broad powers to regulate OTC trading to the extent that derivatives transactions, counterparties or reference underlying interests have a substantial connection to Ontario.
As a result of the Initial Changes, the Act has been amended so that:
- insider trading restrictions that previously applied to trading of securities of reporting issuers by insiders now also apply to the trading of derivatives tied materially to the reporting issuer's securities
- the OSC now has authority to regulate derivatives trading markets, and the OSC's investigative, compliance and enforcement powers now apply to derivatives and derivatives trading activities
- anti-market manipulation provisions in the Act have been extended to apply to trading in all types of derivatives and underlying interests of derivatives
- derivatives exchanges and derivatives Alternative Trading Systems (ATSs) are now subject to regulation in the same manner as stock exchanges and stock ATSs and, accordingly, registration or exemptive relief will be required in order to carry on such business in Ontario
- derivatives clearing agencies will be subject to the same regulatory regime as securities clearing agencies and, accordingly, recognition by the OSC or exemptive relief will be required in order to carry on a clearing business in Ontario
- derivatives trade repositories may now apply to be recognized by the OSC as designated trade repositories.
When the Pending Changes are proclaimed in force, the Act will:
- require registration as advisers by those engaged in the business of advising derivatives counterparties, and as dealers by those engaged in the business of trading derivatives, as principal or agent, subject to exemptions and exclusions yet to come
- permit the OSC to make regulations related to the trading, clearing, collateralization, settlement and reporting of derivatives transactions
- enable the OSC to prescribe trading venues for specified derivatives
- permit particular derivatives to be regulated on a basis comparable to securities.
The Initial Changes and Pending Changes go beyond the bare essentials that would be needed to regulate the areas of derivatives trading contemplated in the Canadian Securities Administrators' November 2010 Consultation Paper 91-401 on Over-the-Counter Derivatives Regulation in Canada (the CSA Consultation Paper). The changes also extend the OSC's regulatory reach beyond what was specifically anticipated in the draft national securities legislation. Taken together, the Initial Changes and Pending Changes, once proclaimed, will be decidedly broader and will allow Ontario to move authoritatively to adopt derivatives regulations with teeth, to close existing gaps between the securities and derivatives marketplaces and to harmonize derivatives regulation with evolving global trading, clearing, collateralization, settlement, reporting and registration standards.
In the aftermath of the financial crisis, the G20 countries resolved to tighten the supervision over, and to specifically regulate, OTC derivatives markets on a common international basis. Derivatives have been blamed for causing, or at least catalyzing, the recent liquidity and financial crises. At their meeting in September 2009 in Pittsburgh, the G20 leaders committed that:
"All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end–2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."
This commitment was reaffirmed by the G20 leaders at the June 2010 summit in Toronto, where the leaders also stated their commitment to:
"...strengthen financial market infrastructure by accelerating the implementation of strong measures to improve transparency and regulatory oversight of hedge funds, credit rating agencies and over-the-counter derivatives in an internationally consistent and non-discriminatory way."
Over the last few months, international regulatory and consultative bodies such as the Financial Stability Board and the Basel Committee on Bank Supervision, as well as domestic regulators such as the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), have produced numerous reports directed at implementing the G20 commitments, and Canadian regulators at the provincial and federal levels are actively developing rules and policies to implement these changes. In addition to the CSA Consultation Paper, the Canadian OTC Derivatives Working Group (an inter-agency formed in December 2009 and chaired by the Bank of Canada with members from the Office of the Superintendent of Financial Institutions, the federal Department of Finance, the OSC, the Autorité des marchés financiers, the Alberta Securities Commission and the Bank of Canada) published a report in October 2010 scoping out how Canada could implement its G20 commitments in relation to OTC derivatives.
The CSA Consultation Paper released by Canada's securities administrators is intended to facilitate the fulfillment of Canada's G20 commitments and accordingly focuses on proposals for:
- the clearing of appropriate OTC derivatives through centralized clearinghouses, thereby creating credit hubs to eliminate or mitigate the systemic risk inherent in a bilateral contracting approach
- the reporting of derivatives trades by counterparties to trade repositories
- electronic trading of OTC derivatives that pose a systemic risk to the market
- risk-based capital and collateral requirements to reflect the risks assumed by counterparties
- the surveillance of OTC derivatives markets, the development of market conduct standards and the policing of abusive practices in the OTC derivatives marketplace.
The CSA Consultation Paper also recognizes the need for user exemptions in order to avoid unnecessary or over-burdening regulation. Further study of important issues such as the segregation of capital in the Canadian OTC derivatives context is advocated. The topic of registration requirements applicable to participants in the derivatives realm is not covered in the CSA Consultation Paper, but instead is highlighted as a subject for future consultation.
A global perspective is critical to understand the ultimate direction that Canada's derivatives regulation will take. While Canada's derivatives market is huge – estimated to have an aggregate outstanding notional amount of US$12.4-trillion as of December 2009 – it represents only about 2% of the global derivatives market. Accordingly, the CSA Consultation Paper recognizes that Canadian securities regulators' actions should generally be synchronized with the broader global initiatives regarding OTC derivatives. International harmonization and the avoidance of regulatory arbitrage underlie the concerted efforts being made by international groups such as the International Organization of Securities Commissions and the Financial Stability Board.
Ever mindful of the gravitational pull exerted by the dominant U.S. market, Canada's ultimate regulatory response will no doubt reflect on the direction and specific regulation undertaken by the SEC and CFTC in the derivatives area. Developments in Europe and Asia may also influence the direction of Canada's regulatory response, as derivatives markets are global in scope and co-ordination will be essential to avoid conflicting or duplicative requirements for cross-border transactions. Many of the comment letters submitted in response to the CSA Consultation Paper also underscore the importance of harmonizing or at least co-ordinating Canadian regulations with international developments and not pre-empting the developing international process. Real insight into the scope and extent of Canada's particular rules for OTC derivatives will therefore likely wait until those matters are fleshed out as part of the global process – especially the efforts being made by the SEC and the CFTC under the Dodd-Frank Act. Moreover, it remains to be seen whether all of the Canadian provinces will implement securities rules coming out of the CSA Consultation Paper in a uniform manner and whether federal regulators (including in the securities area, if the federal government's current initiative to replace provincial securities laws with federal securities laws is ratified by the courts in the upcoming Supreme Court of Canada reference) and the federally regulated banks that dominate Canadian OTC markets will co-operate with the provinces in implementing a consistent harmonized regulatory landscape that will apply to all market participants.
Ultimately, once the Pending Changes come into force, the final details of Ontario's derivatives regime will be decided and implemented by the OSC using new rule-making authority. For now, insight into the ultimate shape of regulation can only be gleaned from the commentary of governmental authorities and influential market participants and agencies. The CSA Consultation Paper (and the responding comment letters) and the Report by the Canadian OTC Derivatives Working Group are good places to look for such insight and background.
application OF Ontario'S securities regulatory FRAMEWORK TO OTC derivatives TRADING
The approach to the regulation of derivatives in the Initial Changes and Pending Changes roughly tracks the way securities trading is currently regulated in Canada. The derivatives provisions weave through the relevant provisions of the Act so that OTC derivatives (and, in some cases, the underlying interests on which the derivatives are based) may, in appropriate cases, be treated like securities. This represents a significant paradigm shift away from the current unregulated and largely institutional OTC derivatives market towards a "public interest" based approach to regulation similar to the one applicable to Canada's securities trading markets.
A key premise of the framework contemplated by the Pending Changes is broad regulatory authority over all derivatives trading, including imposing registration and disclosure document requirements. However, the Pending Changes contemplate that specific exemptions and exclusions will be made to permit particular derivatives, categories of derivatives, particular trading activities and specified derivatives users to be excluded from some or all aspects of the regulation. The scope of these exemptions and carve-outs is not yet defined. Those details will be contained in future rules and policies. They will, of course, be of greatest interest to current OTC derivatives market participants.
INITIAL CHANGES TO THE ACT
The following Initial Changes now apply to OTC derivatives trading in Ontario as a result of the Initial Changes:
1. Look-Through Provisions – Certain provisions of the Act applicable to trading and other activities related to a reporting issuer's securities now apply equally to a derivative, the market price, value, delivery obligations, payment obligations or settlement obligations of which are, in a material way, derived from, referenced to or based on the market price, value, delivery obligations, payment obligations or settlement obligations of the reporting issuer's securities. Most importantly, the prohibition in the Act on trading while in possession of material undisclosed information by persons in a "special relationship" with a reporting issuer, together with the related insider trading liability provisions, now specifically applies to prohibit trades in such related derivatives.
2. Regulation of Derivatives Trading Markets – The OSC has been given broad authority to regulate organized trading and clearing of derivatives and to act as a regulator for derivatives markets in Ontario. As a result, derivatives clearing agencies are subject to the same
basic regulatory regime as securities clearing agencies; namely, they will need to apply for recognition by the OSC, or exemptive relief. Under the Initial Changes, the OSC's regulatory authority extends only to regulating existing organized derivatives markets and clearing agencies and does not extend to the regulation of individual trades. Once the Pending Changes are proclaimed, the OSC will be able to prescribe classes of derivatives which must be traded on recognized markets, cleared by recognized clearing agencies, reported to recognized trade repositories and collateralized and capitalized in accordance with specified requirements. Also, under the Initial Changes, derivatives trade repositories may apply to be recognized by the OSC as designated trade repositories. However, there is not currently any direct OSC authority to require derivatives trading to be centrally cleared or reported.
3. Anti-manipulation – The prohibitions on activities that lead to a misleading appearance of trading activities or an artificial price, and on making misleading statements, now extend to all derivatives trading as well as to trading that impacts the interests underlying a derivative. This is an amplification of the previous requirement under the Act, which only applied to prohibit such deceptive practices in relation to securities and derivatives for which the underlying interest was a security.
4. Enforcement – The Initial Changes extend investigation, examination, compliance, decision-making and enforcement powers under the Act to derivatives trading. For example, the OSC now has the power to cease-trade derivatives and to make orders based on convictions or sanctions related to derivatives-related offences in other jurisdictions.
5. Scope of "Trading", "Purchase" and "Sale" – A foundational concept in the Initial Changes is when a "trade", "purchase" or "sale" of a derivative takes place. Consistent with a broad regulatory scope, the terms are defined to generally include most consensual or unilateral actions that impact one's economic interests under a derivative transaction.
A "trade" will include entering into, making material amendment to, terminating, assigning, selling or otherwise acquiring or disposing of a derivative, or a novation of a derivative other than with a clearing agency. A material amendment, novation or assignment of a derivative existing at the time the legislation takes effect may therefore be affected. There is currently no grandfathering provision to exclude existing derivatives, although there is plenty of scope in the rule-making powers for the OSC to extend those types of transitional provisions to ease the burden of implementation. Similarly, a "purchase" and "sale" of a derivative is defined to include entering into, making a material amendment to, acquiring, terminating, assigning or otherwise disposing of a derivative, or a novation of a derivative other than with a clearing agency.
6. Counterparty Trade Reporting and Basic Investor Protections – Registered dealers are now required to provide a written confirmation (similar to the current requirement for securities trades) to the counterparty for each derivatives trade for which the dealer acts as principal or agent containing the information required by regulation (although no such regulation has yet been made). Furthermore, a registered dealer acting as agent in connection with a derivatives transaction is required upon request by the OSC to disclose counterparties' names to the OSC. Certain standard investor protections applicable to securities trading now also apply to derivatives trading including, in particular, the general prohibition on misleading representations regarding the availability of refunds, future values, eligibility for exchange or the merits of the derivative. Marketing materials may also be restricted and subject to production if requested by the OSC if necessary for the protection of the public.
pending CHANGES TO THE ACT
The following are the key areas of regulation contemplated by the Pending Changes:
1. Registration of Dealers and Advisers – The Act currently regulates individuals and companies engaging in the trading of securities, as principal or agent (as a "dealer") and/or engaging in the business of advising others as to the buying and selling of securities (as an "adviser"). Categories of registrations and the related proficiency and industry requirements, as well as exemptions from those requirements, are set out in detailed rules (including the bylaws and rules of applicable self-regulatory organizations) made pursuant to the Act.
The same general format for registration is contemplated for those trading or advising in relation to derivatives in Ontario. Beyond the general approach, the specific categories for registration, particular registration requirements and the related exemptions are likely to be quite different for derivatives than for the counterpart requirements applicable to securities. The Pending Changes specifically contemplate the possible adoption of a policy to establish criteria around when a person is engaged in the business of trading in derivatives or providing advice with respect to buying and selling derivatives. Such a policy could be based on substantially similar principles to those set out in the existing CSA commentary on engaging in the business of trading in, and advising in respect of, securities.
As a result, dealers, banks and other market participants in the business of trading or advising in relation to OTC derivatives in Ontario should anticipate having to satisfy some level of proficiency, competency, solvency and accountability standards in the form of a modified registration regime and attendant rules designed specifically for OTC derivatives. It would not be surprising to find that these requirements will have some regard to comparable standards and requirements stipulated by the Act and by the Investment Industry Regulatory Organization of Canada in relation to securities trading.
The scope of the exceptions from these registration requirements will be particularly relevant for market participants not currently engaged in the securities business in Ontario. Presumably there will be some degree of overlap in the registration requirements related to trades in securities and in derivatives, in which case, there may be an opportunity for a current securities dealer or adviser to piggyback on at least some of these new requirements. Also, presumably there will be some degree of mutual recognition with respect to foreign institutions active in Ontario and that are appropriately qualified under their local laws to engage in derivatives trading or advising activities. Again, those details remain to be seen.
The registration requirements and exemptions contemplated in the Pending Changes will likely receive a great deal of comment and criticism, once published in the form of proposed rules. Just as the SEC is focused on "securities-based swaps", it would not be surprising to find that the OSC focuses its registration efforts primarily on derivatives linked to equities, credit and perhaps commodities, leaving institutional interest rate and foreign exchange derivatives largely unfettered by registration requirements. We believe the goal should be to come up with requirements that are informed, proportionate and balanced in their scope and appropriately narrow in their application, and to recognize that the vast majority of OTC derivatives trading takes place among a limited number of very large and sophisticated institutions. The Pending Changes layer in various placeholders to allow for such exemptions.
2. Mandatory Clearing – Mandatory clearing and settlement of OTC derivatives through a clearinghouse is a cornerstone of the global initiative. It is the primary way regulators propose to limit the systemic risk inherent in the current bilateral contracting market. Like other credit-hub models, including those currently applicable to exchange-traded futures, a clearinghouse would serve to limit bilateral exposure in the derivatives market, permit netting across a broad class of derivatives trades and clearing members, and require proper collateralization of all cleared derivatives transactions on an aggregate basis. These measures will be designed to limit the likelihood that a material counterparty default would spread contagion through the financial system.
The Pending Changes provide the OSC with powers to make rules requiring the clearing and settling of trades in prescribed classes of derivatives through a clearing agency. A clearing agency for derivatives is defined (subject to certain clarifying exceptions) as a centralized facility for the clearing and settlement of trades in derivatives that either: enables a party to substitute the credit of the clearing agency for the credit of the other transacting parties; arranges or provides for multilateral settlement or netting; or provides clearing services that mutualize or transfer among participants in the clearing agency any credit risk arising from transactions executed by its participants.
The Pending Changes do not specifically require that such a clearing agency be located in or connected to Ontario. This is important since it remains an open question whether the mandatory clearing of OTC derivatives would be appropriately limited to a local facility – the issue being one of scale and specialization in the context of particular types of OTC derivatives and underlying interests. However, the OSC is given rule-making power to impose restrictions on the ownership, control and direction of a clearing agency.
As this aspect of the Pending Changes (and the attendant rule-making) is fleshed out, it will be very important to think through the practicality of related collateral posting obligations and the knock-on effects to parties transacting derivatives through clearing participants rather than directly as members of the clearinghouse. These requirements may directly impact on the economic feasibility of transacting in OTC derivatives, and the ultimate approach may raise important credit-risk management and competition issues for market participants generally.
3. Documentation and Distribution Practices – For derivatives specifically designated by the OSC under its rule-making powers and not otherwise exempted, a disclosure document satisfying certain disclosure standards will need to be filed and accepted by OSC Staff and delivered to the counterparty before a trade in such designated derivatives can be undertaken. It is not clear whether such disclosure for particular types of OTC derivatives would be in the form of a standardized disclosure document analogous to those currently required to be provided in respect of certain options and futures transactions, or whether the applicable regime would contemplate a prospectus-like review of a document specifically prepared for the transaction in question.
More generally, derivatives other than designated derivatives or standardized exchange-traded derivatives may be subject to additional distribution requirements akin to the requirements applicable to primary distributions of securities, and possibly even broader requirements if specifically included for such purposes in a class of derivatives prescribed by the OSC in its future rules. Presumably these and other related trading requirements will not apply to non-securities-related derivatives or transactions involving sophisticated or otherwise accredited parties, although that remains to be seen. The Pending Changes include a provision specifying that non-compliance will not, in and of itself, render a derivative void, unenforceable or subject to rescission.
4. Trade Repositories – Another critical part of the global initiative is to require that OTC derivatives transactions be reported to a trade repository, which collects and maintains reports of completed trades. The ultimate goal is to allow authorities to have appropriate access to trade information on underlying entities, regardless of where the counterparties are located geographically. This will require Canadian authorities to have access to data from international trade repositories. If international trade repositories would not provide adequate data access and coverage of Canadian participants and products, a Canadian trade repository will need to be established.
The Pending Changes include only the bare-bones elements necessary to implement rules requiring that OTC trades be reported through a trade repository. In particular, the Pending Changes specifically contemplate the basis on which a trade repository could be designated and regulated, although the significance of such a designation and its purpose in the overall scheme seems a bit unclear at this point. Presumably the rule-making power in this regard (i.e., to prescribe record-keeping, reporting and transparency requirements relating to derivatives) will be used to enable the OSC to adopt reporting standards for OTC derivatives that permit adequate regulatory oversight and are harmonized with those in other countries.
5. Trading Venues – The G20 commitments to promote transparency and market efficiency for OTC derivatives encourage the migration of standardized OTC derivatives to electronic trading platforms or exchanges where appropriate. At this stage, authorities in Canada and elsewhere are assessing various models and suggestions from industry in this regard, including to achieve transparency for those transactions not capable of execution on a public trading venue.
The Pending Changes include the essential elements necessary to permit the OSC to require that specified OTC trades be transacted through an appropriate trading venue. The rule-making power in this regard (i.e., to require classes of derivatives to be traded on a recognized exchange or ATS), as well as specific order and decision-making powers given to the OSC under the Pending Changes, may be used to enable the OSC to direct that trading in specifically identified types of derivatives take place on recognized (and therefore
regulated) venues. This recognition power suggests that the OSC may impose customized requirements for certain transactions and on the operators of the recognized venues.
6. Rule-Making Powers – The Pending Changes provide a wide range of derivatives rule-making powers to the OSC, including: to regulate the clearing, settlement, collateralization, margining, capital and reporting of derivatives trades; to impose position limits on derivatives transactions; to require that specified classes of derivatives be traded on a recognized exchange or on an ATS; to impose requirements for investment funds in respect of derivatives; and to define and give effect to the substantive requirements, restrictions and exceptions contemplated by the other provisions of the Pending Changes. As noted, the rule-making process will flesh out the substantive details of regulation, including critical exemptions and exclusions. As with securities rule-making, rules proposed in the ordinary course will be published for comment and implemented based on the prescribed notice and commenting processes already contemplated under the Act.
Implementation and Timing OF PENDING CHANGES
Ontario's approach to regulation will need to coexist with other provincial regulatory initiatives relating to derivatives and will also need to be reconciled with the existing federal jurisdiction over banks and certain other federally regulated financial institutions. It remains to be seen how Quebec, which already has a stand-alone Derivatives Act, will implement the G20 commitments. Quebec's updated derivatives legislation already appears capable of accommodating substantially similar regulation (see our July 2008 Blakes Bulletin on Securities Regulation: Quebec Adopts Derivatives Legislation). The other provinces and territories, whose securities legislation has not yet been modified to reflect comprehensive powers to regulate OTC derivatives, may use the Ontario approach as a template for implementing the G20 commitments. Also, if the current initiative to bring securities regulation under the jurisdiction of a single federal regulator comes to fruition, the approach taken by Ontario may influence the ultimate direction of the national securities legislation and related regulations to be adopted in the derivatives area.
In order to meet the G20 commitment to enact appropriate derivatives legislation by the end of 2012, it is anticipated that the next two years will be busy ones for legislators, securities regulators and those interested in the derivatives marketplace around the world. Assuming that Canada follows the lead of the SEC and CFTC, in terms of their specific and detailed rules, the U.S. timetable may be very influential on the counterpart processes undertaken in Canada. The SEC and the CFTC regularly update their rule-making activities and implementation plans and Canadian market participants and regulators are expected to closely examine these developments.
Market participants involved in cross-border derivatives will also need to have an eye to developments abroad, since other countries' approaches may directly impact their businesses to the extent their activities reach into those other jurisdictions. In this regard, it is important to note that The European Commission has proposed a very ambitious timeline to implement its OTC derivatives regulation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.