On April 13, 2012, the Canadian Securities Administrators Derivatives Committee (the "Committee") released Consultation Paper 91-405 on end-user exemption ("Consultation Paper 91-405") [available here]. Consultation Paper 91-405 is part of a series of eight papers that expand on the proposals for the regulation of over-the-counter (OTC) derivatives set out in Consultation Paper 91-401. The comment period for Consultation Paper 91-405 will expire on June 15, 2012.
To date, the CSA have released consultation papers regarding their proposals on (i) trade repositories, (ii) surveillance and enforcement and (iii) segregation (of posted collateral) and portability (of customer accounts between clearing members). Please see our earlier client alerts entitled Over-The-Counter (OTC) Derivatives Market in Canada: On the Road to Reform and Regulation [available here] and Canadian Securities Administrators Release Consultation Paper 91-404 [available here] on some of these prior consultation papers. After the release of Consultation Paper 91-405, the CSA expect to release consultation papers on the topics of (i) central counterparty clearing, (ii) registration requirements, (iii) exchange and platform trading and (iv) capital and collateral requirements.
THE END-USER EXEMPTION PROPOSAL
As indicated in Consultation Paper 91-401, the Committee proposes to regulate the OTC derivative market through requirements such as registration, trading, clearing, margin, capital and collateral and trade reporting to a trade repository. However, the Committee proposes that these requirements, other than trade reporting, not be applied to a limited category of end-users of OTC derivatives contracts; specifically, those market participants that are not in the business of derivatives trading but that enter into derivatives contracts in order to mitigate commercial risks related to their business activities. In the Committee's view, contracts entered into by end-users that do not trade OTC derivatives contracts for speculative purposes do not represent a substantial risk to the market or to the broader economy. In order to rely on the exemption, an end-user will first have to provide notice to the regulator.
The Committee is considering the following eligibility criteria for the end-user exemption:
- Trading for own account, not a registrant or affiliate of a registrant. An "end-user" must trade in OTC derivatives for its own account. Entities that are in the business of trading for or advising others in the trading of OTC derivatives will not be eligible for the end-user exemption.
- Not a financial institution. The end-user exemption will not be available to financial institutions or other market participants acting in a capacity that is similar to a financial institution.
- Hedging to mitigate commercial risks related to the
operation of a market participant's business. To be
eligible for the end-user exemption, the use of OTC derivatives
must be for hedging purposes (i.e., "mitigation of commercial
risk"), instead of using derivatives to generate profit. On
the definition of hedging, the Committee cites the definition
adopted by the working group established by the Committee on
Payment and Settlement Systems (CPSS) of the Bank for International
Settlements and the Technical Committee of International
Organization of Securities Commissions (IOSCO) in relation to
Principles for the Regulation and Supervision of Commodity
Derivatives Markets. The Committee considers such definition to be
appropriate for describing trading for the purpose of
"mitigation of commercial risk". The proposed definition
of "hedging" is as follows:
... the entering into of a derivatives transaction or a series of derivatives transactions, and the maintaining of the position or positions resulting from the transaction or series of transactions if:
- the intended effect of the transaction or series of transaction
- to offset or reduce the risk related to fluctuations in the value of an underlying interest or a position, or of a group of underlying interests or positions; or
- to substitute a risk to one currency for a risk to another
currency, provided the aggregate amount of currency risk to which
the hedger is exposed is not increased by the substitution;
- the transaction or series of transactions results in a high degree of negative correlation between changes in the value of the underlying interest or position or group of underlying interests or positions being hedged and changes in the value of the derivatives with which the value of the underlying interests or positions is hedged; and
- there are reasonable grounds to believe that the transaction or
series of transactions no more than offsets the effect of price
changes in the underlying interest or position, or group of
underlying interests or positions, being hedged.
- the intended effect of the transaction or series of transaction is
The Committee notes that a substantially similar definition appears in the Derivatives Act (Quebec). We would add that a substantially similar definition is also in National Instrument 81-102 Mutual Funds ("NI 81-102"), the applicable regulatory instrument that governs publicly offered mutual funds, in connection with the regulation of the use of derivatives by mutual funds.
OTHER CONSIDERATIONS: HEDGING WITHIN CORPORATE FAMILY AND LARGE DERIVATIVES PARTICIPANTS
The Committee made note of situations where OTC derivative hedging activities are done within one legal entity to hedge business risks of a related affiliated entity or series of legal entities within the affiliated group. The Committee indicates that it has not yet determined whether the end-user exemption will specifically provide for an exemption in such situations, or whether it would be left up to market participants to make an application for relief from the OTC derivative regulation to which it would otherwise be subject.
The Committee proposes that "Large Derivatives Participants" would not be eligible for the end-user exemption and, instead, will be required to meet registration requirements. Large Derivatives Participants are entities who otherwise meet the eligibility criteria for the end-user exemption, but who are nevertheless key participants in the market or whose default would represent a systemic risk to the market because of the size or significance of their trading in relation to the overall market. The Committee expects that the consultation paper on registration will discuss when registration will be required for a Large Derivatives Participant and what specific requirements will apply.
IMPLICATIONS OF THE END-USER EXEMPTION
The specific eligibility criteria for the end-user exemption will have tremendous implications for users of derivatives. Whether an end-user will be subject to requirements such as registration, trading, clearing, margin and capital and collateral will depend on whether the end-user is able to meet the prescribed conditions in order to rely on the end-user exemption. For this reason, we would urge our clients to consider the proposal and submit comments to the Committee. In particular, we would suggest that entities that use OTC derivatives to mitigate commercial risk consider whether they would be able to apply the definition of "hedging" to their use of derivatives. As noted above, the definition of "hedging" that the Committee noted as being appropriate is substantially similar to the definition that has been adopted in NI 81-102. In our experience, a number of mutual funds have had difficulty in interpreting and applying the three components of the hedging definition and corporate end-users may encounter similar difficulties.
With respect to the investment fund industry, we are concerned that the proposed narrow application of the end-user exemption, coupled with the narrow interpretation of the definition of hedging often applied by the securities regulatory authorities, will result in many investment funds not being able to take advantage of the end-user exemption in respect of many of their derivatives trades. If an investment fund does not meet the eligibility criteria for the end-user exemption (i.e., if the investment fund uses derivatives for non-hedging purposes), it is unclear whether the investment fund will be subject to all the requirements related to the use of OTC derivatives, including registration requirements. In addition, there has been no indication from the CSA on whether the rules regulating the use of derivatives by public mutual funds in NI 81-102 will be amended as a result of the CSA's initiative on the regulation of OTC derivatives. As a result, it is unclear how the proposed OTC derivative rules and NI 81-102 will interact to regulate the use of derivatives by publicly offered mutual funds. We would, therefore, encourage fund managers to submit their comments and suggestions on Consultation Paper 91-405 to the Committee so that the drafting of OTC derivatives rules will be informed by the views of the investment management industry.
We note that the proposed end-user exemption does not include a carve-out for foreign exchange. Given the fluidity and transparency of the FX interbank market, there was no mention in Consultation Paper 91-405 as to whether or not there would be a similar exemption as proposed in the U.S. regarding foreign exchange trading where the trading is done for speculative, rather than hedging, purposes.
Lastly, without a "de minimis" end-user exemption, it is unclear as to how those retail investors that trade in OTC derivatives through registered investment dealers will be treated under the new derivatives regime. In Consultation Paper 91-405, the Committee has reiterated its position that a prescribed threshold based on volume or notional dollar value of trades is not appropriate to include in the end-user exemption at this time. It seems inappropriate to conclude that speculative trading by the retail populace (in forex, gold, oil etc.) has had, or would have, any significant impact on a systemic basis to the functioning of our capital markets; certainly not an impact that would warrant additional oversight (including clearing trades through trade repositories) and regulation by the Committee. We look forward to Consultation Paper 91-406 for the Committee's proposals on the registration regime for derivative market participants and the adequacy of the existing securities dealer model.
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.