Canada: International Standards For Derivatives Market Intermediary Regulation

IOSCO Releases Final Report
Last Updated: July 19 2012
Article by Carol E. Derk and Francesca F. Smirnakis

Most Read Contributor in Canada, September 2016

On June 6, 2012, the Technical Committee of the International Organization of Securities Commissions (IOSCO) released its Final Report on International Standards for Derivatives Market Intermediary Regulation (the Final Report) prepared by IOSCO's Task Force on OTC Derivatives Regulation (the Task Force). The Final Report highlights 15 high-level recommendations for international standards relating to the regulation of market participants that are in the business of dealing, making a market or intermediating transactions in over-the-counter (OTC) derivatives (OTC derivative market intermediaries or DMIs). The Final Report provides guidance on areas that require international coordination among market authorities and that may be susceptible to regulatory risk because of cross-jurisdictional differences in rules and requirements relating to the OTC derivative industry. Market participants in Canada should be mindful of these differences and consider the Task Force's recommendations in light of existing rules and regulations in Canada that currently impact their activities. In general, the Task Force's recommendations address the following six substantive areas of regulation that should help mitigate systemic risk, manage counterparty risk and protect market participants, all of which would be desirable outcomes in any OTC derivatives market:

  1. Who should be regulated as DMIs (recommendation 1);
  2. Registration/licensing standards (recommendations 2 – 5);
  3. Capital standards or other financial resources requirements for non-prudentially regulated DMIs (recommendation 6);
  4. Business conduct standards (recommendations 7 – 9);
  5. Business supervision standards (recommendations 10 – 14); and
  6. Recordkeeping standards (recommendation 15).

1. Who should be regulated as DMIs?

If you engage in DMI activities, such as providing intermediation services to allow clients to enter into OTC derivatives, creating market liquidity by quoting prices in a particular OTC derivative, marketing OTC derivatives to counterparties or providing indirect clearing services for parties to OTC derivatives that are not able or willing to clear directly with a central counterparty clearing house (CCP), then you should be registered or licensed and you should comply with specific substantive regulations and/or requirements and standards imposed by the relevant market authority. According to the Task Force:

Recommendation 1: DMIs should generally include those who are in the business of dealing, making a market or intermediating transactions in OTC derivatives. However, DMIs should not include end-users and market participants who enter into OTC derivatives transactions but are not engaged in the business of dealing, making a market or intermediating transactions. DMIs should be subject to registration or licensing and applicable substantive regulations and/or requirements and standards once registered or licensed in some form by the relevant market authority or authorities, recognizing that in certain limited circumstances full application of substantive regulations and/ or requirements and standards may not be appropriate for certain types of entities.

The Task Force recognizes that registration or licensing exemptions may be appropriate for certain DMIs; however, it does not support a general exemption for those only transacting with non-retail entities, as such an exemption would defeat the objectives of registering or licensing DMIs.

2. Registration/Licensing Standards

The Task Force's second set of recommendations are intended to address the cross-jurisdictional differences in the following areas in order to better align the regulatory landscape for DMIs:

  • The existence of a distinct registration or licensing regime for DMIs;
  • Registration or licensing triggers;
  • Registration or licensing classifications; and
  • Registration refusal or revocation.

The Task Force focuses on developing an agreed upon set of standards for DMIs, regardless of the applicable registration or licensing process or categories, and emphasizes that the substance and outcome of the regulatory regime outweighs the form it takes. The Task Force recognizes that many jurisdictions do not have registration requirements specific to DMIs, but rather have a more general registration category for intermediaries in financial products. If all of the recommendations are implemented, it should not matter whether there is a separate identifiable DMI registration or licensing scheme. In this context, the Task Force proposes:

Recommendation 2: Registration or licensing requirements applicable to DMIs should be tailored to OTC derivatives activities.

In addition, the Task Force recognizes that although registration or licensing regimes for DMIs may apply to a wide range of OTC derivative products, each possessing varying degrees of risk, it is appropriate to establish minimum standards for market participants and treat all DMIs consistently, rather than potentially creating specific registration requirements for each type of product. In order to ensure the maintenance of registration and licensing, DMIs should be required to periodically update the relevant market authority with relevant, material information. Moreover, when the minimum standards are not met, authorities should be able to withdraw, suspend or impose conditions on the DMI's registration or license.

Recommendation 3: The registration or licensing of DMIs should establish minimum standards and require DMIs to provide and update information with regard to their OTC derivatives activities to regulators to assist them in determining whether registration or license should be granted and/or revoked. All registering or licensing authorities should have the power to grant or reject and suspend or withdraw the registration or license of DMIs registered or licensed by such authority.

The availability of relevant information (e.g., names of senior management, category of license, registration status, permitted activities, etc.) is key to ensuring that counterparties or clients can make informed decisions about a DMI that they are considering transacting with.

Recommendation 4: Relevant material information on licensed or registered DMIs should be made publically available.

The Task Force recognizes the international nature of the OTC derivatives market and the need for DMIs to be able to operate in multiple jurisdictions. The Task Force recommends that even though DMIs regularly transact with counterparties or clients located in other jurisdictions, DMIs should be registered or licensed in their home jurisdiction with adequate monitoring of, and imposition of registration and licensing requirements on, DMIs that carry on business in foreign or host jurisdictions. In certain situations, the host jurisdiction may choose to rely on the home regulator's supervision of the DMI operating in the foreign host jurisdiction, but may impose supervisory arrangements. Regulators are encouraged to work together to put into place a regulatory system that balances adequate regulation and supervision with the crossjurisdictional nature of DMI activities.

Recommendation 5: If a DMI registered or licensed in its home jurisdiction is carrying on OTC derivatives business in another jurisdiction in which the DMI is not registered or licensed, the market authority of the host jurisdiction in which the DMI is carrying on business should ensure that there are appropriate supervisory arrangements in place for the OTC derivatives business carried on by that DMI. These arrangements should take into account how the DMI is supervised in the host jurisdiction and any cooperative arrangements in place between the market authorities of the home and host jurisdictions. Market authorities should closely cooperate to identify overlaps, conflicts and gaps between jurisdictions with respect to cross-border issues relating to DMI supervision and to ensure that the DMI's activities in the host jurisdiction are adequately supervised. It is further recommended that jurisdictions coordinate their approaches via multilateral or bilateral channels to reduce overlaps and conflicts, to the extent possible.

3. Capital Standards or Other Financial Resources Requirements for Non- Prudentially Regulated DMIs

The Task Force also focuses on the maintenance of adequate capital by, and the imposition of other financial resource standards on, DMIs (including those who are not prudentially regulated) to support their OTC derivatives activities. This should instill confidence among derivative market participants, encourage trading activity, deepen liquidity and reduce concerns over systemic risk in global financial systems, which is essential to the stability and integrity of financial markets. In many jurisdictions, the capital requirements for DMIs are subject to prudential supervision. Where this is not the case, the Task Force suggests:

Recommendation 6: Market authorities should consider imposing some form of capital or other financial resources requirements for DMIs that are not prudentially regulated that reflect the risks that these intermediaries undertake.

4. Business Conduct Standards

Business conduct standards are critical to enhancing market confidence and efficiency and preventing fraud and abuse. The Task Force believes that all DMIs should be required to act honestly, fairly, professionally and in good faith in accordance with standards set by market authorities in rules of business conduct, regardless of whether the DMI is transacting with retail or non-retail clients. The Task Force believes that DMIs should observe high standards of integrity, fair dealing and market conduct and should comply with any law, code or standard relevant to regulation as it applies to the DMI. The Task Force recommends that existing prohibitions against fraud, manipulation and other abusive practices, currently dealt with in securities and/or criminal legislation in many jurisdictions, be extended to OTC derivatives and DMIs.

Recommendation 7: DMIs should be subject to business conduct standards. These standards would include, among other things, prohibitions against fraud, misrepresentation, manipulation and other abusive practices.

Looking at suitability requirements, the Task Force suggests certain non-retail clients may be in need of additional protection when dealing with OTC derivatives. It therefore recommends that jurisdictions should consider whether certain classes of non-retail entities need added protection or whether retail-level business conduct requirements should be extended to both retail and certain non-retail clients and counterparties.

Recommendation 8: Business conduct requirements should be tailored, as appropriate, for the OTC derivatives market. This could be based on the reasonable assessment of the nature of the party dealing with a DMI or on the complexity of and the risk associated with the specific OTC derivatives market product or service.

The Task Force believes that DMIs that hold client assets as collateral should have safeguards in place to segregate and protect those assets. Segregation would also facilitate the transfer or novation of transactions cleared by a DMI on behalf of a client through a CCP.

Recommendation 9: For cleared OTC derivatives transactions, DMIs should segregate collateral belonging to clients from their own proprietary assets and employ an account structure that enables the efficient identification and segregation of positions and collateral belonging to DMI clients. Where applicable and possible, DMIs should have in place procedures to facilitate the rapid transfer or porting of cleared client positions and collateral.

5. Business Supervision Standards

The Task Force emphasizes the need for appropriate and effective corporate governance frameworks in order to successfully oversee and manage DMIs. A good governance structure should ensure that the DMI's board and management pursue objectives that are in the interests of its stakeholders and the broader public.

Recommendation 10: DMIs should be required to have effective corporate governance frameworks designed to ensure appropriate management of OTC derivatives activities within the DMI.

The Task Force believes that sufficient and appropriate compliance policies and procedures, internal organization, supervisory systems and risk management systems tailored to OTC derivatives transactions should be in place in order to adequately manage risk.

Recommendation 11: DMIs should be required to design supervisory policies and procedures to manage their OTC derivatives operations and the activities of their representatives.

Recommendation 12: DMIs should be required to maintain risk management systems and organization to properly identify and manage their OTC derivatives related business risks.

The Task Force also suggests that jurisdictions should consider imposing competency requirements on representatives of DMIs involved in OTC derivatives activities to ensure that they possess the necessary levels of knowledge and expertise to understand the risks and obligations resulting from OTC derivatives transactions and the operation of OTC derivatives markets in general.

Recommendation 13: DMI's management should be required to establish, maintain and apply policies, procedures and systems of control sufficient to provide reasonable assurance that the DMI and each individual acting on its behalf are competent and comply with applicable regulatory standards and the DMI's internal policies and procedures.

The Final Report focuses on the importance of a DMI developing and maintaining a business continuity plan as a means to mitigate, respond to and recover from potential business disruptions or disasters that impact a firm's ability to service counterparties or clients, protect assets received from counterparties or clients by way of margin and meet its obligations to counterparties or clients.

Recommendation 14: DMIs should be required to develop and maintain an effective business continuity plan, based on their size, risks, and the nature of their operations, to allow them to mitigate, respond to and recover from business disruptions or disasters.

6. Recordkeeping Standards

With respect to recordkeeping requirements, the Task Force recommends principlebased requirements that are flexible and can capture all future activity. These should be supplemented by prescribed, specific requirements that set the minimum standard of what should be recorded.

Recommendation 15: DMIs should be required to retain OTC derivatives transaction records and be able to provide them in a timely, organized and readable manner. The record retention period for OTC derivatives transactions should apply for a specified period after its termination, maturity or assignment.

A full copy of the Final Report is available on IOSCO's website at [available here].

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