Canadian Securities Administrators Release Consultation Paper 91-301
In December 2012, the Canadian Securities Administrators OTC Derivatives Committee (the "Committee") released Consultation Paper 91-301 that includes model provincial rules on (i) Derivatives: Product Determination and (ii) Trade Repositories and Derivatives Data Reporting (collectively, the "Model Rules") [available here]. The Model Rules build, in part, on the Committee's previously issued derivatives consultation papers. The comment period for the Model Rules will expire on February 4, 2013.
DERIVATIVES: PRODUCT DETERMINATION (THE "SCOPE RULE")
The Scope Rule is meant to provide a broad definition of the term "derivative" for purposes of both existing and proposed provincial securities legislation. Although the Scope Rule will initially only apply for purposes of the Trade Repositories and Derivatives Data Reporting rule, it is expected that the Scope Rule will apply to future derivatives rules, with appropriate amendments.
Under the Scope Rule, a very limited group of contracts or instruments are excluded from the definition of derivatives, including those governed by gaming control legislation, insurance or annuity contracts, foreign exchange ("FX") spot market contracts that physically settle in two business days, contracts for the immediate or deferred physical delivery of a physical commodity other than cash or a currency and bank and similar deposits.
The Scope Rule also establishes guidelines to follow if a particular contract or instrument could fall within both the definition of derivatives and the definition of securities. Generally, all investment contracts and over-the-counter ("OTC") options that are both derivatives and securities are prescribed not to be securities and all other instruments and contracts that are both derivatives and securities are prescribed not to be derivatives.
The result is that the definition of derivatives captures a very broad set of contracts or instruments. In the Explanatory Guidance to the Scope Rule, the Committee clarifies that contracts entered into for consumer, business or non-profit purposes that do not involve investment, speculation or hedging, such as employment contracts, contracts for business purchase and sale transactions and commercial sale arrangements, would not be considered to be derivatives. The need to provide this guidance is an indication of the broad interpretation to be given to the term derivative.
The Scope Rule is similar in many respects to U.S. definitional rules implementing Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). U.S. derivatives regulation also divides OTC derivatives into two broad categories: on the one hand, securities (a financial product category that includes put and call options) and security-based swaps (generally, derivatives whose underliers are a security, such as a bond or an equity, or certain narrow-based indices) and, on the other hand, "swaps", an exceedingly broad term that encompasses nearly all other OTC derivatives, with certain exceptions.
The exclusions under the Scope Rule are largely the same as the product exclusions in the final rules promulgated under Dodd-Frank. However, in the U.S., FX forwards and FX swaps are excluded from the definition of "swap" for most purposes under a recent determination by the U.S. Department of Treasury. This means that the Committee is proposing to regulate a broader range of currency derivatives than the FX derivatives that are within the regulatory reach of the Commodity Futures Trading Commission ("CFTC").
TRADE REPOSITORIES AND DERIVATIVES DATA REPORTING (THE "TR RULE")
As implied by its name, the TR Rule covers two subjects: the requirements for establishing and operating a trade repository in Canada and the requirement to report OTC derivative trades.
With respect to the establishment and ongoing operation of a trade repository, the TR Rule includes:
- the form that must be completed to apply for designation as a trade repository
- the requirement to prepare and file annual and interim financial statements
- the requirement to establish legal rules, policies and procedures and governance arrangements that are clear and transparent
- requirements as to the make up and role of the board of directors and the role of management and the chief compliance officer
- the requirement to impose fair fees that are equitably allocated among users
- the requirement to establish a comprehensive risk-management framework that addresses general business risk and system and other operational risk requirements
- the need to ensure the safety and confidentiality of derivatives data and
- requirements with respect to the outsourcing of key services or systems.
It is not clear who will apply to operate a trade repository in Canada – whether there will be a Canadian market participant who is interested in taking on this function or whether the U.S. trade repositories will apply for designation in Canada.
The other part of the TR Rule addresses the reporting requirements with respect to all OTC derivative trades, including pre-existing trades that have outstanding contractual obligations (unless those trades terminate within 365 days of the effective date of the reporting obligation). Subject to a very narrowly drafted exemption for physical commodity trades where the local counterparty (not including a derivatives dealer) has less than $500,000 in aggregate notional value under all outstanding transactions, detailed derivatives data for each OTC transaction must be reported to a designated trade repository. If there is no designated trade repository that accepts derivatives data in respect of a particular trade or asset class, then the data must be reported electronically to the local securities regulator.
The reporting counterparty will be the derivatives dealer (if one of the parties is a derivatives dealer) or as agreed to in writing between the parties. We expect that the reporting obligation will fall to the financial institution that is a party to the OTC derivative. The report is required to be made in real time unless it is not technologically practicable to do so. The scope of the data that is required to be reported is very detailed and will create an onerous reporting burden on financial institutions that write OTC derivatives trades.
The trade data is to be made available to the securities regulatory authorities on a direct, continuous and timely basis. In addition, the counterparties to a transaction will be provided with access to all derivatives data relevant to the particular trade and each counterparty is deemed to have provided the consent required to release the data on such basis. Derivatives data will also be made available on a periodic basis to the public. The public will be able to access aggregate data on open positions, volume, number and prices, as well as breakdowns, where applicable, by currency of denomination, geographic location of the reference entity or asset, asset class, product type, whether the transaction is cleared, maturity and geographic location and type of counterparty. The trade repository must also make transaction level reports of the principal economic terms of each transaction available to the public within one to two business days after receiving those terms from the reporting counterparty.
We are concerned that although the intent is to publish data that does not identify the participants to the trade, proprietary trading data will now be publicly available. In addition, in some cases the level of data required to be reported will effectively reveal the identity of the parties. The Committee recognizes that this outcome is likely in some circumstances and states that the trade repository is not required to determine whether published data could reveal the identity of a counterparty based on the terms of the transaction.
Like its U.S. counterpart, the TR Rule seeks to bring transparency to a previously-opaque OTC derivatives market by requiring market participants to disclose trade terms to a trade repository (in the U.S., the repository is referred to, in trade parlance, as an "SDR", or a swap data repository, for swaps, and "SB-SDR", or security-based swap data repository, for security-based swaps) or to appropriate regulators (i.e., the CFTC for swaps and the Securities and Exchange Commission for securities and security-based swaps). Also generally similar to the TR Rule, U.S. reporting requirements set into motion an elaborate reporting regime wherein data is reported to repositories and regulators, generally by the largest market participants. The proposed requirements for operating a trade repository in the U.S. and Canada are similar in most material respects.
On the other hand, the TR Rule is different in several respects from the U.S. reporting rules. For example, U.S. real-time reporting requirements permit delays in real time reporting in certain circumstances for block trades in order to help maintain the anonymity of trades and trading parties. In the TR Rule, these trades need to be reported on a real-time basis, but there is a delay of one to two business days before those trades are reported to the public.
If you have any questions on the Model Rules or would like our assistance in submitting comments to the Committee, please contact the author of this alert or any other member of the BLG Derivatives Group. The BLG Derivatives Group consists of a multi disciplinary team of over 30 Financial Services, Securities and Capital Markets, Investment Funds, Energy and Tax lawyers located in offices across Canada and the United States. They are experienced in the business, regulatory and administrative issues that confront participants in the derivatives industry and market. Members of the BLG Derivatives Group routinely act on derivatives matters on behalf of financial institutions, governments, Crown corporations, securitization conduits, investment and pension funds, product manufacturers, distributors, corporate end users and other market participants.About BLG
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