On November 25, 2011, the Canadian Securities Administrators Derivatives Committee (the "CSA Committee") published CSA Consultation Paper 91-403 – Derivatives: Surveillance and Enforcement ("CSA Paper 91-403")1 setting out proposals for market conduct, surveillance and enforcement in respect of OTC derivatives.
This paper is the second in a series of eight CSA Committee consultation papers that build on the high level proposals for regulation of over-the-counter ("OTC") derivatives outlined in the CSA Committee's Consultation Paper 91-401 – Over-the-Counter Derivatives Regulation in Canada released on November 2, 2010 ("CSA Paper 91-401").2 Of particular importance in CSA Paper 91-403 is the introduction of market conduct rules for OTC derivatives. The CSA Committee states that harmonized market conduct rules, effective surveillance and monitoring, and consistent enforcement will create greater transparency in the OTC derivatives market, decrease improper market conduct and help support Canada's G-20 commitments to improve OTC derivatives markets by mitigating systemic risk through regulatory oversight.
CSA Paper 91-403 is divided into three parts, (i) market conduct rules; (ii) surveillance and monitoring; and (iii) enforcement.
harmonized market conduct rules
While Canada generally has a harmonized approach to regulation of market conduct in traditional securities markets, this consistency does not extend to OTC derivatives markets. The CSA Committee recommends that provincial market regulators be granted the authority to legislate on the following market conduct issues in the context of OTC derivatives markets:
- Market manipulation and fraud
- Misrepresentations and misleading or untrue statements
- Prohibited representations
- Abusive trading practices (e.g. front running)
- Record keeping and audit trail requirements
- Insider trading
- Evasion or avoidance
- Abuse of exemptions
- Position limits
- Business conduct standards for registrants
The CSA Committee's recommendation in respect of the majority of these market conduct issues is to implement rules in the OTC derivatives context comparable to existing rules in the securities marketplace. The CSA Committee proposes that the existing prohibitions against market manipulation, fraud, misrepresentation, making certain representations about securities, and abusive trading practices in capital markets be extended to OTC derivatives markets. For example, the CSA Committee recommends extending the prohibition in securities law against giving undertakings, written or oral, as to the future value or price of a security to the OTC derivatives context. As well, the CSA Committee recommends prohibiting persons who have an intention of effecting a trade in an OTC derivative from making representations that they or anyone else will refund any amount paid, unless the OTC derivative's terms provide for a refund or a right to a refund.3
A number of the CSA Committee's recommendations mirror the regulatory approach taken in the United States pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act.4 In particular, the CSA Committee's recommendations to extend rules existing in the securities marketplace with respect to market manipulation and fraud, record keeping and audit trail requirements to OTC derivatives markets are reflected in this U.S. legislation.
The CSA Committee also proposes the use of markers for transactions involving insiders and important shareholders in OTC derivatives markets, similar to those used in the traditional securities context, to assist with surveillance.
Although the CSA consultation paper dealing with exemptions has not yet been released, the CSA Committee has suggested that rules to prevent abuse of these exemptions, as well as a system for monitoring and penalizing general evasion and avoidance of OTC derivatives regulations, should be implemented by provincial market regulators. The CSA Committee seeks to address abuse of exemptions from new mandatory requirements – such as clearing, margin or collateral requirements – for certain transactions and certain categories of end-users that trade in OTC derivatives. It seeks to prevent abuses such as the misrepresentation of one's status as qualifying for the end-user exemption.
The CSA Committee mentions that both Europe and the United States have proposed new requirements for position limits with the objective of managing risk and reducing excessive speculation in derivatives markets. Unlike Europe or the United States, the CSA Committee is not, at this time, proposing implementation of position limits without further research. This research should address how position limits could be implemented without interfering with legitimate trading activity.
surveillance and monitoring
Currently, provincial market regulators have a limited ability to monitor the activities of OTC derivatives markets. The CSA Committee recommends the development of a comprehensive, coordinated approach to surveillance and monitoring of OTC derivatives markets, that includes cross-product and cross-market analysis, in order to facilitate detection of improper market conduct, systemic risks, and problematic positions.
The CSA Committee proposes that provincial market regulators, in coordination with other Canadian financial market regulators, monitor participant positions through data collection relating to positions held by registrants and other key participants.
It also recommends that provincial market regulators have the authority to access, receive, and analyze data about OTC derivatives and market participants. Collaboration with domestic and international regulators and regulated entities, such as self-regulatory organizations, is also recommended. Provincial market regulators may also need to work with provincial governments to implement carve-outs from the provincial access to information legislation to preserve the confidentiality of data. Further study and research is recommended regarding operational issues, such as which entity will be responsible for surveillance, including whether a centralized system should be developed, or whether each province should perform its own surveillance.
The CSA Committee recommends that existing compliance, investigation, and enforcement powers in securities legislation be extended to cover trading in OTC derivatives. In particular, it proposes that provincial market regulators be granted the authority to conduct compliance reviews, compel disclosure of information, prescribe regulatory, quasi-criminal and civil liability offences, issue penalties, and issue a variety of orders. It states that the development of a whistleblower framework may be addressed in the future.
Canadian market participants have until January 25, 2012, to provide comments on CSA Paper 91-403. The CSA Committee hopes that CSA Paper 91-403 will generate commentary and debate in the area, assisting members of the CSA Committee in formulating new policies and rules regarding OTC derivatives regulation. Once comments are received and reviewed, the CSA Committee will finalize the rule-making guidelines and the provinces will begin the rule-making process.
effect of these proposals
With the exception of position limits, the CSA Committee's proposals regarding market conduct rules are reflective of the traditional mandate of securities regulators to protect investors and preserve capital market integrity, rather than the G-20's focus on mitigating systemic risks associated with OTC derivatives. This may be problematic because it treats OTC derivatives as investment products, like traditional securities, rather than as risk management tools.
Therefore, market participants should pay careful attention to the proposed market conduct rules and work with the CSA Committee to formulate rules that work in the OTC derivatives context.
As Canada moves toward uniform regulation of OTC derivatives, we
will continue to monitor the CSA Committee's proposals for OTC
derivatives regulation, and will publish bulletins on each of the
CSA Committee's future consultation papers as they are
1. "CSA Consultation Paper 91-403 - Derivatives:
Surveillance and Enforcement" (25 November 2011).
2. For a review of CSA Paper 91-401, see McMillan LLP Derivatives Law Bulletin "Change Is Near but Unclear: Canadian Regulators Publish Initial Proposals on OTC Derivatives" (November, 2010); for a review of CSA Consultation Paper 91-402 – Derivatives: Trade Repositories ("CSA Paper 91-402"), please see McMillan LLP Derivatives Law Bulletin " Reporting for Duty: Canadian Regulators Publish Framework for OTC Derivatives Trade Reporting and Repositories" (June, 2011).
3. It should be noted that both of these proposals regarding prohibited representations have already been adopted in Ontario as part of the December 2010 amendments to the Securities Act relating to OTC derivatives.
4. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. III-203, 124 Stat 1376 (2010).
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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