Co-author: Money Khoromi, Student at Law
On January 16, 2014, the Canadian Securities Administrators Over-the-Counter Derivatives Committee ("CSA Committee") published CSA Staff Notice 91-304 Model Provincial Rule – Derivatives: Customer Clearing and Protection of Customer Collateral and Positions ("Staff Notice 91-304"). Staff Notice 91-304 includes the Model Provincial Rule on Customer Clearing and Protection of Customer Collateral and Positions together with its explanatory guidance (the "Model Rule"). The Model Rule sets out requirements for the treatment of customer collateral by derivatives clearing agencies, clearing members and clearing intermediaries (collectively, "Clearing Entities"), including requirements relating to the segregation and use of customer collateral in over-the-counter ("OTC") derivatives transactions. The Model Rule is aimed at ensuring that customer clearing is done in a manner that protects customer collateral and positions and improves derivatives clearing agencies' ("Clearing Agencies") resilience to clearing member defaults.
On December 19, 2013, the CSA Committee published CSA Staff Notice 91-303 Proposed Model Provincial Rule on Mandatory Central Counterparty Clearing of Derivatives ("Staff Notice 91-303"). This draft rule sets out the requirements for central counterparty clearing of OTC derivatives transactions. In conjunction with this publication, certain members of the CSA published draft Rule 24-503 Clearing Agency Requirements ("Draft Rule 24-503"). Draft rule 24-503 sets out the application process requirements for recognition as a clearing agency or exemption from the recognition requirement, as well as ongoing requirements for recognized clearing agencies. The Model Rule, Staff Notice 91-303, and Draft Rule 24-503 all relate to central counterparty clearing. The CSA Committee is, therefore, urging market participants to consider them comprehensively.
In 2009, the G20 nations agreed to a comprehensive set of reforms in response to concerns surrounding systemic risks inherent in OTC derivatives markets ("G-20 Commitments"), which were aimed at enhancing transparency, mitigating systemic risk, and protecting against market abuse. In response to the G-20 Commitment relating to mandatory central clearing, the CSA Committee published Consultation Paper 91-404 Derivatives: Segregation and Portability in OTC Derivatives Clearing (the "Segregation and Portability Consultation Paper") on February 10, 2012. The Model Rule reflects comments received by the CSA Committee on the Segregation and Portability Consultation Paper and international developments in this area.
Important Considerations Respecting the Model Rule
(a) Complete Legal Segregation
The Segregation and Portability Consultation Paper recommended that the "Complete Legal Segregation" model (also known as the Legally Segregated Operationally Commingled or LSOC model) be adopted for customer collateral. In this paper, Complete Legal Segregation is described as having the following characteristics:
Although the Model Rule never refers to Complete Legal Segregation, it includes all the characteristics of Complete Legal Segregation.
(b) Collection of Initial Customer Margin
Clearing Agencies must collect initial margin for each customer of their clearing members on a gross basis. The requirement to collect initial margin on a gross basis is also indirectly imposed on clearing members and clearing intermediaries since both are bound by the initial margin requirements imposed by Clearing Agencies. Collection of initial margin on a gross basis is consistent with other international regulatory regimes. The Model Rule prohibits the offsetting of initial margin positions of different customers against one another. However, Clearing Agencies and clearing members are not prohibited from determining initial margin required from a customer by netting across the various positions held by that customer.
(c) Segregation of Customer Collateral
Customer collateral is defined as all property received or held by a Clearing Entity from or on behalf of a customer, that is intended to or does margin, guarantee, secure, settle or adjust a cleared derivative, and includes initial margin, variation margin and excess margin. Clearing Entities must keep customer collateral segregated from their own assets. Nonetheless, customer collateral from or on behalf of multiple customers may be comingled. The ability to comingle property is limited to customer collateral and thus, would not apply to other assets of a particular customer. For example, a customer's customer collateral must be segregated from that customer's collateral relating to a futures transaction, which is not a cleared derivative.
(d) Holding of Customer Collateral
i. How can Customer Collateral be Held
A Clearing Entity must hold customer collateral either directly or through one or more customer accounts at a permitted depository. If held directly, "reasonable protection" must be provided for the collateral. The Model Rule does not define "reasonable protection" nor does it provide any guidelines by which to discharge the duty imposed. In order to maintain customer collateral at a permitted depository, Clearing Entities must: (a) maintain one or more customer accounts with the permitted depository; (b) ensure that the customer account clearly identifies the name of each customer or otherwise shows that the account is segregated for and on behalf of one or more customers and indicates that the property in the account is customer collateral; and (c) ensure that the permitted depository treats all property in the customer account as customer collateral. The account(s) must also be setup in compliance with the segregation of customer collateral requirements outlined above.
ii. Permitted Depository
The Model Rule defines permitted depository to include any Canadian bank or trust company, a recognized or exempt clearing agency, or a foreign bank or trust company.
In the Segregation and Portability Consultation Paper, the CSA Committee had asked for comments about whether or not customer collateral had to be subject to Canadian laws. The inclusion of foreign institutions comes in response to the near unanimous response of commenters that there should not be a Canadian law requirement.
(e) Excess Margin
Excess margin refers to any customer collateral collected by a clearing member or clearing intermediary from a customer in excess of the amount required by the Clearing Agency for the cleared derivatives of the customer.
Excess margin may be held by the clearing member or clearing intermediary in a permitted depository, or transferred to a Clearing Agency as long as certain pre-conditions are met. Clearing Entities must have policies and procedures in place to identify and record each customer's excess margin. The process must be carried out at least each business day. However, the obligation is limited to excess margin held by the entity in question. For example, a Clearing Agency is not required to identify and record excess margin held by a clearing member.
(f) Use of Customer Collateral
i. How Customer Collateral may be used
Clearing Entities must not use or permit the use of customer collateral for any purpose other than to invest in a permitted investment (defined below). The risk of loss must be borne by the Clearing Entity which makes the investment. Due to certain clearing arrangements involving the granting of security interests in customer collateral, a narrow carve-out is available for a lien on customer collateral which arises in connection with a cleared derivative. However, Clearing Entities must take all commercially reasonable steps to promptly address any improper liens imposed on customer collateral.
Customer collateral cannot be applied to satisfy the obligations of a clearing member resulting from the clearing members default. Similarly, a clearing member cannot apply customer collateral to satisfy a defaulting clearing intermediary's obligations. However, a defaulting customer's collateral may be used by a clearing agency to satisfy that customer's obligations.
ii. Permitted Investments
The Model Rule defines a permitted investment as "cash or highly liquid financial instruments with minimal market and credit risk that are capable of being liquidated rapidly with minimal adverse price effect." Examples of permitted investments listed in the explanatory guidance include Canadian federal, provincial and municipal debt securities, Canadian bank deposit certificates, Canadian government guaranteed commercial paper and money market funds.
Foreign investments with the same conservative characteristics as the above-listed investments would also qualify as permitted investments.
(g) Disclosure Requirements
The Model Rule requires that Clearing Entities make certain disclosures to customers. A clearing intermediary must provide prior written disclosure to customers regarding the additional risks of clearing indirectly through a clearing intermediary, as well as the policies and procedures for transferring customer collateral and positions to a non-defaulting clearing member or intermediary in the event of the clearing intermediary's default. In addition, a clearing member must obtain confirmation of a customer's written acknowledgment to these disclosures prior to accepting a cleared derivative from a clearing intermediary on behalf of the customer.
Clearing Entities must publicly disclose their investment guidelines on their websites and obtain the customer's written acknowledgment which confirms receipt of the disclosure. The explanatory guidance affirms that the written confirmation can be satisfied through online procedures.
(h) Reporting Obligations
Clearing Entities that receive customer collateral must electronically submit customer collateral reports to their applicable local securities regulator within two business days of the end of each calendar month in the prescribed form applicable to each.
Clearing Entities that receive customer collateral must also provide their customers with access to certain prescribed information relating to each customer's collateral and positions on a daily basis.
(i) Transfer of Customer Collateral and Positions
Clearing Agencies are required to put policies and procedures in place to facilitate the prompt and effective transfer of customer collateral and positions from a defaulting clearing member to a non-defaulting one ("Default Transfer").1 In addition, subject to any notice or other contractual requirements, Clearing Agencies are required to implement rules and procedures to facilitate the transfer of customer collateral and positions between non-defaulting clearing members in the event that such a transfer is requested by the customer ("Business-As-Usual Transfer"). The Business-As-Usual Transfer allows customers to initiate transfers of their collateral and positions in the normal course of business. Clearing Agencies are only obligated to facilitate a Default Transfer or Business-As-Usual Transfer once the following conditions have been met: (a) the customer has consented to the transfer; (b) the customer is not currently in default; (c) the transferred position will have appropriate margin at the receiving clearing member; (d) any remaining positions will have appropriate margin at the transferring clearing member; and (e) the receiving clearing member has consented to the transfer. According to the explanatory guidance, the CSA Committee is of the view that clearing members should also implement policies and procedures to facilitate a prompt transfer of customer collateral and positions that it holds to a non-defaulting clearing member in the event of its own default.
Similarly, clearing members that permit customers to act as clearing intermediaries are required to establish policies and procedures to facilitate a prompt Default Transfer or Business-As-Usual Transfer for the customers of that clearing intermediary.
Other Required Legislative Changes
The Canadian Market Infrastructure Committee ("CMIC"), a group made up of major participants in the Canadian OTC derivatives markets, in its comment on the Segregation and Portability Consultation Paper stated:
CMIC recommended, among other things, amending the provincial personal property security legislation to deal with security interests in cash collateral and amending the federal insolvency statutes to create a regime allowing for the portability of transactions and margin despite a clearing member or clearing intermediary's insolvency.
Neither of these recommended legislative changes have been implemented. It is not at all clear what the insolvency regime is for clearing members or clearing intermediaries and if segregation of collateral is even possible in the event of a clearing member insolvency. This lack of clarity makes the Model Rule's required disclosures about the consequences of an insolvency, with regards to segregation and excess collateral, a near impossibility. No derivatives market participant can make any definitive statement about the application of Canadian insolvency laws without legislative amendments.
It is admirable that the CSA Committee wishes to implement its portion of the legal changes required to bring about a Canadian OTC derivatives clearing regime, but to do so without first putting in place the other legislative changes (including the changes to the personal property security legislation, which are a matter for the governments directly involved in the CSA Committee) is a recipe for confusion. It may be prudent for the CSA Committee to wait for the necessary legislative amendments before proceeding with the regulatory changes since the process of law-making by elected officials takes longer and engages different constituencies than the process of rule-making by public servants.
Next Steps and Comments
The CSA Committee encourages market participants and the public to submit comment letters addressing any issues or questions raised by Staff Notice 91-304. Comments must be submitted by March 19, 2014. The CSA committee will consider the comments and finalize the rule-making guidelines. Thereafter each province will then begin the rule-making process. We expect that this rule will be finalized by mid 2014 and become effective in the fourth quarter of 2014.
We invite market participants to discuss any comments and questions with us. We are available to assist those wishing to submit comments to the CSA Committee regarding Staff Notice 91-304.
1 A "non-defaulting clearing member" is a clearing member that (i) has not defaulted, and is not reasonably expected to default on its obligations at a derivatives clearing agency as they come due, and (ii) is not in default, as that term is defined in the rules and procedures of the relevant derivatives clearing agency.
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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