As we discussed in December, the CSA recently released proposed model rules on mandatory central counterparty clearing of derivatives. The proposed model rule is in two parts. The first relates to mandatory central counterparty clearing, including proposed end-user and intra-group exemptions. The second relates to determining the types of derivatives subject to mandatory clearing. The CSA has stated that "to the greatest extent appropriate" the determination process will be coordinated between the local provincial regulators to be consistent across Canada and will be consistent with international standards.
There is, as yet, no indication of the transactions that will be subject to mandatory clearing. These will eventually be listed in Appendices A and B of the rule.
Provincial securities (or in the case of Quebec derivatives) statutes set out the basic regulatory authority to mandate the clearing of derivatives.
Basic Clearing Requirement (s. 4)
The basic requirement to submit a transaction for clearing is in section 4(1) of the rule. The duty is imposed on the local counterparty to a transaction in a clearable derivative.
Transaction is defined as "entering into, making a material amendment to, assigning, selling or otherwise acquiring or disposing of a derivative or the novation resulting from the transferring or altering of the obligations arising from the derivative, other than a novation resulting from the submission of a derivative to a clearing agency." The reference to a material amendment should be considered in light of the fact that only new transactions will be subject to mandatory central counterparty clearing. However, a transaction will be subject to the clearing requirement if, on or after the rule is in force, a material amendment is made to the transaction, or the transaction is novated, assigned, sold or otherwise disposed of. A material amendment, according to the Explanatory Guidance, is one that changes information that would reasonably be expected to have a significant effect on the derivative's attributes, including its value, the terms and conditions of the contract evidencing the derivative, transaction methods or the risks related to its use. Several factors would be relevant in this determination, such as whether the modification would result in a large change in the value of the transaction and could result in differing cash flows or creating upfront payments.
The local securities or derivatives regulatory authority determines what is a clearable derivative.
A local counterparty is a counterparty to a transaction if at the time of entering into the transaction one or more of the following describe the counterparty: (a) it is organized under the laws of the province or has it head office or principal place of business in the local jurisdiction (similar to the TR Rule) or (b) the counterparty is an affiliate of a person described in (a) and such person is responsible for the liabilities of the affiliate.
There is, however, a substituted compliance regime for these affiliate transactions. If the only reason that it has to be cleared is because (b) applies, the local counterparty can submit the transaction for clearing under the law of another local jurisdiction or the laws of a foreign jurisdiction that is listed in Appendix B of the rule (not yet attached).
A local counterparty may still be required to clear by laws in multiple jurisdictions if, for example, it is organized under the laws of one local jurisdiction, but has its principal place of business in another province or even country, which is not an uncommon situation in Canada. There is no substituted compliance regime in that case.
The clearing agency has to be one that is recognized or exempt from recognition in Canada.
The transaction must be submitted for clearing by the end of the business day on which it is entered into, or the next day if entered into after business hours of the clearing agency.
The clearing agency must immediately notify the local counterparty if the transaction has been rejected for clearing. The Explanatory Guidance states that the Committee considers that a rejected transaction is void ab initio and therefore the counterparties must be notified immediately.
A clearing agency is required to list on its website all derivatives and classes of derivatives it clears and identify which are "clearing derivatives or classes of clearable derivatives".
End User (Hedger) Exemption (s. 7)
Mandatory clearing will not apply if one of the counterparties is entering into the transaction to hedge or mitigate commercial risk related to the operation of its business and it is not a "financial entity".
A financial entity includes a bank, trust company, loan company, cooperative credit association, credit union, treasury branch, pension entity, investment fund, person or company subject to registration requirements or registered or exempt from registration under the securities legislation of a jurisdiction of Canada. It does not include insurance companies.
It also includes an entity, created by a federal or provincial statute, that is an agent (or in Quebec a mandatory) of the federal or provincial government and the purpose of which is to provide management services. According to the Explanatory Guidance, this refers to Canadian institutional funds created by federal or provincial legislation which would not necessarily be a pension fund or investment fund (e.g. the Caisse de depot et placement du Quebec).
Also included is a person or company, organized outside of Canada that is analogous to any of the entity types listed (e.g. building societies) that would be regulated under the applicable legislation of Canada or the province had it been organized in Canada or the local jurisdiction.
This exemption would also apply to an affiliate of the person or company that qualifies for this exemption if the affiliate is acting as agent of the person or company, the transaction is a hedge or mitigates the commercial risk of the person or company or another affiliate (that is not a financial entity) and the affiliate is not subject to a registration requirement under the securities laws of a jurisdiction of Canada. In other words, a financial entity (other than an entity subject to a registration requirement under securities laws – even if exempt) acting as agent for non-financial entities in the group will be considered an end-user. [Query, how is the agent is subject to the clearing requirement to begin with if it is contracting as "agent"? Presumably, the requirement applies to the principal. This must mean "agent" in some vernacular sense.]
Section 3 of the rule explains that a derivative is held for the purpose of hedging or mitigating commercial risk when all of the following apply:
(a) it establishes a position which is intended to reduce risks relating to the commercial activity or treasury financing activity of the counterparty or of an affiliate, and, alone or in combination with other derivatives, directly or through closely correlated financial instruments meets any of the following:
(i) that derivative covers the risks arising from the change in the value of asset, services, inputs, products, commodities or liabilities that the counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business;
(ii) that derivative covers the risks arising from the indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in subparagraph (i), resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk;
(b) such position is not held for any of the following purposes:
(i) for a purpose that is in the nature of speculation;
(ii) to offset or reduce the risk of another derivative transaction, unless that other position itself is held for the purpose of hedging or mitigating commercial risk.
The Explanatory Guidance notes that the focus is on the purpose and effect of the transaction, being hedging, as opposed to investing or speculation. There should be a reasonable commercial basis to conclude that transactions were intended to be part of the party's hedging strategy. The hedging strategy should be documented and subject to regular compliance audits. Supporting documentation should include the risk management objective and the nature of risk being hedged, date of hedging, hedging instrument, hedged item or risk, how hedge effectiveness will be assessed, and how hedge ineffectiveness will be measured and corrected as appropriate.
Intragroup Exemption (s. 8)
The clearing requirement does not apply to an intragroup transaction if (a) both parties agree to rely on this exemption, (b) the transaction is subject to appropriate centralized risk evaluation, measurement and control procedures, and (c) there is a written agreement setting out the terms of the transaction between the parties (unless they are registered as dealers or subject to a dealer registration requirement under Canadian securities laws). There are two types of intragroup transactions contemplated by the rule. The first (s.8(1)(a)) is a transaction between two affiliated entities whose financial statements are prepared on a consolidated basis in accordance with generally accepted accounting principles (Canadian or US GAAP, or IFRS for entities with a parent entity in Canada). The second (s.8(1)(b)) is a transaction between two counterparties prudentially supervised on a consolidated basis by "[applicable local regulator]" (eg. OSFI).
If relying on this exemption, each pairing of affiliated counterparties must submit a Form F1 (Intragroup Exemption Form) to the local securities regulator within 30 days following the execution of the first transaction made under this exemption and it remains valid for one year, subject to a 10 day timely reporting requirement of any material change to that information.
It is not clear whether this form with be publicly accessible.
Government Transactions (s. 11)
The clearing requirement does not apply if one of the counterparties is the Government of Canada, the government of a province or territory, a crown corporation or an entity wholly owned by the federal or provincial government whose obligations are guaranteed by the federal or provincial government.
Improper Reliance
The securities regulator can direct a local counterparty to submit a transaction for clearing if it determines that improper use of the exemption has been made. (There is nothing in the rule that allows a party to rely on representations from its counterparty as to whether it is hedging.)
Record Keeping (s. 10)
Parties relying on exemptions must maintain for 7 years from the date the transaction expires or terminates, records of all documentation demonstrating that they are eligible to benefit from the exemption. For a local counterparty relying on the hedger exemption under section 7, this includes the approval by the board of directors, trustees, etc. Records must be kept in a safe and durable form in any manner that permits it to be provided to the regulator in a reasonable period of time. The Explanatory Guidance sets out the following documentation the Committee believes should be kept:
(a) Documentation of an end-user's macro, proxy or portfolio hedging strategy or program and the results of regular compliance audits to ensure such strategy or program continue to be used for relevant hedging purposes.
(b) Documentation of the approval of the board of director's, or similar body, of reliance upon the end-user exemption. Supporting documentation with respect to each transaction for which the end-user exemption will be relied upon, setting out the basis on which the transaction is for the purposes of hedging or mitigating commercial risk, including:
(i) risk management objective and nature of risk being hedged,
(ii) date of hedging,
(iii) hedging instrument,
(iv) hedged item or risk,
(v) how hedge effectiveness will be assessed, and
(vi) how hedge ineffectiveness will be measured and corrected as appropriate.
(c) Full and complete records of any analysis undertaken by the end-user to demonstrate it satisfies the requirements necessary to rely on the end-user exemption.
With respect to the end-user exemption, the board of directors would be required to approve the business plan or strategy which authorizes management to use derivatives as a risk management tool. This requirement is intended to ensure both management and the board of directors are required to consider the implications of trading in derivatives and the manner in which a hedging strategy will be implemented prior to relying on the end-user exemption.
Determining What May be Cleared - Part 4 - Bottoms Up!
Clearing agencies will be required to submit electronic information on new clearing services for derivatives or classes of derivatives to the regulator within a specified number of days after providing the new service. Also, within a specified number of days of this rule coming into effect, clearing agencies will be required to submit information for all derivatives for which they provides services as of the date of coming into force of the rule. (s.12)
The regulator may publish a notice inviting written representations within a minimum period of 60 days before it determines whether a derivative or class of derivatives is a clearable derivative or a class of clearable derivatives. (s.13) [Does this mean it could make the determination without such an invitation?]
The regulator may impose conditions on any determination or review prior determinations (s.14).
The regulator must maintain a public register that includes the following information:
(a) a list of the clearing agencies authorized to clear derivatives;
(b) a list of clearable derivatives and classes of clearable derivatives;
(c) the dates from which the mandatory central counterparty clearing with respect to a derivative or class of derivatives that is determined to be a clearable derivative or class of clearable derivatives takes effect, including any transitional period for implementation.
The Explanatory Guidance states that the regulator will consider, amongst others, the following factors:
(a) the level of standardization, such as the availability of electronic processing, the existence of master agreements, product definitions and short form confirmations;
(b) the effect of central clearing of the derivative on the mitigation of systemic risk, taking into account the size of the market for the derivative and the resources of the clearing agency available to clear the derivative;
(c) whether the derivative would bring undue risk to the clearing agency;
(d) the outstanding notional exposures, liquidity and reliable and timely pricing data;
(e) the existence of third party vendors providing pricing services;
(f) the existence of an appropriate rule framework, and the availability of capacity, operational expertise and resources, and credit support infrastructure to clear the derivative on terms that are consistent with the material terms and trading conventions on which the derivative is then traded;
(g) whether the clearing agency would be able to risk manage the additional derivatives that might be submitted due to the clearing requirement determination;
(h) the effect on competition, taking into account appropriate fees and charges applied to clearing, and if the proposed clearing requirement determination could harm competition;
(i) alternative derivatives or clearing services co-existing in the same market;
(j) the existence of a clearing obligation in other jurisdictions;
(k) the public interest.
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.