The Canadian Securities Administrators (CSA) has proposed mandatory central counterparty clearing of certain standardized over-the-counter (OTC) derivative transactions consistent with its goal to improve transparency in the OTC derivatives market and enhance the overall mitigation of systemic risk.
On February 12, 2015, the CSA published for comments proposed National Instrument 94-101 – Mandatory Central Counterparty Clearing of Derivatives (Clearing Rule) and its proposedCompanion Policy 94-101CP(Clearing CP). Comments in writing are welcome until May 13, 2015.
Coming into force using a phase-in approach, the Clearing CP and Clearing Rule (together, Proposed Instrument) would (i) first apply to clearing members of a regulated clearing agency1 providing clearing for the mandatory clearable derivative; (ii) six months later apply to financial entities (as defined) above a specified threshold that remains to be determined; (iii) six months later apply to all other financial entities; and (iv) finally, six months later apply to all counterparties. In effect, non-financial entities would benefit from an 18-month grace period after the requirement to mandatorily clear trades applies to clearing members.
The Proposed Instrument has two parts: (i) circumscribing the circumstances under which counterparties to an OTC derivatives transaction are subject to mandatory central clearing or exempted, and (ii) circumscribing the types of derivatives that are subject to mandatory central counterparty clearing.
Mandatory Central Counterparty Clearing
Under the Clearing Rule, a "local counterparty," which is an entity, or the affiliate of such an entity that is responsible for the liabilities of this entity, that is organized under the laws of the jurisdiction of Canada or that has its head office or principal place of business in such a jurisdiction must submit for clearing a transaction that consists of entering into, materially amending, assigning, acquiring or disposing of a derivative2 that has been determined to be a mandatory clearable derivative.
When a transaction has already been submitted for clearing under the laws of another jurisdiction of Canada, or under the laws of a designated foreign jurisdiction, substituted compliance may be available. In addition, a local counterparty in certain jurisdictions may also be eligible for substituted compliance if the transaction is submitted for clearing to a clearing agency or a clearing house that is recognized or exempted from recognition under the securities legislation of another jurisdiction of Canada.
Exemptions to Mandatory Central Counterparty Clearing
Two exemptions to the clearing requirement are provided in the Clearing Rule: the end-user exemption and the intragroup exemption.
The proposed end-user exemption would apply when at least one of the counterparties is not a financial entity and that counterparty is entering into the transaction to hedge or mitigate its commercial risk or that of an affiliate.
A financial entity for the purpose of the Proposed Instrument is a cooperative, bank, loan corporation, loan company, trust company, trust corporation, insurance company, treasury branch, credit union, caisse populaire, financial services cooperative or league, pension fund, investment fund or any person that is subject to registration requirements, registered or exempted from registration requirement or a person organized under the laws of a foreign jurisdiction that is similar to such an entity.
The Clearing Rule provides a definition of the terms "hedging or mitigating commercial risk": at the time of the transaction, establishing a position that is intended to reduce risks relating to the commercial activity or treasury financing activity of the counterparty or an affiliated entity of the counterparty and either (i) the transaction covers risk from the change in the value, price, rate or level of assets, services, inputs, products, commodities or liabilities that the counterparty or an affiliated entity of the counterparty 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 or (ii) covers the risk arising from the indirect impact on an asset or a liability of the counterparty or its affiliates resulting from fluctuation of one or more interest rates, inflation rates, foreign exchange rates or credit risk. In some cases macro, proxy or portfolio hedging may benefit from the exemption. The relevant strategy or program should then be documented and, where reasonable, subject to regular compliance audits to ensure it continues to be used for relevant hedging purposes.
The end-user exemption applies without the need to submit any document to the applicable regulator. However, a counterparty relying on this exemption should retain appropriate records demonstrating the eligibility of the transaction, particularly to prove that it was entered into in order to hedge or mitigate risks. For this purpose, according to the guidance given by the CSA in the Clearing CP, it is advisable to maintain records of the following information:
- risk management objective and 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.
The proposed intragroup exemption would apply where affiliated entities that prepare consolidated financial statements, or counterparties prudentially supervised on a consolidated basis, enter into a transaction in a mandatory clearable derivative.
This exemption applies when both counterparties have agreed to rely on the exemption and the terms of the transaction have been set out in a written agreement. In addition, the transaction must be subject to centralized risk evaluation, measurement and control procedures.
A counterparty relying on the intragroup exemption must submit a form to the applicable regulator identifying the other counterparty and the basis for relying on the exemption.
The local counterparty may rely on its counterparty's factual representation to determine that an exemption is available. However, when doing so, the local counterparty remains responsible for determining whether, given the facts available, the exemption is available and should retain all documents that show it properly relied on the exemption.
Determination of Mandatory Clearable Derivatives
All regulated clearing agencies will be required to inform the relevant regulator of all OTC derivatives or classes of OTC derivatives for which it provides clearing services when the Clearing Rule comes into force, and, on an ongoing basis, within 10 days of agreeing to provide such clearing services.
After receiving such notification from a regulated clearing agency, each regulator will determine whether such cleared derivative or class of derivatives should be made a mandatory clearable derivative.
In assessing whether a derivative or class of derivatives should be a mandatory clearable derivative, the regulators will consider various factors, including its standardization, its risk profile and the liquidity and characteristics of its market. In addition, the CSA will attempt to make its determination in a harmonized manner across Canada and in accordance with international standards, in particular by consulting the relevant guidance from the OTC Derivatives Regulators Group, which is composed of representatives of OTC derivatives regulators in Australia, Brazil, Ontario, Quebec, the European Union, Hong Kong, Japan, Singapore, Switzerland and the United States.
Footnotes
1 For example, in Ontario, the clearing agencies either recognized or exempted from recognition by the Ontario Securities Commission are Canadian Depository for Securities Limited (CDS), Canadian Derivatives Clearing Corporation (CDCC), Chicago Mercantile Exchange Inc. (CME), CLS Bank International, CME Clearing Europe Limited, FundSERV Inc., ICE Clear Canada, Inc., ICE Clear Credit LLC, LCH.Clearnet Limited, LCH.Clearnet LLC, Omgeo Canada Matching Ltd., the Options Clearing Corporation and SS&C Technologies Canada Corp. In Quebec the clearing agencies either recognized or exempted from recognition by the Autorité des marchés financiers are CDCC, CME, CDS, ICE Clear Canada, Inc., LCH.Clearnet Limited, Natural Gas Exchange and The Options Clearing Corporation.
2 The novation of a mandatory clearable derivative, unless it results from submitting the derivative to a Regulated Clearing Agency, is also subject to mandatory clearing.
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