As part of a series of developments in the area of derivatives regulation, the Canadian Securities Administrators (CSA) proposed a rule, on January 21, 2016, aimed at ensuring that clearing is carried out by clearing intermediaries and clearing agencies in a manner that protects customer collateral and positions and improves the ability of a derivatives clearing agency to withstand a clearing member default. The rule will allow for different clearing models (principal to principal or FCM) and is broadly aligned with principles adopted in the US and other jurisdictions. Comments are due by April 19.
Two types of entities are the focus of Proposed National Instrument 94-102 Derivatives: Customer Clearing and Protection of Customer Collateral and Positions (NI 94-102): clearing intermediaries (CI) and regulated clearing agencies (RCA).
A RCA for the purposes of NI 94-102 is a clearing agency that is registered as such or has an exemption from registration in the particular province or territory. For Alberta, the three Territories and the four Maritime provinces, it includes a clearing agency that is registered in or exempted by another province.
A CI can be a "direct intermediary" or an "indirect intermediary". A direct intermediary is an entity that is a participant in the relevant RCA, provides clearing services (directly or indirectly) for a customer and requires, receives or holds the customer's collateral in providing those services. An indirect intermediary is an entity that provides those services but is not the RCA participant with respect to the transaction.
CIs and RCAs are, pursuant to NI 94-102, subject to rules related to the treatment of customer collateral, record-keeping, reporting and disclosure and the transfer of customer collateral and positions to a non-defaulting CI (i.e. porting). In addition, NI 94-102 provides for substituted compliance. Some of the more pertinent aspects of NI 94-102 are addressed below.
1. Treatment of Customer Collateral
The heart of NI 94-102 is the segregation requirements and limits on the use of customer collateral, which are summarized as follows:
- Segregation of collateral. CIs and RCAs are required to segregate customer collateral (as a whole) from their own property and that of other persons. In addition, CIs must segregate the customer collateral of the customer of an indirect intermediary from the indirect intermediary's property. Importantly "segregation" means to separately hold "or account for" customer collateral and positions,, meaning that segregation is very much a record keeping matter.
- Permitted depositories. CIs and RCAs must hold all customer collateral in one or more accounts at a "permitted depository" and clearly identify such accounts as holding customer collateral. A permitted depository includes Canadian financial institutions and Schedule III banks, RCAs, registered investment dealers, prudentially regulated foreign entities, and certain foreign banks and trust companies.
- Initial margin. While all customer collateral may be held in omnibus accounts and variation margin calculated by an RCA on a net basis across customers of the CI, initial margin must be provided to the RCA on a gross basis by customer. The RCA may, however, calculate the initial margin requirement based on netting all of the transactions of the particular customer.
- Use - General. There is a general prohibition on RCAs or CIs using or permitting the use of customer collateral. It can, however, be used to margin, guarantee, secure, settle or adjust cleared derivatives of the customer. No surprise there since that's why it's posted.
- Permitted Liens. No liens or claims are allowed on the customer's collateral or its positions except liens securing a claim resulting from a cleared derivative in favour of: (i) the customer itself; or (ii) the RCA or relevant CI responsible for clearing the cleared derivative to which the position or customer collateral relates. The lien in favour of the customer is helpful in the context of principal to principal clearing models where the collateral legally speaking belongs to the CI.
- Use on CI Default. In the case of a CI's default, the customer collateral can only be used (by a CI or the RCA) to satisfy the obligations of the CI that relate to the customer's cleared derivatives. So for example if the customer's positions are closed out on a CI default because they cannot be ported, the RCA can apply the collateral to the CI's obligations that relate to the customer's closed out derivatives.
- Excess margin. CIs and RCAs must have rules, policies or procedures in place with respect to daily identification and recording of the value of excess margin that it holds attributable to each customer. Excess margin is customer collateral with a value in excess of the amount required by the RCA to clear and settle that customer's cleared derivatives. Unlike the case with initial or variation margin, CIs and RCAs may use excess margin to secure or extend the credit of the customer. So, for example, it can stand as security for the customer's futures transactions or uncleared derivatives obligations. The rules regarding the holding of customer collateral still apply to excess margin so presumably this permission does not go so far as to allow a title transfer credit support arrangement or rehypothecation rights.
- Investment. Property received as customer collateral may also be invested in a "permitted investment" – essentially cash or a highly liquid financial instrument with minimal risk. It may also be used to buy or sell permitted investments under written repo agreements with a term of no more than one business day, among other conditions. Any losses on investments are borne by the CI or RCA. Transforming collateral to a form required for posting to a CI or RCA is not considered to be investment of the collateral. These investment limits apply to excess margin as well.
2. Record-keeping, Reporting and Disclosure
NI 94-102 contains record-keeping, reporting and disclosure requirements which are aimed at ensuring that individual customer collateral and positions are readily identifiable.
CIs and RCAs are required to keep certain prescribed records for 7 years in a readily accessible location. The record-keeping requirements range from recording on a daily basis the amount of customer collateral the CI and RCA requires to the total amount of excess margin held by the CI or RCA.
There are extensive disclosure requirements in NI 94-102. For example, investment policies and guidelines, the treatment of collateral and the effect of bankruptcy laws on the customer's rights are some of the disclosures CIs are required to make to the customers or indirect intermediaries it services prior to clearing any derivatives for them. Some of these disclosures are in turn required to be provided by RCAs to direct intermediaries.
Certain prescribed disclosures are required in the other direction as well: a direct intermediary must provide the RCA with information sufficient to identify the customer, the customer's positions and the customer collateral and, at least once each day thereafter, provide information that identifies the positions and collateral. Indirect intermediaries must provide the same information to the CI through which it provides clearing services.
There is also a requirement for RCAs and CIs to make monthly collateral reports to the relevant regulatory authorities.
3. Transfer of customer collateral and positions
Finally, NI 94-102 contains requirements aimed at ensuring that if a CI is in default, customer collateral and positions can be transferred to one or more non-defaulting CIs without having to liquidate and re-establish the positions. The obligation is framed quite generally. If the porting is required because a CI is in default, the RCA and the defaulting CI must "facilitate" a transfer of customer positions and collateral (or their liquidation proceeds) to a non-defaulting CI. This is also required when the CI is not in default, but presumably instigated by a customer request. These porting obligations are subject to several conditions, including that the customer's account is not in default, there are appropriate margins to support transferred positions and the customer and receiving direct intermediary have consented to the transfer.
Where a CI is providing clearing services for an indirect intermediary it must have policies in place that facilitate porting if it is in default or if the indirect intermediary is in default or its customer requests the porting.
4. Substituted Compliance
A substituted compliance provision has been included to ease the
regulatory burden on foreign CIs and RCAs. More specifically,
foreign CIs that are regulated under the laws of a foreign
jurisdiction equivalent to NI 94-102 and foreign RCAs that are
recognized or exempt from recognition by a Canadian securities
regulatory authority and that are in compliance with the laws of a
foreign jurisdiction that is equivalent to NI 94-102 can qualify
for substituted compliance with respect to certain obligations
under the rules. Appendix A will eventually set out the NI 94-102
rules that substituted compliance can apply to together with the
equivalent foreign substitute rule. According to the
CSA, the provisions specified for substituted compliance are to be
determined on a jurisdiction by jurisdiction basis and will depend
on a review of the laws and regulatory framework of the foreign
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