Draft derivatives regulations and a revised draft of the uniform
Capital Markets Act (CMA) were issued in August 2015 as
part of the process to implement the new Cooperative Capital Market
Regulatory System (Cooperative System). The governments of Ontario,
British Columbia, New Brunswick, Saskatchewan, Prince Edward Island
and the Yukon (Participating Jurisdictions) intend to participate
in the Cooperative System and to adopt the CMA and these proposed
regulations. The introduction of the Cooperative System will
fundamentally overhaul the Canadian securities and derivatives
regulatory landscape.
We discussed the derivatives laws that were set out in the initial
September 2014 draft of the CMA in our November 2014
Blakes Bulletin: Regulation of Derivatives Trading Under the
Proposed Canadian Cooperative Capital Markets Regulatory
System. A number of minor changes have been made to
the treatment of derivatives in the revised CMA and initial drafts
of regulations to the CMA have now also been provided, including
two regulations focussed on derivatives trading:
- Regulation 91-501 Derivatives and Strip Bonds (Derivatives Registration and Exemption Rule), which sets out exemptions from derivatives dealer and adviser registration requirements reflecting exemptions that currently apply in a number of provinces.
- Regulation 91-502 Trade Repositories and Derivatives Data Reporting (Trade Reporting Rule), which largely reproduces the current Ontario rule relating to derivatives trade repositories and trade reporting.
The Participating Jurisdictions and the federal government have
agreed to use their best efforts to enact the CMA by June 30, 2016.
For general background on the Cooperative System, please see our
September 2015
Blakes Bulletin: Cooperative System
Legislation and Regulations Released: Fees, "Interface"
and Transition Unresolved.
Given the scope of the proposed changes, Blakes is publishing a
series of bulletins discussing aspects of the proposed Cooperative
System, which can be accessed
here. This bulletin discusses the proposed regulation of
derivatives trading under the CMA.
CURRENT DERIVATIVES REGULATORY REGIMES AND CMA IMPACT
Over the past five years, the Canadian Securities Administrators
(CSA) have worked to develop a uniform national approach to
regulate certain aspects of derivatives trading in Canada including
trade reporting and central clearing, and to develop a national
uniform registration regime for derivatives dealers and advisors
that would parallel the existing national securities registration
regime.
The proposed form of CMA and draft regulations would generally
continue this harmonization process in the Participating
Jurisdictions with limited changes to the current status
quo. This should permit the Cooperative System's single
jointly-appointed regulatory authority (Authority) to continue to
develop uniform derivatives regulations in coordination with CSA
members in non-Participating Jurisdictions.
The CMA will replace the existing Securities Acts of each
of the Participating Jurisdictions, which govern both securities
and derivatives trading, as well as the Ontario Commodity
Futures Act (CFA), which currently provides a parallel
regulatory regime for exchange-traded futures and options.
The CMA does not provide a prescriptive codification of derivatives
rules related to registration requirements, trade reporting,
central clearing, margin requirements or the use of swap execution
facilities. Instead, it follows the "platform" approach
and provides the Authority with a broad authority to "make
regulations for carrying out the purposes and provisions of [the
CMA], including regulations... governing trading, acquiring and
making representations about securities or derivatives, including
prescribing prohibitions and restrictions relating to trading,
acquiring and making representations" and governing
registration requirements.
DERIVATIVES TRADE REPORTING REQUIREMENTS
The initial draft Trade Reporting Rule is, for the most part, substantively identical to the current Ontario trade reporting rule. The main differences that may be of particular interest are as follows:
- Currently derivatives trade reporting obligations do not apply in any of the Participating Jurisdictions other than Ontario. Once in effect, the new Trade Reporting Rule will require reporting whenever either or both parties to the derivative transaction is a "local counterparty" in any of the Participating Jurisdictions.
- An entity that engages in the business of trading in derivatives in any of the Participating Jurisdictions will be considered to be a "derivatives dealer" for the purposes of the new Trade Reporting Rule in all of the Participating Jurisdictions, which will be relevant for the purposes of determining which party (or parties) has reporting responsibility.
- The draft Trade Reporting Rule permits counterparties to agree which party to a transaction will be subject to reporting obligations if both parties are derivatives dealers or neither party is a derivatives dealer. This simplifies the approach in the current Ontario trade reporting rule, which requires adherence to a specific multilateral agreement administered by the International Swaps and Derivatives Association to effectively assign reporting responsibility.
- The Ontario "Scope Rule", which describes certain categories of derivatives that are not subject to the trade reporting requirement (Scope Rule), has been substantially adopted and is now included in the body of the draft Trade Reporting Rule .
- Amendments to the Ontario trade reporting rule that are expected to be implemented in the near future, such as an obligation on all derivative counterparties to obtain Legal Entity Identifiers, have not been reflected in the draft Trade Reporting Rule , but are expected to be reflected in future versions of the new Trade Reporting Rule .
- Trade repositories will make a single application to the Authority for recognition as a designated trade repository in all Participating Jurisdictions. No transitional provisions in respect of the implementation of the Cooperative System have yet been published, but we expect that a transition mechanism will be provided for trade repositories that have been designated by the Ontario Securities Commission.
DERIVATIVES DEALER AND ADVISER REGISTRATION REQUIREMENTS
The CMA provides that all dealers and advisers must be
registered with the Authority unless an exemption is applicable.
The term "dealer" includes a person who engages in, or
holds itself out as engaging in, the business of trading in
securities or derivatives as principal or agent.
"Adviser" means a person engaging in, or holding itself
out as engaging in, the business of advising others with respect to
investing in, purchasing or selling securities or trading
derivatives.
Permitted Client and Qualified Party Blanket
Exemption
The draft Derivatives Registration and Exemption Rule provides a
broad exemption from registration and prospectus requirements in
respect of OTC derivatives transactions, which applies if each
party to the transaction is a "permitted client" and/or a
"qualified party", each acting as principal (Permitted
Client Blanket Exemption). For this purpose, "permitted
client" has the meaning provided in the securities
registration rule (National Instrument 31-103), which
includes most institutional market participants including financial
institutions, registrants, pension funds, corporations with over
$25million in assets and individuals with net financial assets in
excess of $5million. The definition of "qualified party"
largely overlaps, covering similar or identical categories of
institutional market participants and also includes a hedging
entity that buys, sells, trades, produces, markets, brokers or
otherwise uses a commodity in its business and enters into the
relevant OTC derivatives transaction to hedge that exposure, or the
transaction is otherwise linked to the commodity in a specified
manner.
An exemption for transactions between qualified parties is
currently available pursuant to British Columbia Blanket Order 91-501
and also reflects blanket orders adopted in a number of other
Canadian provinces. Accordingly, exemptions from registration
requirements existing in a number of provinces will initially be
preserved by the Derivatives Registration and Exemption Rule as
currently drafted. However, it is important to note that dealers
and advisers engaged in OTC derivatives business in Ontario are not
currently subject to registration requirements unless the
derivative also constitutes a "security". Consequently,
derivatives dealers and advisers may need to take steps in advance
of implementation of the CMA to ensure that Ontario counterparties
fall within the exempt categories.
One point of contention arising from the imposition of registration
requirements on OTC derivatives dealers and advisers in Ontario is
that Canadian banks currently benefit from a general exemption from
Ontario registration requirements, but the proposed CMA does not
preserve that exemption.
To the extent an entity cannot rely on the Permitted Client Blanket
Exemption, registration in one of the existing securities dealer or
adviser registration categories would be required until a separate
derivatives registration regime is developed. Initially, investment
dealers, exempt market dealers and certain restricted dealers would
be permitted to trade OTC derivatives under the proposed regime,
and specific registration terms for restricted dealers may
potentially be negotiated with the Authority. Entities may also
make applications to the Authority seeking exemption from
registration requirements, requests which may be granted if doing
so is not prejudicial to the public interest.
Permitted Client Blanket Exemption's Temporary
Nature
The Permitted Client Blanket Exemption is an interim exemption that
is expected to ultimately be replaced once a new derivatives
registration rule is developed by the CSA as contemplated in the
CSA Consultation Paper discussed in our May 2013
Blakes Bulletin: Canadian Securities Administrators Unveil
Proposed Derivatives Registration Regime. The CSA may
issue a draft derivatives registration rule in the next nine
months. The CSA rule may provide a registration exemption for
Canadian banks and may also provide a registration exemption for
non-Canadian dealers and advisers that are subject to derivatives
registration regimes in qualifying home jurisdictions if prescribed
conditions are satisfied (similar to the exemptions provided to
international securities dealers and advisers from securities
registration rules).
Scope Rule Exemption
A registration and prospectus exemption is also available for
trading in certain OTC derivatives that are excluded from
derivatives trade reporting requirements under the Scope Rule. This
exemption applies in respect of trading in physically-settled spot
foreign exchange transactions, physically-settled commodity
transactions, deposit instruments of Canadian financial
institutions and qualifying gaming, insurance and annuity
contracts, in each case subject to certain requirements based on
the Scope Rule.
Fair Dealing and Other Requirements Imposed on
Registrants
The current CMA draft includes an obligation on all registrants to
deal fairly, honestly and in good faith with their clients. This
reflects the existing standard of conduct for securities dealers
and advisers in Canada. All registrants are also required to
identify, disclose and manage conflicts of interest in accordance
with the regulations. Other registration requirements specifically
applicable to derivatives dealers such as recordkeeping, reporting
and transparency requirements and requirements in respect of
margin, collateral, capital and clearing would be set out in
forthcoming CSA rules or the rules of the applicable
self-regulatory organization.
Trading in Exchange Contracts — Registration
Exemptions
The registration and exemption regime in respect of trading in
exchange contracts is complicated by the divergent approaches
currently followed in Participating Jurisdictions. The term
"exchange contracts" is currently used in some
Participating Jurisdictions and generally refers to exchange-traded
derivatives that have standardized terms and conditions determined
by the exchange and by their terms are cleared.
Some of the notable exemptions and divergences from existing
provincial laws include:
- The Ontario CFA "hedger" exemption from dealer registration requirements will not be preserved on the basis that entities are only required to register as dealers if they are engaged in the business of trading in securities or derivatives.
- The Ontario CFA "unsolicited trade" exemption from dealer registration requirements will not be preserved, but it is noted that an exemption is provided for trades in exchange contracts made through or to a registered dealer, provided that the trade satisfies certain requirements.
- The international dealer and international adviser exemptions under National Instrument 31-103 will not apply to exchange contracts, but dealers and advisers headquartered in the United States or the United Kingdom are provided with very similar exemptions in respect of exchange contracts in the draft Derivatives Registration and Exemption Rule.
Only investment dealers and certain restricted dealers are permitted to trade exchange contracts without an exemption.
CENTRAL CLEARING, COLLATERAL AND EXCHANGE TRADING REQUIREMENTS
No derivatives clearing, margin or trade execution rules are
expected to be published in connection with implementation of the
Cooperative System.
The CSA may introduce rules in respect of mandatory clearing of
specified classes of OTC derivatives as well as indirect clearing
client protection rules in the next three months, for
implementation in 2016. Any such rules agreed to under the CSA
process would be expected to also ultimately be adopted as
regulations under the CMA.
MARKET CONDUCT RULES, OTHER CMA RULES OF GENERAL APPLICATION
The CMA includes market conduct rules that are generally
applicable to both securities and derivatives trading, and are
similar to, but expand upon those set out in provincial
Securities Acts.
The CMA revisions add a prohibition on front-running information
relating to an investor's intention to trade either a
derivative or an underlying interest of a derivative if the
information would reasonably be expected to affect relevant market
prices or values. Tipping third-parties in respect of such
information or encouraging third-parties to engage in such trading
is also generally prohibited, subject in each case to specified
defences.
The other derivatives market conduct rules included in the initial
draft of the CMA have been retained with minor amendments. These
rules prohibit activities such as:
- Engaging in any practice that results in a false or misleading appearance of trading activity in or an artificial price or value for a derivative.
- Making materially false or misleading statements that would reasonably be expected to have a significant effect on the market price or value of a security, derivative or the underlying interest of a derivative.
- Directly or indirectly engaging in any act or course of conduct relating to securities or derivatives "that (a) results in an unjust deprivation or a risk of an unjust deprivation of a person's money or other property or of the value of the person's property; or (b) the person knows or reasonably ought to know perpetrates a fraud on any person".
- Engaging in an unfair practice in relation to a trade, including: (a) putting unreasonable pressure on another person to trade in or hold a derivative, (b) taking advantage of another person's "inability or incapacity to reasonably protect his or her own interest because of physical or mental disability, ignorance, illiteracy, age or other inability to understand the character, nature or language of any matter relating to a decision...to trade in or hold a derivative" and (c) engaging in any other prescribed practice that is fraudulent, manipulative, deceptive or unfairly detrimental to investors.
- Improperly influencing the determination of a benchmark.
- Making false or misleading statements about something that a reasonable investor would consider important in deciding whether to maintain a relationship with the counterparty.
The CMA also makes it an offence to do or omit to do anything
for the purpose of aiding, abetting or counselling a contravention
of capital markets law or to conspire with any person to contravene
capital markets law.
Other CMA rules of general application include proposed employee
whistleblower protections and rules granting the Authority and the
Chief Regulator investigative powers such as the authority to order
any market participant to provide specified information or records
for the enforcement of capital markets laws or the regulation of
capital markets.
PRESCRIBED DISCLOSURE DOCUMENTS FOR 'DESIGNATED DERIVATIVES' AND TAILORED OBLIGATIONS FOR OTHER CLASSES OF DERIVATIVES
The draft Derivatives Registration and Exemption Rule provides
that OTC derivatives constitute "securities" for the
purposes of CMA prospectus requirements. As noted above, an
exemption from prospectus requirements for OTC derivatives entered
into between permitted clients and/or qualified parties is provided
by the Permitted Client Blanket Exemption. If the conditions
applicable for that exemption are not satisfied for a particular
OTC derivatives transaction, then standard securities prospectus
exemptions such as the accredited investor exemption would also be
available, though securities trade reporting obligations may also
apply in this case. The terms of the securities prospectus
exemptions will be set forth in a forthcoming version of National
Instrument45-106 Prospectus Exemptions. Given the breadth
of these exemptions, securities prospectus obligations generally
are not expected to apply to OTC derivatives trading except in
respect of transactions with retail investors.
The CMA also provides that for trading in "designated
derivatives" a disclosure document in prescribed form must be
filed with the Chief Regulator and, if required by the rules, a
receipt must be obtained from the Chief Regulator (similar to a
receipt for a prospectus, which suggests a review and comment
process).
The commentary issued with the revised draft of the CMA indicates
that it "is anticipated that designated derivatives will
include derivatives that raise investor protection concerns, but
for which traditional securities regulatory requirements are not
appropriate. The regulations will prescribe varying levels of
disclosure depending on the specific circumstances, including the
nature of the product and the identity of the parties."
Finally, classes of derivatives may be made subject to any
prescribed provisions of the CMA or related regulations. The
commentary indicates that this "will allow the applicable
requirements to be tailored to the class of derivative and to
address other relevant factors such as the type of counterparty and
the method of transacting".
REGULATION OF CLEARING AGENCIES AND MARKETPLACES
Clearing agencies, including derivatives central counterparties,
which carry on business in a Participating Jurisdiction will be
required to apply to obtain either recognition or an exemption from
recognition from the Authority. The Authority will maintain broad
regulatory and rule-making authority over all clearing agencies
similar to under current provincial securities legislation. This
approach maintains the status quo in respect of regulation
of clearing agencies in Ontario. Draft transition provisions
describing whether and how clearing agencies may maintain or renew
existing recognition and exemption orders have not yet been
issued.
Currently, derivatives clearing agencies are not subject to any
specific rule or instrument governing their conduct but rather are
subject to conditions set out in individual recognition and
exemption orders issued by securities commissions. These conditions
reflect established practice and staff policies including OSC Staff Notice 24-702 –
Regulatory Approach to Recognition and Exemption from
Recognition of Clearing Agencies. The commentary
issued with the draft CMA regulations indicates that the treatment
of existing staff notices, local policies and interpretation notes
is under review and that new instruments such as National Instrument 24-102 Clearing
Agency Requirements would be expected to be adopted
under the Cooperative System if adopted by the Participating
Jurisdictions prior to commencement of operations.
Exchanges will also be required to obtain either recognition or an
exemption from the Authority in order to carry on business in a
Participating Jurisdiction. The term "exchange" is not
defined in the draft CMA or regulations but may generally be
considered to include traditional commodities futures exchanges but
not OTC derivatives trading facilities. Exchanges will continue to
be subject to existing National Instruments, including National Instrument 21-101
Marketplace Operation and National Instrument 23-103 Electronic
Trading and Direct Electronic Access to Marketplaces,
which are being adopted under the Cooperative System.
Under Ontario law, the term "alternative trading system"
included certain OTC derivatives trading platforms, which subjected
such platforms to rules in respect of operations and trading that
apply to marketplaces. In contrast, under the draft CMA, only
prescribed OTC derivatives trading platforms would be included as
marketplaces subject to those rules.
DEADLINE FOR COMMENT
The comment period for the draft CMA and regulations runs through December 23, 2015.
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.