On August 25, 2015, the participating provinces and territory in the Cooperative Capital Markets Regulatory System achieved an important milestone towards implementation of the system by publishing a revised consultation draft of the uniform provincial and territorial capital markets act (now known as the Capital Markets Act), along with the drafts of the initial regulations proposed for adoption by the participating provinces and territory under the draft uniform act. These materials have been published for a 120-day public comment period.
This article is part of Gowlings' Guide to the Proposed Initial Regulations and related materials. In this segment of our guide, we discuss the proposed initial regulations on derivatives. To view other sections of the guide, click here.
The Uniform Act
Part 6 of the draft uniform act (Trading in Derivatives) addresses trading in derivatives, and prohibits a person from trading in a designated derivative unless a prescribed disclosure document has been filed and, where required by the regulations, a receipt has been issued by the new chief regulator. Only the overarching requirements are included in the draft uniform act, with the detailed requirements set out in the regulations.
Proposed Derivatives Regulatory Framework
(a) Overlap between “security” and “derivative”
Both securities and derivatives will be regulated under the draft uniform act. The terms “security” and “derivative” have overlapping meanings such that some instruments will be both a security and a derivative. It is proposed that where a product falls into both categories, the securities and derivatives requirements in the draft uniform act would both apply.
(b) Classification of Derivatives
As a transitional measure, all “derivatives” in the participating provinces and territories are proposed to be broadly classified into two categories: exchange contracts and over-the-counter (OTC) derivatives. Under this approach, there is no need to supplement the derivatives definition in the draft uniform act with further product classifications.
Exchange contracts are derivatives traded on an exchange with standardized terms and conditions determined by that exchange and for which a clearing agency substitutes the credit of the clearing agency for the credit of the other parties to the derivative. All other derivatives will be categorized as OTC derivatives.
(c) Repeal of Commodity Futures Act (Ontario)
In Ontario, today, exchange-traded derivatives are not regulated under securities legislation but rather through a separate commodity futures act that applies to commodity futures contracts and commodity futures options. It is expected that when the draft uniform act is enacted and comes into force, the Ontario Commodity Futures Act (or “Ontario CFA”) will be repealed and that an “exchange contract” in the participating provinces and territories will include the commodity futures contracts and commodity futures options currently regulated under the Ontario CFA.
(d) Certain Derivatives Excluded
While the definition of “derivative” in the draft uniform act is broad, there is a need to exclude certain contracts and instruments which fall within the definition but for which it would be inappropriate to apply all of the provisions of the draft uniform act. It is therefore proposed that the following derivatives, among others, will be excluded from the prospectus and registration requirements in the draft uniform act (if not also a security or an exchange contract) and the trade reporting requirements under proposed CMRA Regulation 91-502Trade Repositories and Derivatives Data Reporting:
- contracts regulated by gaming control legislation of Canada or a jurisdiction of Canada;
- insurance or annuity contracts entered into under insurance legislation of Canada or a jurisdiction of Canada;
- contract for purchase and sale of currency that (i) requires settlement by the delivery of the referenced currency within two business days, (ii) is intended by the parties, at the time of execution of the transaction, to be settled by delivery of the referenced currency within the period in (i); and (iii) does not allow for it to be rolled over;
- contract for delivery of a commodity (other than cash or currency) that is intended, at the time of execution, to be settled by delivery of the commodity and does not allow for cash settlement in the ordinary course; and
- evidence of deposits at banks, credit unions, or loan and trust companies.
The exclusions are necessary to preserve the status quo in British Columbia and Ontario. For example, in these provinces today, gaming contracts are excluded from regulation as a security. However, under the draft uniform act, these contracts would be caught by the definition of “derivative” and therefore would be subject to the registration requirement and other requirements that apply to derivatives unless exempt or excluded.
It is proposed however that exempt derivatives would be subject to general market conduct provisions in the draft uniform act. This will represent a regulatory change in British Columbia relating to certain short-term currency contracts and certain contracts for the physical delivery of a commodity.
(e) Registration of Dealers and Advisers
(i) Registration Requirement
A person that meets the business trigger test under the draft uniform act of carrying on the business (or holding oneself out as carrying on the business) of trading in or advising with respect to derivatives must register. Adopting a business trigger approach for dealers in exchange contracts will represent a regulatory change in Ontario, where the Ontario CFA requires dealer registration based on a “trade trigger” (which means that the requirement to register is triggered when a trade is made between two parties rather than when a person is in the business of dealing in a derivative).
It is proposed that the requirements in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations will apply to registrants in respect of all derivatives in the participating provinces and territories (unless the context otherwise requires). The advantage of this approach is that registration requirements for securities and derivatives would be consolidated in one instrument that already exists as a national instrument. This is consistent with the approach currently used in British Columbia for registration as it relates to exchange-traded derivatives (known as exchange contracts) (which have been incorporated into National Instrument 31-103 where they are treated, subject to certain exceptions, in the same manner as securities), but will represent a regulatory change in Ontario from the “status quo” as it exists in Ontario under the Ontario CFA.
The business trigger factors described in the Companion Policy to National Instrument 31-103 for dealing and advising in securities require modification and supplementation in order to provide appropriate and useful guidance that reflects the nature of advising in derivatives. As a result, the participating provinces and territories have proposed additional factors to be discussed in the Companion Policy to appropriately identify a person that is in the business of dealing or advising in derivatives. These factors take into account the characteristics that distinguish derivatives dealing and advising from dealing or advising in securities. For a summary of these additional factors, see note (1) below.
The factors proposed for identifying a person that ought to be registered as a dealer or adviser in derivatives in the participating provinces and territories do not include one of the factors currently applicable in the securities context, namely, “directly or indirectly carrying on the activity with repetition, regularity or continuity”. This factor could potentially capture a person that merely trades in derivatives and that should not be viewed as a dealer for regulatory purposes. As a result, the participating provinces and territories have clarified that frequent or regular transactions are not on their own determinative of whether an individual or firm is in the business of trading in derivatives for a business purpose.
(ii) Categories of Registration
The participating provinces and territories have proposed not to create derivative-specific categories of registration at this time. Rather, the following categories of dealer registration under National Instrument 31-103 will extend to derivatives dealers in the participating provinces and territories: investment dealer (which requires IIROC membership), exempt market dealer (in the case of OTC derivatives only) and restricted dealer (subject to specific conditions of registration).
This is consistent with the existing regulatory approach in British Columbia, where most entities that are registered in the province to trade exchange contracts are registered as investment dealers. It is also consistent with the existing regulatory approach in Ontario, where an entity registered to trade exchange contracts in Ontario must be registered as a “futures commission merchant” (which must maintain membership with IIROC) under the Ontario CFA.
In the participating provinces and territories, exempt market dealers will not be permitted to act as a dealer by trading in an exchange contract.
(f) New CMRA Regulations for Derivatives
Today, the regulation of derivatives is inconsistent. Exchange-traded derivatives are regulated under securities legislation in British Columbia based on the concept of “exchange contracts”, but in Ontario, exchange-traded derivatives are governed under separate commodity futures legislation. OTC derivatives are regulated as securities in British Columbia, but the application of securities legislation to OTC derivatives in Ontario is less clear because the definition of “security” in the Ontario Securities Act is not as broad as in British Columbia.
In order to provide a harmonized framework for the regulation of exchange contracts and OTC derivatives, the participating provinces and territories have proposed two new regulations that would apply only to these jurisdictions: proposed CMRA Regulation 91-501 Derivatives and Strip Bonds and proposed CMRA Regulation 91-502 Trade Repositories and Derivatives Data Reporting. The proposed regulations are intended to serve only as interim rules pending the development of a comprehensive regime for the regulation of derivatives in the participating provinces and territories and will be updated to reflect the G-20 work underway by the Canadian Securities Administrators OTC Derivatives Committee.
1. Proposed CMRA Regulation 91-501 Derivatives and Strip Bonds
Proposed CMRA Regulation 91-501 Derivatives and Strip Bonds together with its related forms and companion policy, is derived from existing local rules of the participating provinces and territories. The intent of this proposed regulation is to replace these local rules and provisions, as well as to provide guidance and impose requirements that address other requirements contemplated by the draft uniform act that cannot be easily added to the existing national instruments.
Below, we summarize the key aspects of this proposed regulation relating to: (i) exchange contracts; and (ii) OTC derivatives.
(i) Exchange Contracts
The proposed regulation prescribes exchange contracts not to be securities for purposes of the definition of a “security” in the draft uniform act, meaning that no prospectus requirement will apply to exchange contracts (the draft uniform act does not contain a stand-alone prospectus requirement for derivatives). This is consistent with the regime that applies to exchange-traded derivatives in British Columbia today where these derivatives are carved out of the definition of a “security” in the British Columbia Securities Act. This will however represent a regulatory change in Ontario as a commodity futures contract or commodity futures option that is not traded on a recognized exchange constitutes a “security” for the purposes of the Ontario Securities Act. There are no commodity futures exchanges that are registered or recognized by the Ontario Securities Commission - they are generally exempted. Accordingly, all exchange-traded futures and options are effectively also securities in Ontario.
Risk Disclosure Statement
There is no specific disclosure requirement in the draft uniform act for persons trading in or advising on exchange contracts. To eliminate gaps that would allow exchange contracts to be traded without any disclosure requirement, the proposed regulation requires registered dealers and advisers to deliver a written risk disclosure statement (which could be in the form required by securities legislation in the local jurisdiction before the launch of the system) to a client before purchasing or selling an exchange contract for the client, or advising the client to purchase or sell the exchange contract. The requirement to provide regulator approved, exchange contract risk disclosure will be represent a regulatory change for advisers in British Columbia.
It is proposed that the same exemptions from the registration requirement that exist in National Instrument 31-103 today for exchange contracts will exist for the participating provinces and territories once the system is launched.
An area that will see a regulatory change in Ontario relates to the availability of the registration exemptions under the Ontario CFA. As noted above, it is expected that the Ontario CFA will be repealed when the draft uniform act is implemented and the registration exemptions available under the Ontario CFA for commodity futures contracts and commodity futures options (such as the “hedger” exemption or exemption for “unsolicited trades”) would no longer be available. This also includes the adviser registration exemption in paragraph 31(a) of the Ontario CFA for various financial institutions advising on commodity futures contracts and commodity futures options. In some instances, however, a market participant relying on an Ontario CFA registration exemption may be able to rely on the exemptions in National Instrument 31-103 that apply to exchange contracts.
The proposed regulation also contains additional registration exemptions relating to exchange contracts.
Exemption for International Dealers and Advisers
The proposed regulation contains a registration exemption relating to international dealers and advisers that deal in or advise on “non-Canadian exchange contracts”. This will represent a regulatory change in both British Columbia and Ontario.
The exemptions for international dealers and advisers in sections 8.18 and 8.26 of National Instrument 31-103 are available for securities-related activities to a dealer or adviser based in a foreign jurisdiction that deals in or advises on “foreign securities”. There is no statutory registration exemption available to foreign dealers or advisers in relation to exchange contracts(2) (although there are examples of discretionary exemptive relief being granted from the registration requirement for dealing in exchange contracts that are patterned after section 8.18 of National Instrument 31-103).
To address this gap, the proposed regulation provides exemptions from the registration requirement to foreign dealers and advisers registered under securities or derivatives legislation in the U.K. or U.S. in respect of trading or advising activity relating to exchange contracts traded on exchanges outside Canada and cleared through one or more clearing agencies outside Canada. Restricting the availability of the exemptions to U.K. and U.S. dealers and advisers is generally consistent with exemptive relief granted under the Ontario CFA.
The availability of the proposed exemptions is subject to a number of conditions, including (i) delivery by the foreign dealer or adviser to its Canadian clients of the risk disclosure that the person is required to deliver to similar customers in its home jurisdiction, and (ii) filing with the new chief regulator a prescribed form disclosing, among other things, any settlement agreements entered into by the person with a securities or derivatives exchange. Neither of these conditions form part of the National Instrument 31-103 international dealer or adviser exemptions.
It is proposed that the market conduct provisions in the draft uniform act that are applicable to derivatives will apply to exchange contracts. This includes, for example, provisions relating to false or misleading statements, prohibited representations, market manipulation, unjust deprivation and unfair practices.
(ii) OTC Derivatives
The proposed regulation prescribes, on an interim basis, all OTC derivatives to be securities for the purposes of Part 5 of the draft uniform act (Prospectus Requirements). As a result, all OTC derivatives will, absent an exemption, be subject to the prospectus requirement. This will represent a regulatory change in Ontario, where the prospectus requirement only applies to OTC derivative contracts that fall within one of the heads of the definition of a “security” in the Ontario Securities Act. As a result, it is not always clear whether, and in what circumstances, certain types of OTC derivatives are “securities” for purposes of Ontario securities laws(3).
Prospectus disclosure requirements would be difficult to complete for OTC derivatives, however the proposed regulation contains a prospectus exemption for OTC derivatives trades where each party is a permitted client or a qualified party, each acting as principal.
It is proposed that OTC derivatives that are only securities because of the aforementioned prescription, will not be subject to non-prospectus related requirements in the draft uniform act that are applicable only to securities.
Registration Exemption for Specified Financial Institutions
Today, in Ontario, specified financial institutions (including banks listed in Schedule I, II or III to the Bank Act) may rely on the general exemption from the registration requirement contained in subsection 35.1(1) of the Ontario Securities Act if, in so acting, the financial institution limits its activities to only those activities not prohibited under its governing legislation. This exemption, which applies to specified financial institutions in the business of trading OTC derivatives that are “securities”, will not be available under the draft uniform act.
Registration Exemption for Permitted Clients or Qualified Parties
The proposed regulation does exempt from the registration requirement trades in OTC derivatives between “qualified parties” or “permitted clients”, each acting as principal in the trade. This exemption is similar to blanket order exemptions in British Columbia exempting OTC derivative trades between qualified parties. Discretionary exemption orders have been granted in Ontario for trades in OTC derivatives between permitted clients.
To rely on the proposed exemption each party to the trade must be a qualified party or permitted client, however the exemption is directly relevant only for a person that is in the business of trading in OTC derivatives. For example, if a party to an OTC derivatives trade is a permitted client, but is not in the business of trading in OTC derivatives, there would be no need for that party to rely on the exemption.
The proposed exemption may mitigate the impact on Ontario as a result of not carrying forward the general exemption from the registration requirement for financial institutions contained in subsection 35.1(1) of the Ontario Securities Act.
Registration Exemption for Trades of Agricultural Commodities Derivatives
The proposed regulation does not provide an exemption for trades in OTC derivatives where the OTC derivative is a contract for the production, purchase or sale of an agricultural commodity and each party to the contract is engaged in the production, purchase or sale of that commodity.
2. Proposed CMRA Regulation 91-502 Trade Repositories and Derivatives Data Reporting
Proposed CMRA Regulation 91-502 Trade Repositories and Derivatives Data Reportingtogether with its related forms and companion policy, is derived from OSC Rule 91-507Trade Repositories and Derivatives Data Reporting. It will require derivatives dealers and clearing agencies to report derivatives transactions involving local counterparties. Most OTC derivative transactions will be required to be reported under the proposed regulation, whereas exchange contracts will generally be exempt from the data reporting requirements.
The adoption of OSC Rule 91-507 should minimize concerns from trade repositories, trade reporting and trade reporting systems about disruptions, as their reporting activities under OSC Rule 91-507 are underway.
(i) How does CMRA Regulation 91-502 differ from OSC Rule 91-507?
The proposed regulation adopts OSC Rule 91-507, largely, in its current form as of March 2, 2015. The noteworthy changes that have been proposed relate to exemptions from reporting derivatives data.
Limited Exemption from Reporting Trades of Commodities Derivatives
The participating provinces and territories have proposed a limited exemption from the obligation to report derivatives data for a transaction based on commodities, other than cash or currency, where the local counterparty (i) is not a derivatives dealer, and (ii) has, at the time of the transaction, less than a to-be-determined aggregate notional value, without netting, under all its outstanding transactions including the additional notional value related to that transaction.
The participating provinces and territories have invited comments as to what is the appropriate threshold dollar value for exemption from reporting in relation to a trade in a derivative that is a contract for a commodity (other than cash or currency). The threshold under OSC Rule 91-507 is $500,000, but has been raised to $250 million (although calculated slightly differently) under Multilateral Instrument 91-101 Derivatives: Product Determination, published for comment by British Columbia, New Brunswick and Saskatchewan (as well as by some of the non-participating jurisdictions) in January 2015.
The purpose of the reporting exemption is to reduce the regulatory burden on commodity derivatives market end-users.
Incorporation of the Ontario Scope Rule
OSC Rule 91-506 Derivatives: Product Determination defines the types of derivatives that will be subject to reporting requirements under OSC Rule 91-507. The participating provinces and territories have proposed not to carry forward OSC Rule 91-506 as a stand-alone regulation, but rather to incorporate its content into section 25 of CMRA Regulation 91-502 in order to identify which transactions in derivatives are excluded from the data reporting requirements of CMRA Regulation 91-502.
(ii) Inter-Affiliate Trades
End-users are currently subject to reporting obligations under OSC Rule 91-507, which includes a requirement to report end-user inter-affiliate transactions. However, in June 2015, the Ontario Securities Commission issued a staff notice announcing that it is considering certain amendments to OSC Rule 91-507 regarding the reporting of inter-affiliate transactions by end-users. The staff notice clarified that the Ontario Securities Commission is not contemplating exempting all trade reporting requirements for end-user inter-affiliate transactions, but until the amendments come into force, compliance by end-users with inter-affiliate trade reporting requirements will not be enforced. This follows the granting of temporary relief to end-users for certain inter-affiliate trades by the Autorité des marchés financiers and the Manitoba Securities Commission.
The participating provinces and territories have announced that they will be considering staff notices, and that following their review, they will communicate which are expected to apply in the participating provinces and territories. Consequently, the reporting of inter-affiliate transactions by end-users under the proposed regulation remains to be determined.