On February 22, 2016, this blog piece that I wrote – “Canadian Derivatives Regulation: The New Looming Reality of Compliance and Costs for Energy Companies” for the Dentons Global Energy Blog was published on various publications such as Lexology and Mondaq. Since this publication, the Office of the Superintendent of Financial Institutions Canada (“OSFI”) on February 29, 2016, issued the final version of its Guideline E-22 Margin Requirements for Non-Centrally Cleared Derivatives, which requires the exchange of margin to secure performance on non-centrally cleared derivatives transactions between covered entities. The final version of Guideline E-22 addressed some of the concerns I raised in the original article such as the fact that certain Canadian energy market participants could be deemed Covered Entities because of the breadth of the instruments covered by the Guideline. In the final version of Guideline E-22, OSFI has clarified that non-financial entities are not included in the definition of a Covered Entity as after careful consideration; it believes that it would be appropriate to exclude non-financial entities from the definition of Covered Entities.
I also raised the concern expressed by energy market participants regarding the breadth of the instruments covered by OSFI in the draft version of Guideline E-22. In the final version, OSFI has stated that despite its broad definition of a “derivative”, “physically settled commodity transactions are not included in the definition of a derivative and therefore not subject to the margin requirements of this Guideline”.
As a result, this is the update of the original article here below:
The Canadian energy companies, including energy producers, energy infrastructure companies, energy trading and marketing organizations, natural gas distribution companies, power transmission and generation companies, electric utilities and global companies who enter into over-the-counter (“OTC”) derivatives transactions with Canadian energy companies are now going to have to comply with new regulatory obligations involving the oversight and regulation of OTC derivatives as the reform of Canadian derivatives regulation picks up steam in the Canadian western provinces. The recent publication on January 22, 2016 of the Canadian Securities Administrators (“CSA”) Multilateral Instruments 91-101 Derivatives: Product Determination and 96-101 Derivatives: Trade Repositories and Derivatives Data Reporting (“Reporting Rule”), respectively introduce the first compliance obligations vis-à-vis reporting of OTC derivatives transactions for the energy industry.
RECENT RULES IMPLEMENTING THE REFORM OF OVER-THE-COUNTER (OTC) DERIVATIVES MARKETS IN CANADA
Energy derivatives market participants in Canada and foreign market participants who enter into OTC derivatives transactions with Canadian energy companies are witnessing a multitude of rulemakings by the Canadian prudential and securities regulators as required by Canada’s G20 commitments. These actions include the publication by (“OSFI”) on February 29, 2016 of its final version of Guideline E-22, which requires the exchange of margin to secure performance on non-centrally cleared derivatives transactions between covered entities. OSFI hopes these margin requirements will mitigate systemic risk in the financial sector as well as promote central clearing of derivatives where practicable. OSFI addressed the letter announcing the final version of the Guideline to Banks; Foreign Bank Branches; Bank Holding Companies; Trust and Loan Companies; Co-operative Credit Associations; Co-operative Retail Associations; Life Insurance Companies; and Property and Casualty Insurance Companies. The Guideline would not apply to non-federally-regulated financial institutions even if they meet the definition of a “Covered Entity” which includes “a non-financial entity belonging to a consolidated group whose aggregate month end average notional amount of non-centrally cleared derivatives for March, April, and May of any year following the implementation date exceeds $50 billion”.
On January 21, 2016, members of the CSA published for comment Proposed National Instrument 94-102 Derivatives: Customer Clearing and Protection of Customer Positions and Collateral and its companion policy for a 90-day comment period. The proposed instrument sets out requirements for the treatment of customer collateral, record-keeping and disclosure for clearing intermediaries and regulated clearing agencies providing clearing services for OTC derivatives. The purpose of the proposed instrument is to ensure that the clearing of customer OTC derivatives transactions will be carried out in a manner that protects customers’ collateral and positions and to improve clearing agencies’ resilience to default by a clearing intermediary.
Given the existing exemptions in Alberta and British Columbia ASC Blanket Order 91-506 and BCSC Blanket Order 91-501 Over-the Counter Derivatives, respectively, that currently precludes energy commodities futures trading from regulation, many parties must fear that impending rules would be so broad in scope that previously unregulated OTC derivatives transactions routinely used by energy companies would become subject to the jurisdiction of a provincial securities or federal prudential regulators and their new regulatory requirements that could include registration requirements. Many market participants believe the energy industry functioned well with the OTC derivatives exemption from regulation for energy futures markets in Canada. They believe the routine use of OTC derivatives to hedge market volatility due to many variable factors would be severely disrupted if regulated.
Energy companies use OTC derivatives with financial institutions and other commodity market customers to exchange floating price streams with fixed price streams. For example, an electric utility’s annual revenue is based in part by the spot prices paid by an Independent System Operator that operates anywhere in Canada for the power generated. Without the derivative instrument, that annual revenue could vary widely based on demand. With an OTC derivative instrument, however, the utility enters into an agreement whereby the variable price paid for the power generated (revenue) is transferred to another counterparty in exchange for a fixed revenue stream for the year, or vice versa depending on the specific circumstances. OTC derivatives such as swaps work when counterparties have opposing views of the risks involved, and therefore agree to trade revenue streams.
Energy companies are very troubled that the final CSA Registration Rule could categorize these companies that execute daily OTC derivatives transactions as “derivatives dealers,” subjecting them to mandatory capital, margin, and clearing requirements, as has been noted by various energy companies in comments submitted to different CSA members. One lingering concern is that the current exclusion of derivatives that are physically settled as seen in the final version of OSFI E-22 Guideline would not be transposed into every other Rule issued or enacted in the future.
The end result of the current Reporting Rule may not be a sea change for Canada energy companies, hedging transactions. However, as many rules remain in development such as the Registration; Clearing; Margin; and Capital Rules, the extent of the reform of OTC derivatives regulation in Canada on the energy industry remains to be seen. This causes a level of uncertainty as Canadian energy companies and other participants have to move forward with regulatory compliance assessments and initiatives.
As a result, many Canadian energy companies must take a cautious approach and carefully monitor the new rules as they are developed, to determine whether any impact on their companies OTC derivative transactions exist.