The 3-Minute Version:
As the latest regulatory initiative to fundamentally restructure derivatives trading in Canada, on January 29, 2015 the Canadian Securities Administrators Derivatives Committee (the “Committee”) published a consultation paper entitled CSA Consultation Paper 92-401 – Derivatives TradingFacilities (the “Consultation Paper”). The Consultation Paper is the seventh in a series of proposals to fundamentally change the way in which over-the-counter (“OTC”) derivatives are regulated in Canada. In particular, the Consultation Paper sets out the Committee’s regulatory proposals for OTC derivatives trading facilities (“DTF”). The complete Consultation Paper is available here.
The Committee recommends the development of a regulatory framework for DTFs. Within the regulatory structure there will be OTC derivatives that are mandated to be traded on a DTF (the “Mandated OTC’s”) and OTC derivatives that are not required to be traded on a DTF (the “Non-Mandated OTC’s”). Market participants will not be required to trade Non-Mandated OTC’s through a DTF, although it would be permitted. For Mandated OTC’s, additional requirements will apply to the DTF, including with respect to pre-trade transparency. The Consultation Paper proposes a definition of a DTF, recognition requirements, organizational requirements and pre-and post-trade transparency requirements. Overall, the goal of the proposed regulatory system is to encourage liquidity, transparency and standardization in Canada’s OTC derivatives market. The organizational requirements proposed are comparable to the rules established for marketplaces under NI 21-101, with appropriate differences. Approaches in both the United States and the European Union have informed the proposed regulatory approach. Interestingly, the Consultation Paper was released at the same time that the U.S. swap execution facility (“SEF”) regulatory framework became subject to a major overhaul proposed by Commissioner J. Christopher Giancarlo of the U.S. Commodity Futures Trading Commission (“CFTC”).
The Rest of the Story:
In September 2009 at the Pittsburg Summit, Canada and the other G20 countries made a commitment that “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate.” The Committee recommends the following goals in order to achieve this G20 Commitment:
- develop a regulatory framework for DTFs, that is, organized trading platforms for the trading of OTC derivatives; and
- require suitable OTC derivatives, or classes of OTC derivatives, to trade exclusively through a DTF.
In order to attain these goals the Committee has suggested a number of specific recommendations.
Derivatives Trading Facilities Defined
The Committee proposed that DTFs be defined as “a person or company that constitutes, maintains, or provides a facility or market that brings together buyers and sellers of OTC derivatives, brings together the orders of multiple buyers and multiple sellers, and uses methods under which the orders interact with each other and the buyers and sellers agree to the terms of trades.”
The Consultation Paper notes that this definition is intended to include multi-dealer or many-to-many platforms that lead to the execution of OTC derivatives transactions. Bilateral or one-to-many facilities, and facilities where no trade is executed, are not meant to be captured by the definition.
Regulatory Framework for DTFs
The regulation of DTFs will be similar to the regulation currently in place for an exchange. The framework will require all DTFs to obtain either an authorization from the securities regulatory authority in each jurisdiction in which it operates, or an exemption. The authorization would permit the DTF to provide facilities for trading Mandated OTC’s and Non-Mandated OTC’s. A DTF will be expected to monitor its participants for compliance with its rules and to take disciplinary action against participants as appropriate. If a DTF exercises discretion in the execution of transactions, it will be subject to additional requirements and will be regulated similarly to a derivatives dealer. This means that requirements such as a duty to act fairly, honestly and in good faith, to maintain confidentiality with respect to customer information and requirements surrounding individual representatives will apply.
DTFs to be organized similarly to Marketplaces
The proposed organizational requirements are comparable to those requirements established for marketplaces that are regulated under National Instrument 21-101 – Marketplace Operation and National Instrument 23-101 – Trading Rules. The Committee suggests regulations relating to a number of issues, including:
- Fair access to trade and price information;
- Access to services offered;
- Transparency in fees, services order types, technology requirements, policies and procedures;
- Record-keeping and record preservation;
- System requirements;
- Independent system reviews;
- Financial resources;
- Conflicts of interest; and
- Reporting to securities regulators.
A DTF and a marketplace will remain distinct concepts. However, to the extent appropriate, the rules governing DTFs will aim to be consistent with the rules governing marketplaces. The Committee is also proposing that some DTFs be able to operate similarly to dealers and exercise some discretion in their trade execution process. In this case, the DTF must retain a third-party regulation service provider to monitor and enforce compliance.
What will Happen to Existing Marketplaces that offer OTC Derivatives?
For existing marketplaces, the Committee suggests that:
- Exchanges trading derivatives that are not OTC derivatives will not be considered a DTF;
- Marketplaces that want to trade in OTC derivatives will need to obtain authorization to operate as a DTF; and
- If a trading platform is both a DTF and a marketplace, attempts will be made to avoid conflicting and duplicative regulation (likely on a case-by case basis).
Execution methods proposed include a range of multiple-to-multiple trading functionalities and are generally quite broad (including continuous or periodic order book, request for quote, request for stream, etc.). However, transactions with Mandated OTC’s may require certain execution methods.
When would mandatory trading on a DTF be required?
The decision to classify an OTC derivative as a Mandated OTC will be made only after assessing and reviewing trading and clearing data over an appropriate amount of time. In determining whether a particular class of derivatives should be traded exclusively on a DTF, the Committee expects that a number of factors will be considered, including whether that class of derivatives is subject to a clearing obligation, whether it is sufficiently liquid and standardized, whether the derivative class is subject to a similar trading mandate in other jurisdictions and whether it is already trading through a DTF or a foreign trading platform.
Pre-trade and Post-trade Transparency Requirements
In general, the Committee proposes post-trade transparency for all OTC derivative trading. A report of all transactions executed on the facility will need to be made available to the public in real time or as close to real time as technically possible. For Mandated OTC’s, the DTF will also be required to provide a specified level of pre-trade transparency, including pre-trade disclosure of the bid and offer prices and market depths. This would be provided to all users of the facilities. An exemption from pre-trade transparency requirements may be available for orders that, because of their size, could expose liquidity providers to undue risk.
Exemptive Relief for Foreign-based DTF regulated in its home jurisdiction
The Committee proposes that a foreign-based DTF may receive an exemption if it can show that the regulation in the foreign jurisdiction to which it is subject is comparable to that in Canada. In this situation, the CSA members will still retain general oversight, but will not provide the day-to day regulation. The foreign-based DTF may be subject to certain reporting requirements.
We continue to closely monitor the development of this new body of law and regulations in Canada, the U.S. and elsewhere. Without harmonization of the rules that apply to OTC derivatives, the global derivatives market may suffer from fragmentation, reduced liquidity and greater costs for market participants. To illustrate, according to statistics compiled by ISDA, certain derivative trade execution volumes between U.S. and European swap dealers have fallen 77% since the U.S. SEF trade execution mandates for swaps were introduced. Commissioner Giancarlo of the CFTC is currently seeking a complete overhaul of the SEF rules in the U.S. It remains to be seen how these global regulators will harmonize their approach to derivatives trading facilities.