The Canadian Securities Administrators (“CSA”) on February 24, 2016 published for comment National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (the “Revised Clearing Rule”), modifying the proposed requirements for clearing certain over-the-counter (“OTC”) derivatives transactions through a regulated clearing agency. The publication of the Revised Clearing Rule represents the CSA’s third articulation of clearing rules, following the publication of a model provincial clearing rule in January, 2014, and the publication of an initial draft clearing rule (the “Initial Clearing Rule”) in February, 2015. The scope of the clearing obligation under the Revised Clearing Rule is significantly narrower than what was previously proposed under the Initial Clearing Rule. For an overview of the Initial Clearing Rule, please see our previous article.
Overview of the Revised Clearing Rule
The Revised Clearing Rule may be notionally divided into two halves: (i) the first half sets out a requirement to clear certain OTC derivatives transactions through a regulated clearing agency; and (ii) the second half sets out the CSA’s determination as to which OTC derivatives transactions will be subject to the clearing requirement.
Requirement to Clear Through a Regulated Clearing Agency
Under the Revised Clearing Rule, a “local counterparty” to a transaction in a “mandatory clearable derivative” must submit that transaction for clearing where certain additional criteria (the “New Criteria”) are met. A “local counterparty” is a person or company, other than an individual, that is: (i) organized under the laws of the local jurisdiction; or (ii) has its head office or principal place of business in the local jurisdiction; or (iii) is an affiliate of an entity referred to in (i) or (ii) and that entity is responsible for all or substantially all of the liabilities of such affiliate. A “mandatory clearable derivative” is a derivative that has been determined by regulators as being subject to the clearing requirement, as discussed below.
The Revised Clearing Rule will only require a local counterparty to clear a transaction in a mandatory clearable derivative where one or more of the following New Criteria are satisfied with respect to each counterparty in the transaction:
- it is a participant subscribing to the services of a regulated clearing agency for the class of derivative to which the mandatory clearable derivative belongs, or an affiliated entity of such a participant; or
- it is a local counterparty that, together with its local affiliated entities, has an aggregate gross notional amount of more than Canadian $500 Billion in outstanding derivatives, excluding intragroup transactions.
Transactions that meet one or more of the New Criteria will be required to be submitted to a regulated clearing agency by the end of the day of execution, or if executed outside of normal business hours, the end of the following business day.
The Revised Clearing Rule includes three broad exemptions from the clearing requirement described above. First, certain governments, government entities (i.e. crown corporations and other entities whose liabilities are guaranteed by the government) and supra-national organizations (i.e. the Bank for International Settlements and the International Monetary Fund) are excluded from the application of the Revised Clearing Rule.
Second, the Revised Clearing Rule includes an intragroup exemption which applies to affiliated entities or counterparties that are prudentially supervised on a consolidated basis or that prepare financial statements on a consolidated basis. The exemption includes several additional criteria, including that both counterparties agree to rely on the exemption as evidenced in a written agreement, and that the transaction is subject to centralized risk management controls. Furthermore, parties relying on this exemption are required to file a form with the regulator certifying certain information, including that the conditions to the exemption have been satisfied. This form must be filed electronically no later than the 30th day after a local counterparty first relies on the exemption. The CSA indicated that the intragroup exemption is based on the premise that risk created by these transactions should be dealt with in a centralized manner to allow for the risk to be identified and managed appropriately.
Finally, the Revised Clearing Rule includes an exemption for so-called “multilateral portfolio compression exercises” conducted by a third-party provider. In a multilateral portfolio compression exercise, more than two counterparties change or terminate the notional amounts of some or all of their prior transactions, and replace these prior transactions with new transactions, so as to reduce the aggregate notional amount of their transactions. In order to incentivize multilateral portfolio compression exercises, which may have the effect of reducing systemic risk, the CSA has provided an exemption from the clearing requirement for parties who engage in such exercises. The exemption is available where counterparties are changing, terminating and replacing transactions in derivatives that were not mandatory clearable derivatives at the time they were entered into, irrespective of whether such derivatives have since become mandatory clearable derivatives. This exemption was not available under the Initial Clearing Rule.
Determination of OTC Derivatives Subject to Mandatory Central Counterparty Clearing
The second half of the Revised Clearing Rule sets out the CSA’s determination as to which derivatives constitute “mandatory clearable derivatives”. At the outset, the CSA only proposes to classify certain classes of interest rate derivatives (i.e. forward rate agreements and the following interest rate swaps: fixed-to-float swaps, basis swaps, and overnight index swaps) denominated in certain major currencies (i.e. U.S. dollars, Euros, British pounds and Canadian dollars).
In classifying these interest rate derivatives as mandatory clearable derivatives, the CSA indicated that it examined a wide number of criteria including: (i) the standardization of legal documentation for such derivatives; (ii) whether there was sufficient transaction activity in such derivatives to absorb the risk of default of two large participants in a clearing agency; (iii) whether there was sufficient liquidity and market activity for such derivatives to allow for a close out or hedging in a default scenario; and (iv) whether there was fair, reliable and generally accepted pricing information for such derivatives. In addition, the CSA considered publicly available data, derivatives transaction data reported pursuant to trade reporting rules, as well as foreign regulators’ proposals.
With respect to foreign regulations, market participants should note that although the proposed list of mandatory clearable derivatives includes a number of derivatives that are already subject to clearing requirements in foreign jurisdictions such as the United States and Europe, it also includes derivatives that are denominated in CAD, which are not currently subject to a clearing requirement in any foreign jurisdiction. The CSA acknowledged that because the market for interest rate derivatives denominated in CAD involves counterparties outside of Canada, the competitiveness of local counterparties could be negatively impacted by the Revised Clearing Rule if local counterparties are required to clear their transactions and their foreign competitors are not. As a result, the CSA indicated that it would consider delaying the onset of the clearing requirement for interest rate derivatives denominated in CAD, until such time as foreign jurisdictions have adopted a similar clearing requirement.
Similarly, market participants should note that the proposed list of “mandatory clearable derivatives” will apply to all jurisdictions of Canada other than Quebec. A comparable list of mandatory clearable derivatives will be published in Quebec, following a decision by the Autorité des marchés financiers as to the contents of that list.
Summary of Changes to Initial Clearing Rule
The CSA introduced a number of changes in the Revised Clearing Rule, most of which relate to the scope of the clearing obligation. The CSA indicated that its revisions to the scope of the clearing obligation reflected concerns regarding the availability of indirect clearing services, and the inappropriateness of requiring clearing for transactions by smaller counterparties.
Under the Initial Clearing Rule, all transactions by a local counterparty in a mandatory clearable derivative were required to be cleared by a regulated clearing agency, subject to the availability of certain exemptions, including an exemption for certain transactions by non-financial entity end-users entering into such transactions for the purposes of hedging or mitigating commercial risk. Under the Revised Clearing Rule, by contrast, only those transactions where both counterparties to the transaction meet one or more of the New Criteria will be subject to a clearing requirement. Some commentators had noted that it would be difficult for smaller market participants to comply with the Initial Clearing Rule, as those participants would not likely be members of a regulated clearing agency, nor would they likely have access to indirect clearing services, which are not yet widely available in Canada.
The Initial Clearing Rule included an exemption for certain transactions by end-users that were aimed at hedging or mitigating commercial risk. A number of commenters had suggested that this exemption was too narrow insofar as it excluded transactions by small financial entities that are effectively end-users, including smaller pension funds and property and casualty insurers. Other commentators had expressed concern that the notion of hedging or mitigating commercial risk was not adequately conveyed in the Initial Clearing Rule, as there were no definitions or guidance on the meaning of key terms such as “speculating” or “intent to reduce risk”. The CSA indicated that because of the narrowing of the scope of the clearing requirement, an exemption for transactions by end-users was no longer needed, and the exemption from the Revised Clearing Rule has been removed.
The net effect of these proposed changes is that fewer transactions should be subject to a clearing obligation under the Revised Clearing Rule than would have been the case under the Initial Clearing Rule. The CSA suggested that it would continue to monitor developments in international clearing rules and that it would revisit the scope of the Revised Clearing Rule in future, when more market participants may have access to indirect clearing services.
Comments on the Revised Clearing Rule
The CSA has invited comments from the public by May 24, 2016 on six specific questions:
- whether the scope of counterparties subject to the clearing requirement is appropriate in light of the CSA’s determination that various classes of interest rate derivatives denominated in certain major currencies will be mandatory clearable derivatives;
- whether the proposed mandatory clearable derivatives are appropriate for the Canadian market;
- whether any additional risks to the market or regulated clearing agencies would result from the proposed mandatory clearable derivatives;
- whether a transition period should be provided after the Revised Clearing Rule has come into force and before transactions in proposed mandatory clearable derivatives must be cleared;
- whether the proposal to require clearing of CAD-denominated interest rate swaps would have a negative effect on Canadian market participants, absent a corresponding requirement in a foreign jurisdiction; and
- whether the characteristics used to define the proposed mandatory clearable derivatives are adequate, and if not, what other variables should be considered.