On December 6, 2012 the OTC Derivatives Committee of the Canadian Securities Administrators (the Committee) published for interim guidance and comment CSA Staff Consultation Paper 91-301. This is a noteworthy step in the efforts by provincial securities regulators to fulfill Canada’s G-20 commitments to regulate OTC derivatives.
The paper sets out two model provincial rules and accompanying model explanatory guidance pertaining to, firstly, trade repositories and derivatives data reporting (the TR Rule) and, secondly, the determination of products which will be treated as derivatives for purposes of the TR Rule (the Scope Rule). The Committee sets out the implementation process, stating that once comments on the model rules have been considered, they may be modified and then each Canadian jurisdiction will need to publish for comment its own rules, explanatory guidance and appendices with appropriate local modifications. The Committee recognizes that this may result in some differences in the final rules from jurisdiction to jurisdiction, but their stated intention is that the substance of the rules be the same across all jurisdictions and that market participants in derivatives products receive the same treatment throughout Canada.
The TR Rule and Scope Rule are drafted on the basis of the Ontario Securities Act which contains framework provisions for the regulation of the derivatives market, including the activities of trade repositories. The implementation process is complicated by the fact that not all existing securities legislation currently provides an appropriate framework to implement such rules. In the case of Alberta and British Columbia, New Brunswick, Nova Scotia and Saskatchewan, existing securities legislation will need to be amended. In Manitoba and Ontario, only OTC derivatives will be subject to those province’s rules, since exchange-traded contracts are currently subject to their respective Commodity Futures Acts. In Quebec, certain provisions of the Scope Rule would not be applicable as they are already covered by the Quebec Derivatives Act. In addition, since the rules will be implemented on a jurisdiction-by-jurisdiction basis, the timing of their coming into force in various jurisdictions may vary.
The TR Rule reflects proposals contained in CSA’s Consultation Paper 91-402 –Derivatives: Trade Repositories which was released on June 23, 2011. The TR Rule covers two areas: (1) the requirements trade repositories must meet to be designated or recognized by provincial regulators as acceptable entities to which market participants may report their trades, and (2) the reporting obligations of derivatives market participants themselves. The Committee envisages that exemptions from certain requirements may be available for foreign trade repositories that are subject to comparable regulatory regimes in other jurisdictions. In keeping with the objective of harmonizing such legislation with regimes elsewhere, the TR Rule broadly follows the approach taken by the CFTC in Part 49 of its regulations relating to swap data repositories and the international standards set out in Principles for financial market infrastructures published by CPSS and IOSCO.
The TR Rule sets out detailed requirements for an entity to qualify as a designated or recognized trade repository. These focus on, among other things, governance, risk management procedures and record-keeping. In the case of foreign trade repositories, the requirements include providing access to their books and records to Canadian regulators and submitting to the jurisdiction of the Canadian courts. The TR Rule stipulates who is required to report and sets out in its appendix detailed requirements regarding what information is to be reported.
The Scope Rule provides a gloss on the broad definition of “derivative” in the Ontario Securities Act and aims to narrow the range of products that are to be treated as derivatives subject to derivatives data reporting obligations under the TR Rule. The Scope Rule will initially apply for purposes of the TR Rule but, in order to provide flexibility, it may be amended as necessary to apply to other model rules as they are promulgated. The Committee notes that the interpretative guidance provided in the Scope Rule is not intended to alter the guidance provided in existing instruments, for example OSC Staff Notice 91-702 relating to contracts for differences offered in the retail markets.
The Scope Rule sets out several sub-rules to determine whether a product is a “derivative” for purposes of the TR Rule. The first sub-rule lists a variety of derivatives (excluded derivatives) which are to be excluded from the definition of “derivative” appearing in applicable legislation, including transactions which are:
- regulated by gaming control legislation;
- insurance or annuity contract issued by licensed insurers in Canada;
- spot market contracts or instruments for the purchase and sale of currencies or physical commodities which, subject to limited exceptions, involve physical settlement only; and
- evidences of deposit issued by banks, cooperatives, credit unions, caisse populaires or loan and trust corporations.
The explanatory guidance also states that the Committee consider that there are other instruments, such as contracts or instruments which, while not expressly excluded, should not be considered “derivatives” if they are entered into for consumer, business or non-profit purposes that do not include investment, speculation or hedging.
The second sub-rule provides that all investment contracts and over-the-counter options (to the extent that they are not excluded derivatives referred to above) that are derivatives and that are otherwise securities solely by reason of falling under the relevant securities act definitions of “investment contract” or “option”, are prescribed not to be securities. The explanatory guidance indicates that OTC foreign exchange contracts and contracts for differences would fall into this category. Physically-settled OTC options over securities would also be covered provided they are not compensation or financing options referred to below:
The third sub-rule provides that all contracts or instruments (other than any contract or instrument to which the first and second sub-rules above apply) that are securities and are otherwise derivatives are prescribed not to be derivatives for purposes of the TR Rule. This is intended to cover structured notes, ABS, exchange-traded notes and warrants which are to be treated as securities, even if they contain an embedded derivative.
Finally, all contracts or instruments that would otherwise be derivatives (other than any contract or instrument to which any of the above sub-rules apply) are prescribed not to be a derivative if such contract or instrument is used by an issuer or an affiliate of an issuer solely to compensate an employee or service provider or as a financing instrument, and its underlying interest is a share or stock of that issuer or its affiliate.
While those familiar with the nuances of the distribution of legislative powers in Canada will understand why this multi-step approach to implementing a pan-Canadian regulatory regime is being taken, it will no doubt strike observers from the derivatives world outside of Canada as surprisingly complicated and cumbersome. Moreover, the potential for variances between the applicable rules in jurisdictions within Canada, although a boon to lawyers practicing in this area, will likely result in some continued inefficiency in the market (although perhaps less than that caused by the existing patchwork regulatory regime).
The introduction to CP 91-301 indicates that the model rules approach will address existing regulation in other areas (such as the regulation of financial institutions). It remains to be seen how these provincial rules will be integrated into the existing federal regime governing the derivatives activities of Canadian banks, which represent the vast majority of the market.
CP 91-301 will be open for comment until February 4, 2013. The Committee notes that it is looking for specific feedback on section 40(2) of the TR Rule which exempts from reporting requirement transactions in relation to physical commodities if the local counterparty is not a dealer or adviser and has less than $500,000 aggregate notional value, without netting, of outstanding transactions at the time of the transaction, including the additional notional value related to the transaction in question.