The Canadian Securities Administrators (CSA) recently published National Instrument 94-102 – Derivatives: Customer Clearing and Protection of Customer Collateral and Positions and the related Companion Policy (collectively, the Rule). The CSA released the Rule in conjunction with its release of National Instrument 94-101 – Mandatory Central Counterparty Clearing of Derivatives (see our January 2017 Blakes Bulletin: Canadian Regulators Finalize Mandatory OTC Derivatives Clearing Rules).
The Rule aims to ensure that the clearing of over-the-counter (OTC) derivatives is carried out by clearing intermediaries (CIs) and regulated clearing agencies (RCAs) in a manner that protects the positions and collateral of their customers. The Rule will only apply to CIs and non-Canadian RCAs in respect of their clearing of OTC derivatives for Canadian local customers (Local Customers).
There is currently no RCA located in Canada that clears the OTC derivatives products covered by the Rule (the Canadian Derivatives Clearing Corporation clears certain exchange-traded derivatives and options, not OTC products).
Given that the market infrastructure for clearing OTC derivatives is largely concentrated outside of Canada, the CSA have sought to minimize overlapping regulatory requirements by including a broad substituted compliance regime in the Rule. The Rule’s substituted compliance provisions will generally allow non-Canadian CIs and non-Canadian RCAs that are clearing transactions of Local Customers to avoid the application of certain of the Rule’s requirements that are duplicative of, or overlap with, foreign regulatory requirements, provided they follow the U.S. or EU rules specified by the CSA.
Substituted compliance with U.S. or EU rules cannot, however, be relied upon to satisfy all of the Rule’s requirements. There are record retention and reporting requirements that all CIs and RCAs clearing for Local Customers will need to observe, and CIs and RCAs that comply with EU rules but not U.S. rules will also be subject to the Rule’s requirements in respect of initial margin and the use of customer collateral.
The Customer Protection Rule will come into force on July 3, 2017.
WHO IS SUBJECT TO THE RULE?
The Rule applies to RCAs, which are defined as clearing agencies that are either recognized or exempt from recognition as clearing entities under applicable provincial securities laws. In Ontario, British Columbia and Manitoba, an RCA is defined as a person or company recognized or exempt from recognition as a clearing agency under the securities laws of that province. In the remaining provinces and three territories, an RCA is a person or company recognized or exempt from recognition pursuant to the securities legislation of any jurisdiction in Canada.
To act as a CI, a firm must be an eligible Canadian financial institution, a registered Canadian dealer or a foreign firm acting for a Local Customer that is prudentially regulated and subject to clearing and customer collateral requirements of either Belgium, France, Germany, Ireland, Japan, Netherlands, Singapore, Switzerland, United Kingdom, the U.S. and, in respect of Euro-denominated derivatives, all other Eurozone countries.
CIs are categorized under the Rule as either direct intermediaries that are participants of RCAs and who clear for customers directly or indirect intermediaries that clear for the ultimate customer through a direct intermediary.
This bulletin focuses on the obligations of direct intermediaries and RCAs, but indirect intermediaries have obligations that are analogous to those of direct intermediaries.
In order to implement the Rule, non-Canadian RCAs and non-Canadian CIs will need to identify which of their customers are Local Customers for purposes of the Rule. Rule will only apply to non-Canadian RCAs to the extent they are clearing OTC derivatives for Local Customers. All CIs (both Canadian and non-Canadian) are only subject to the Rule for clearing services they provide to Local Customers. A Local Customer is an individual resident in Canada or a person or company (other than an individual) that is organized under the laws of a Canadian jurisdiction or has its head office or principal place of business in Canada.
The Rule defines OTC derivatives by reference to the same product scope rules that determine which instruments are in-scope for OTC derivatives reporting obligations in Canada. However, in response to industry comments and to ensure consistency with EU and U.S. rules, the CSA have excluded OTC options on securities from the final Rule. The Rule applies to OTC derivatives cleared on behalf of Local Customers whether those transactions are cleared voluntarily or pursuant to a mandatory clearing requirement.
Customer Collateral Treatment
The Rule requires RCAs and CIs to segregate customer positions and collateral to ensure they are identifiable in the event of a CI default. However, segregation does not prevent the use of omnibus customer accounts as long as customer collateral is segregated on a recordkeeping basis that allows the positions and the value of collateral of each customer to be identified. This is consistent with the legally segregated, operationally commingled approach used by U.S. registered futures commission merchants. Customer collateral cannot be commingled with the property or proprietary positions of a CI or RCA or with any property other than clearing customer collateral.
Customer collateral must be held in an account with a permitted depository and the account must be clearly identified as for the benefit of customers only. A permitted depository includes an RCA as well as CIs and other financial institutions that meet the Rule’s requirements. The Rule includes detailed requirements regarding the identification and recording of excess margin, the calculation and collection of initial margin, the investment of customer collateral and the liens that may be created over customer collateral and positions.
Other than collateral in excess of what is required by an RCA, collateral collected for OTC cleared derivatives may only be used to margin, guarantee, secure, settle or adjust the cleared derivatives of a customer. Absent exemptive relief, this limitation will prevent CIs and RCAs from cross-margining cleared OTC derivatives with other products.
The Rule imposes detailed recordkeeping and record retention requirements on RCAs and CIs. Among other requirements, RCAs and CIs must record and make available on each business day the amount of collateral they require from each customer, the name of each permitted depository at which collateral is held, and the current value of that customer’s collateral (including accruals, gains/losses, charges and any distributions or transfers). RCAs must record the same information for each direct CI from which it has received customer collateral. RCAs and CIs must also keep a detailed record of every investment of customer collateral and each currency conversion related to customer collateral.
The record retention requirements in the Customer Protection Rule apply broadly to the recordkeeping, reporting and disclosure obligations under the Rule. RCAs and CIs are required to keep records, including supporting documents, in a readily accessible and safe location and in a durable form. CIs must keep records and documentation related to a specific cleared derivative for a period of seven years (eight years in Manitoba) following the date on which that cleared derivative expires or is terminated or seven years (eight years in Manitoba) following the date the last OTC derivative cleared by that customer through that CI expires or is terminated. RCAs are only required to keep records and documentation related to a specific cleared derivative until that cleared derivative expires or is terminated. As the record retention requirements in the Rule are not eligible for substituted compliance, RCAs and CIs will need to carefully review their existing record retention requirements to ensure they satisfy the new Rule.
The Rule also contains a number of disclosure requirements. RCAs must provide disclosure to CIs about the RCA’s rules governing the segregation and use of customer collateral, the potential impact of bankruptcy laws in the event of a CI default and the availability of enforcement rights. CIs are required to provide these disclosures to their clearing customers. In addition, CIs are required to provide separate written disclosure to their customers regarding the treatment of customer collateral not held at an RCA. RCAs and CIs that invest customer collateral must also provide disclosure to customers about their investment policies and guidelines. Disclosure of rules, policies and guidelines is only necessary upon the opening of each customer account, not prior to each cleared derivative transaction.
A CI must make available to customers a report at least daily setting out the value of each OTC derivatives position, the current value of customer collateral held by the CI, and the current value of all customer collateral that is posted with an RCA or another CI. Where a customer is clearing through an indirect CI, the direct CI must make the same information available to the indirect CI.
Any RCA or CI that receives customer collateral must electronically submit to the applicable securities regulator, within 10 business days of the end of each calendar month, a prescribed form that details the customer collateral held by it for Local Customers in that jurisdiction.
Reporting by RCAs and CIs to Each Other
CIs must provide RCAs with sufficient information to identify each customer and, on a daily basis, the customer’s positions and the current value of the customer’s collateral.
RCAs must report to direct CIs at least daily the current value of each customer OTC derivatives position, the current value of the customer collateral, the total current value of the customer collateral held at a permitted depository and the location of such permitted depositories.
Transfer of Positions
The Customer Protection Rule requires RCAs and CIs to transfer customer collateral and positions both at the request of a customer and in the event of a CI default. Upon a customer request, the RCA and direct CI are required to transfer the customer’s positions and collateral to another CI if: the customer has consented to the transfer, the customer’s account is not in default, all positions (both transferred and remaining) will have appropriate margin at both the receiving and transferring CI, and the receiving CI has consented to the transfer.
Upon the default of a direct CI, the RCA and CI are required to facilitate a transfer of the positions and collateral, or their liquidation proceeds, to one or more non-defaulting direct intermediaries, and they are to make reasonable efforts to ensure that the transfer is facilitated in accordance with the customer’s instructions.
To minimize the burden of duplicative regulatory requirements, the CSA have allowed non-Canadian RCAs and non-Canadian CIs to comply with comparable U.S. and EU requirements in lieu of most of the Rule’s requirements. The specific U.S. and EU requirements that must be met to be eligible for substituted compliance are contained in Appendix A to the Rule.
As a result of this substituted compliance regime, most of the Rule will not apply to futures commission merchants and derivatives clearing organizations located in the U.S., provided that they clear OTC derivatives for Canadian customers on RCAs in accordance with the applicable Commodity Futures Trading Commission (CFTC) regulations. Any exemptions or discretionary relief granted to a CI in connection with CFTC regulations would not extend to the Rule’s substituted compliance framework and the CI would therefore need to apply to the relevant Canadian regulatory authority for an equivalent exemption. Similarly, CIs and RCAs that adhere to the European Market Infrastructure Regulation requirements applicable to central counterparties and clearing members are permitted to follow the EU requirements identified by the CSA when clearing for Local Customers. However, there are residual provisions of the Rule that RCAs and CIs must comply with even when relying on substituted compliance. Those residual provisions are also set out in Appendix A and can be summarized as follows:
- CIs relying on substituted compliance must comply with record retention requirements and the reporting of certain customer information to regulators and customers
- CIs complying with EU rules must also comply with the Rule’s restrictions on the use of customer collateral and certain restrictions on liens that may be taken on customer collateral and positions
- RCAs relying on substituted compliance must comply with record retention requirements and the reporting of customer collateral information to regulators and direct CIs
- RCAs complying with EU rules must collect initial margin on a gross basis as required under the Rule and comply with its restrictions on the use of customer collateral and certain restrictions on liens that may be taken on customer collateral and positions