Bill C-45 proposes changes to the Payment Clearing and Settlement Act to enhance certainty that clearing house default rules will be enforceable in the event of a clearing member default. These reforms are an important aspect of financial markets reforms that provide incentives for and, in some cases, require standardized OTC derivatives to be cleared. The proposed changes will do two things: (1) they will enhance the stability of the clearing house itself by ensuring it can quickly apply its default rules as against a defaulting member and (2) they will enhance client protections by ensuring that the clearing member’s insolvency will not impede the transfer to new clearing members of client positions.
Part I of the PCSA applies to clearing and settlement systems that are designated by the Bank of Canada (under section 4) as systemically important in Canada. It involves some regulatory oversight as well as protection for the system rules. This part of the Act was drafted with securities and payment clearing and settlement systems in mind, not OTC derivatives clearing systems. Consequently, the definitions used are in some respects deficient for application to a derivatives clearing system. Derivatives clearing systems will inevitably become systemically important in Canada, so the Bank must have a clear power to designate them where appropriate and the rules which support the financial stability of such systems must be fully effective. That means, in part, being able to deal quickly with defaulting clearing members.
Section 13 of Part II provides a blanket safe-harbour for rights to terminate, net and deal with financial collateral for EFCs and a right to terminate and net under other non-EFC netting agreements.
Section 13.1 of Part II allows for designation by the Minister of Finance of securities and derivatives clearing houses in order to provide protection for certain of their rules regarding defaulting members. Such clearing houses are not necessarily systemically important in Canada, but Canadians have an interest in ensuring that the clearing systems Canadian entities participate in are also financially stable so there will be public policy reasons to designate them and thereby protect the enforceability of their default rules.
The proposed amendments affect each of these three aspects of the PCSA.
Designated Clearing and Settlement Systems
With respect to Part I, the new definitions of “clearing and settlement system” and “clearing house” remove the uncertainties around the application section 4 derivatives clearing systems. Systems with connections to Canada – clearing in part in Canadian dollars and involving Canadian participants – can be designated.
Section 8(1) of the PCSA protects actions taken in accordance with the settlement rules. This is a broad protection for default processes as the definition of settlement rules includes rules for taking acting in the event that a participant is unable or likely to become unable to meet its obligations to the clearing house.
The amendments will further clarify the definition of “settlement rules” to include rules regarding delivery obligations and other property transfers in order to cover physical settlement and presumably collateral transfers.
Section 8(1)(c) of the PCSA currently provides for finality of “payments” made under the settlement rules of a designated system notwithstanding any statute or law of Canada or a province. This will be extended to cover deliveries or transfers of interests in property in order to ensure that transfers of collateral or physical settlements cannot be reversed, repaid or set aside.
However, these protections will not be sacrosanct where a bridge bank is incorporated. New section 8(3.1) will prevent termination, netting or collateral enforcement with respect to an eligible financial contract (EFC) if that action is prevented by the new temporary bridge bank stay in the CDIC Act (39.15(7.01)), the conditional bridge bank stay (39.15(7.1)), the inability to rely on contractual rights that allow actions prevent by the two stays (39.15(7.11)) or the stay that applies where EFCs have been assumed by a bridge institution (39.152). See our blog piece of today on the CDIC Act amendments. (However, the temporary bridge bank stay does not prevent close-out by the clearing house as there is an exemption for section 4 designated clearing and settlement systems in CDIC Act 39.15(7.02); what section 8(3.1) is referring to with respect to the temporary bridge bank stay is not entirely clear to me - yet.)
Section 13.1 Designated Clearing Houses
Only a few changes are proposed for section 13.1, which is the protection for certain rules of a clearing house designated under the section.
Currently the section provides that no insolvency law or order has the effect of interfering with the rights or remedies of a securities and derivatives clearing house in respect of any collateral that has been granted to it “to secure the performance of obligations by a clearing member”. This protection will be framed more broadly to apply to collateral granted as security for the performance of “an obligation incurred in respect of the clearing and settlement services provided by the securities and derivatives clearing house” (section 13.1(1)(b)). Presumably the obligation secured could be the obligation of a clearing member’s customers or other participants in the system (for example contributions to default funds that mutualize risk of other clearing members defaulting).
The amendments will also clarify that the bridge institution provisions of the CDIC Act prevail over the section 13.1 protections.
These amendments do not seem to go so far as to provide any express protection for porting client positions to new clearing members where the porting process does not involve termination of the cleared transactions. Protecting rights and remedies with respect to collateral is not enough to protect a right to transfer open transactions from a defaulting clearing member to a new clearing member. The broader protection for the enforceability of the settlement rules in Part 1 would provide that type of protection for a section 4 designated clearing and settlement system.
Section 13 Netting Agreement Protections
Section 13 of the PCSA provides a general overriding protection for eligible financial contracts and other netting agreements between financial institutions against any enforcement impediments imposed by insolvency laws. In addition to clarifying some of the wording in the protection, the amendments clarify that the bridge bank provisions of the CDIC Act prevail over this protection, expand the class of financial collateral that benefits from the protections and expands the definition of netting agreement. To a certain extent these amendments are intended to create additional legal certainty around client clearing.
Expanded Classes of Financial Collateral
The EFC safe-harbours exempt any dealing with “financial collateral” from statutory or court ordered stays (subject to the bridge bank provisions). The definition of “financial collateral” will be expanded to include an “assignment of a right to payment or delivery against a clearing house”. (Presumably this really means the “right to payment or delivery against a clearing house” since “assignment” is a reference to the means of taking the collateral not a description of the collateral itself.) This amendment is designed as a client protection. In some principal model clearing systems the clients of a clearing member take an assignment of the clearing member’s payment right against the clearing house (which essentially will relate to the repayment of surplus collateral) as collateral for the clearing member’s obligations to the client under the cleared transactions. In order for the clients to be certain that their positions can be transferred to a new solvent clearing member they require an unimpeded right to realize on this payment right in order to direct its transfer to the new member.
Further, additional classes of financial collateral can be prescribed by regulation. This would allow designation of precious metals for example.
Expansion of Netting Agreement Definition
Currently the PCSA netting protection in section 13 applies to agreements between financial institutions that are EFCs or that provide for netting of payment obligations. This will be extended to such agreements “between a participant (a member of a clearing house) and a customer to which the participant provides clearing services”. Participants are likely to be financial institutions so essentially this brings within the section 13 protections EFCs with clearing customers that are not financial institutions.