Proposed Model Provincial Rule on Customer Clearing and Protection of Customer Collateral and Positions (the “CustomerClearingRule”) and proposed related explanatory guidance were published by the Canadian Securities Administrators (the “CSA”) as CSA Staff Notice 91-304 on January 16, 2014. The Customer Clearing Rule, together with the proposed Model Provincial Rule on Mandatory Central Clearing of Derivatives (“Central Clearing Rule”) that was published by the CSA as CSA Staff Notice 91-303 on December 19, 2013, form the basis for the proposed Canadian rules relating to central counterparty clearing. BLG’s Client bulletin on the Central Clearing Rule. The comment period for both of these rules ends on March 19, 2014. Following the comment period, provincial rules will be published that address any unique provincial feature. However, the intent is that, to the greatest extent possible, the provincial rules will be harmonized with international standards and will be consistent across Canada.

The purpose of the Customer Clearing Rule is to ensure that customer clearing is done in a manner that protects customer collateral and positions  and improves derivatives clearing agencies’ resilience to a clearing member default. The Customer Clearing Rule does not provide for a detailed explanation of customer clearing; however, readers can refer to CSA Consultation Paper 91-404 Derivatives:SegregationandPortability in OTC Derivatives Clearing.

The Customer Clearing Rule contains requirements for the treatment of customer collateral by clearing members, clearing intermediaries and derivatives clearing agencies, including requirements relating to the segregation and use of customer collateral. These requirements are intended to ensure that customer collateral is protected, particularly in the case of financial difficulties of a clearing member or clearing intermediary. The Customer Clearing Rule includes detailed record-keeping, reporting and disclosure requirements intended to ensure that each customer’s collateral and positions are readily identifiable. It also contains requirements relating to the transfer or porting of customer collateral and positions intended to ensure that, in the event of a clearing member default or insolvency, customer collateral and positions can be transferred to one or more non-defaulting clearing members without having to liquidate and re-establish the positions.

The Central Clearing Rule defines “clearable derivative” as “a derivative that is determined by the [applicable local securities regulator] to be subject to the clearing requirement in accordance with [this Rule/ section x of the Act]” and the definition of “cleared derivative” in the Customer Clearing Rule is “a transaction that is cleared by a derivatives clearing agency”. At this point, neither rule specifies what derivatives will be required to be cleared. If the regulatory regime in Canada follows other global derivative reform legislation, we would expect that, at least initially, clearable derivatives will likely include many types of interest rate and credit default swaps.

The guidance to the Customer Clearing Rule describes the two situations in which a party to  a cleared derivatives transaction is considered to be a “customer” for the purposes of the Customer Clearing Rule: where the customer is located in the applicable Canadian province and where the derivatives clearing agency or the party providing clearing services to a foreign party is located in a Canadian province. For example, if a derivatives dealer located in Ontario provides clearing services to a foreign party, it would be required to treat the foreign party as a customer. The Canadian Securities Administrators OTC Derivatives Committee (the “Committee”) confirms that a clearing member is not considered to be a customer where it transacts with its derivatives clearing agency.

The Committee expects that, subject to any available exemption, both a clearing member and  a clearing intermediary offering clearing services to a customer will be required to register as a derivatives dealer. CSA Consultation Paper 91-407 – Derivatives:Registration, outlines the recommended business trigger for determining whether a person is in the business of trading in derivatives.

The Customer Clearing Rule does not address the treatment of customer collateral under bankruptcy legislation in Canada, although it does recognize the impact that such legislation may have on the proposed collateral arrangements. At this point,  the Committee addresses the issue through disclosure, requiring a derivatives clearing agency to provide written disclosure to its clearing members about the impact of laws, including bankruptcy and insolvency laws, on the clearing agency’s ability to fully segregate or transfer customer collateral. Clearing members are then required to provide this disclosure to their clearing intermediaries and customers. In addition, clearing members and clearing intermediaries are also required to provide written disclosure to their customers outlining the treatment of excess margin in the event of a default by the member or intermediary. We would suggest that in order to fully protect customer collateral, changes should be made to existing bankruptcy legislation.

Similarly, the CSA will need to amend the derivative provisions found in National Instrument 81-102 – Mutual Funds to conform to the requirements in both the Central Clearing Rule and the Customer Clearing Rule.