Canadian Securities Administrators (CSA) Consultation Paper 91-405 Derivatives: End-User Exemption sets out the position of the CSA's Derivatives Committee (Committee) on the application of an end-user exemption for the various proposed regulatory requirements aimed at the over-the-counter (OTC) derivatives market. Subsequently, the CSA issued CSA Staff Notice 91-303 Proposed Model Provincial Rule on Mandatory Central Counterparty Clearing of Derivatives (Proposed Clearing Rule) which includes an end-user exemption. The following provides an overview of the consultation paper and discusses the end-user exemption in the Proposed Clearing Rule.
In the consultation paper, the Committee notes that some of the new regulatory requirements being considered for the OTC derivatives market such as registration, trading, clearing, capital and collateral, would not be appropriate for certain market participants because:
- the impact of the increased regulatory requirements may make it cost prohibitive and burdensome for end-users to use OTC derivatives to hedge or mitigate risks associated with their businesses; and
- the objective of reducing systemic risk may not be advanced.
The Committee notes in the consultation paper that the intention of the end-user exemption is to provide exemptions to market participants on the basis that such market participants are not in the business of trading derivatives and are not systemically important to the market. However, such exemption would not relieve the obligation of such end-users to report trading activities to a trade repository.
The consultation paper sets out the following eligibility criteria for the end-user exemption:
- the market participant must be trading for its own account;
- the market participant must not be a financial institution or a registrant or affiliate of a registrant; and
- the activities of the market participant in the OTC derivatives market must be aimed at hedging, i.e., mitigating commercial risks related to the operation of its business, and not speculation.
The consultation paper also discusses whether the end-user exemption may be available either outright or on an ad hoc basis in circumstances where the OTC derivative hedging activities are done within one legal entity to hedge business risks of a related affiliated entity or series of legal entities within that affiliated group. It also notes that end-user exemption may not be available to certain end-users who conduct trading activity for their own account, primarily for the purpose of mitigating commercial risk, when the end-user is a key participant in the market or, because of the size or significance of their trading in relation to the overall market, in circumstances where the end-user's default would represent a systemic risk to the market. Such market participants would be considered large derivatives participants that would not be eligible for the exemption.
The consultation paper notes that the Committee believes that market participants relying on the end-user exemption should be required to maintain full and complete records of all trading activity, a record of the board of director's approval of the use of OTC derivatives as a risk management tool, and records demonstrating what analysis was done by the end-user to demonstrate it satisfies the requirements necessary to rely on the end-user exemption.
Proposed Clearing Rule End-User Exemption
The Committee's first use of the end-user exemption concept is in the Proposed Clearing Rule. The Proposed Clearing Rule proposes to require local counterparties to a transaction in a clearable derivative to clear the derivatives transaction through a clearing agency unless an exemption is available. A clearable derivative is a derivative that is determined by the securities regulator to be subject to the clearing requirement under this proposed rule.
One of the proposed exemptions to the mandatory clearing requirement under the Proposed Clearing Rule is based on the end-user exemption concept. The end-user exemption as currently proposed would be available if one of the counterparties to the transaction is not a financial entity and is entering the transaction to hedge or mitigate commercial risk related to the operation of its business. Hence to be eligible for the end-user exemption under the Proposed Clearing Rule, the following two requirements must be met by one counterparty:
- the counterparty must not be a financial entity; and
- the transaction is entered into by that counterparty for hedging purposes.
The term "financial entity" is defined in the Proposed Clearing Rule to include typical financial institutions such as banks, trust companies, insurance companies, credit unions and pension funds. However, it also includes entities that are subject to registration requirements under securities legislation of a jurisdiction in Canada or any other jurisdiction. This financial entity restriction raises general concerns regarding the availability of the end-user exemption. The end-user exemption would not be available to all types of securities registrants whether or not the registrant is registered as a derivatives dealer. It would also exclude market participants that have been granted exemptions from the registration requirements under securities laws.
Given the CSA's proposal to impose registration requirements on derivatives dealers (see CSA Consultation Paper 91-407 Derivatives: Registration (CP 91-407)), the exclusion of registrants would include derivative dealers, i.e. entities engaging or holding themselves out as engaging in the business of trading in derivatives as principal or agent. Unfortunately, the current definition of derivatives dealer as discussed in CP 91-407 is very broad and may capture many counterparties that may not consider themselves to be in the business of trading in derivatives. For a further discussion of derivatives dealer, see Canadian Securities Administrators CSA Consultation Paper 91-407 Derivatives: Registration.
The broad nature of the restriction on the end-user exemption through the definition of "financial entity" may result in an extension of derivatives regulation requirements to entities that are not the target of regulation. Further clarity is needed to provide some certainty that end-user exemption is available to those market participants for which the regulator requirements would not be appropriate.
The second requirement that must be met for the end-user exemption to be available is that the counterparty must be entering the transaction for hedging purposes. The Proposed Clearing Rule contains an interpretation of hedging. To constitute hedging, each of the following must be satisfied:
- the derivative establishes a position which is intended to reduce risks relating to the commercial activity or treasury financing activity of the counterparty or of an affiliate, and, alone or in combination with other derivatives, directly or through closely correlated financial instruments meets any of the following tests:
- that derivative covers the risks arising from the change in the value of assets, services, inputs, products, commodities or liabilities that the counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business;
- that derivative covers the risks arising from the indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in the paragraph above, resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risks;
- the derivative position is not held for any of the following reasons:
- for a purpose that is in the nature of speculation;
- to offset or reduce the risk of another derivative transaction, unless that other position itself is held for the purpose of hedging or mitigating commercial risk.
The proposed model explanatory guidance that accompanies the Proposed Clearing Rule provides the following helpful guidelines:
- A market participant would not be precluded from relying on the end-user exemption if a perfect hedge is not ultimately achieved.
- Use of multiple transactions as a hedging strategy would not in itself preclude an end-user from relying on the exemption and an end-user may be able to rely on the exemption even where some of the transactions could be interpreted as not being a hedge, as long as there is a reasonable commercial basis to conclude that such transactions were intended to be part of the end-user's hedging strategy.
- Speculative transactions using derivatives would not prevent a market participant from relying on the end-user exemption for a transaction that would meet the interpretation of hedging or mitigating commercial risk.
However, the proposed model explanatory guidance also notes the need for counterparties to develop policies and procedures to ensure that supporting documents are retained in respect of transactions for which the end-user exemption will be relied on. That documentation may be necessary to prove to regulators that the end-user exemption was available, e.g. the derivatives transaction was entered into for hedging purposes. Hence, it appears that end-users will need to incur significant costs to develop policies and procedures and maintain records to prove that the exemption was available, somewhat defeating the purpose of the exemption of reducing costs of compliance.
Although the Committee acknowledges the need for an end-user exemption, the exclusion of market participants that meet the definition of "financial entity" may significantly limit the availability of the exemption. Hence, many market participants may find that despite the availability of the end-user exemption, they will be subject to the new derivatives regulations which will likely impact their business. One hopes that the CSA will carefully consider the breadth of the restrictions on the availability of the exemption and reduce its expansive nature. In addition, the requirement to have policies and procedure and keep records to prove the end-user exemption was available will increase costs for end-users contrary to the goal of the exemption. In some cases, this may result in end-users restricting their use of derivatives, which may not necessarily be the best course of action for the end-user from a risk mitigation perspective.