As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently released the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 regarding the regulation of OTC derivatives. Specifically, Consultation Paper 91-405 considers the scope and characteristics of a proposed end-user exemption to address market participants that generally only trade to hedge commercial risks. According to the paper, this limited segment of end-users, not systemically important to the market, should be exempted from most of the proposed regulations concerning OTC derivatives. The CSA are accepting comments on the consultation paper until June 15, 2012.

Meeting Requirements

The Consultation Paper considers various criteria for determining who should qualify for the end user exemption. According to the CSA's proposal, an end user would include participants that: (i) trade for their own account; (ii) are not financial institutions; and (iii) hedge to mitigate commercial risks related to the operation of their business or a related affiliated entity or series of legal entities within that affiliated group. End users that otherwise meet the criteria for the exemption may still be found ineligible for the exemption, however, if they are deemed to be "Large Derivatives Participants" considered key participants in the market or whose default would represent a systemic risk to the market. An upcoming consultation paper on registration is expected to consider the thresholds for Large Derivatives Participants. The Committee also specifically rejected including certain criteria in determining whether a participant qualifies as an end-user, including those based on: (i) trade volume or notional dollar values of trades; (ii) sector specific exceptions; and (iii) standardized contracts and clearing.

In considering the definition of "hedging" for the purposes of mitigating commercial risks, the CSA make a number of observations. Specifically, the consultation paper states that the relevant derivatives transactions would have to specifically relate to the risk being hedged and should "reasonably be considered to be a suitable instrument for managing the risk." According to the CSA, the definition of hedging should also include positions that are treated as a hedge for accounting purposes as well as other positions that can be demonstrated to reduce the risk of loss arising from the end-user's business activity.

Ultimately, the CSA cite with approval the definition of hedging accepted by the Committee on Payment and Settlement Systems (CPSS). Generally, the CPSS characterizes hedging as being intended to offset or reduce the risk related to fluctuations in the value of an underlying interest or a position, or to substitute a risk to one currency for a risk to another currency. Under the CPSS definition, the transaction or series of transactions also has to result in a high degree of negative correlation between changes in the value of the underlying interest or position being hedged and changes in the value of the derivatives with which the value of the underlying interests or positions is hedged. According to the CPSS, there must also be reasonable grounds to believe that the transaction no more than offsets the effect of price changes in the underlying interest or position being hedged.

This characterization of hedging, however, assumes that the risk to be hedged will always relate directly to an underlying position or interest. In doing so, the consultation paper ignores activities such as the purchasing of weather derivatives intended to mitigate against the risk of an inclement winter, but that would not directly correlate to an underlying value in frost or snow.

Notification to Regulators

While participants seeking to rely on the end-user exemption would not require formal approval by regulators, they would have to provide notice of an intention to rely on the exemption. This one-time notice would include basic information about the market participant and would only have to be updated if there was a material change in the information.

According to the CSA, the process to be followed by eligible end-users would include attaining approval by the end-user's board of directors of the business plan or strategy authorizing management to use OTC derivatives contracts as a risk management tool. The CSA are silent, however, on how this requirement would apply to non-corporations. The consultation paper also suggests that the business plan would have to be disclosed in order to allow regulators to determine whether there had been compliance with the exemption. According to the consultation paper, these requirements are intended to ensure that the implications of trading OTC derivatives and the implementation of a hedging strategy will be considered by the board and management.

Reporting and Recordkeeping

While end-users would not have to report individual trades to a regulator, the trades would still have to be reported to a trade repository. According to CSA Consultation Paper 91-402, for derivative transactions between non-financial intermediaries, the parties would have to select one of the counterparties to the transaction to be the reporting party.

Considering the breadth of OTC derivatives activity captured, the reporting obligation may prove problematic. For example, is it expected that the obligation to report would capture individuals entering into contracts to hedge against increasing electricity prices, or farmers hedging to protect again inclement weather?

Users of the exemption would also have to maintain records of all trading activity, a record of the board's approval of the use of OTC derivatives and records demonstrating the analysis completed to demonstrate satisfaction of all necessary requirements. The consultation paper, however, does not provide information regarding whether the regulator may inspect the records, or the length of time that such records would have to be maintained.

As stated above, the consultation paper, which includes specific questions for the consideration of commentators, is open for public comment until June 15.