The Canadian Securities Administrators (CSA) have published the final version of proposed National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (the Clearing Rule) and its Companion Policy 94-101 (the Clearing CP) slated to come into effect on April 4, 2017 for clearing participants and October 4 for other parties subject to the rule. The changes from the prior version of the Clearing Rule are relatively minor.

The Clearing Rule applies to direct clearing participants of a regulated clearing agency (and their affiliates) and major swap market participants that are local counterparties (month-end gross notional above CAD 500 billion). For a rule directed primarily at reducing systemic risk, this is a sensible and welcome approach, and one that recognizes that the Canadian market comprises a relatively small part of the global market. Initially, the products mandated to clear will be certain interest rate derivatives and forward rate agreements. In this post we review the main features of the Clearing Rule.

Summary of Changes from Prior Draft

The prior version of the rule applied to affiliated entities of clearing participants. This has been further limited to affiliates that meet a specified notional amount threshold of CAD1 billion of gross notional.

The intragroup exemption is restricted to entities with consolidated financials.

The information required to be reported in order to rely on the intragroup exemption is simplified (ie a single form per group showing each counterparty pairing).

Proposed Basic Clearing Requirement

The basic requirement to submit a transaction for clearing to a “regulated clearing agency” is imposed on a “local counterparty” to a transaction in a “mandatory clearable derivative”, if both parties meets certain counterparty criteria (s. 3(1)).

Counterparty Criteria

The counterparty criteria significantly limit the scope of the clearing requirement.

The clearing requirement applies only if each party at the time of execution meets at least one of the following criteria:

  • a participant subscribing to the services of a regulated clearing agency for a mandatory clearable derivative
  • an affiliated entity of such a participant if its month-end gross notional amount of outstanding derivatives exceeds CAD 1 billion, excluding transactions excluded by the intragroup exemption
  • a local counterparty in any Canadian jurisdiction that meets a specified threshold any time after the Clearing Rule comes into force

The local counterparty test is similar to the definition in the trade reporting rules (s.1(1)), namely one or more of the following describe the counterparty:

  • it is organized under the laws of the local jurisdiction or has it head office or principal place of business in the local jurisdiction, or
  • it is an affiliated entity of such a person and such person is responsible for all or substantially all of its liabilities.

A party may be a local counterparty in more than one jurisdiction. The Clearing CP contains guidance explaining that the regulators are flexible as to how market participants declare their status to each other. An in-scope counterparty should solicit confirmation from its counterparty where there is a reasonable basis to believe it may be near or above the threshold.

The local counterparty threshold is a month-end gross notional amount under all outstanding derivatives of the local counterparty exceeding C$500,000,000,000 in any month after the instrument comes into effect. The local counterparty must include transactions entered into by affiliated local counterparties in the calculation, but not transactions excluded by the intra-group exemption (read on for a description of that exemption).

Entities are affiliated entities if one of them controls the other or each of them is controlled by the same person or company. A trustee is controls a trust, a general partner controls a limited partnership, a 50% or more partner of an ordinary partnership controls the partnership, and the holder of securities sufficient to elect a majority of directors controls a corporation (s.1(3)).

So for example, if a foreign dealer transacts with a Canadian bank, LCH clears the particular mandatory clearable derivative as part of its SwapClear service and both parties are participants in SwapClear, then the rule will apply. Similarly, the rule will apply if an affiliated entity of the foreign dealer is a SwapClear participant, even if the foreign dealer itself is not. The assumption, presumably, is that the foreign dealer can clear through its affiliate. It could also apply if the parties participate in different clearing agencies both of which clear the transaction.

A future iteration of the Clearing Rule may bring other derivatives markets participants into scope.

“Mandatory Clearable Derivative”

The mandatory clearable derivatives will be determined by the local regulatory authority but the intention is uniformity across Canada. They will be published as an appendix to the Clearing Rule. The proposed appendix is

Interest Rate Swaps

Type

Floating

index

Settlement

currency

Maturity

Settlement Currency Type

Optionality

Notional

type

Fixed-to-float

CDOR

CAD

28 days to 30 years

Single currency

No

Constant or variable

Fixed-to-float

LIBOR

USD

28 days to 50 years

Single currency

No

Constant or variable

Fixed-to-float

EURIBOR

EUR

28 days to 50 years

Single currency

No

Constant

or

variable

Fixed-to-float

LIBOR

GBP

28 days to 50 years

Single currency

No

Constant or variable

Basis

LIBOR

USD

28 days to 50 years

Single currency

No

Constant or variable

Basis

EURIBOR

EUR

28 days to 50 years

Single currency

No

Constant or variable

Basis

LIBOR

GBP

28 days to 50 years

Single currency

No

Constant or variable

Overnight

index swap

CORRA

CAD

7 days to 2 years

Single currency

No

Constant or variable

Overnight

index swap

FedFunds

USD

7 days to 3 years

Single currency

No

Constant or variable

Overnight

index swap

EONIA

EUR

7 days to 3 years

Single currency

No

Constant or variable

Overnight

index swap

SONIA

GBP

7 days to 3 years

Single currency

No

Constant or variable

Forward Rate Agreements

Forward rate agreement

LIBOR

USD

3 days to 3 years

Single currency

No

Constant

or

variable

Forward

rate

agreement

EURIBOR

EUR

3 days to 3 years

Single Currency

No

Constant

or

variable

Forward

rate

agreement

LIBOR

GBP

3 days to 3 years

Single currency

No

Constant

or

variable

The CSA has noted that the European Parliament does not currently mandate clearing of CAD interest rate swaps (IRSs), but noted local counterparties complying with European laws under the substituted compliance provision must clear CAD IRS.

Pre-existing Transactions

The Clearing Rule does not apply to transactions that were entered into prior to the Clearing Rule coming into effect. However, if a material amendment is made to a pre-existing transaction, it is novated or assigned or otherwise acquired or disposed of after the rule is in force, then the transaction could be subject to the clearing requirement. A material amendment, according to the Clearing CP, is one that changes information that would reasonably be expected to have a significant effect on the derivative's attributes, including its value, the terms and conditions of the contract evidencing the derivative, transaction methods or the risks related to its use. Several factors would be relevant in this determination, such as whether the modification would result in a large change in the value of the transaction and could result in differing cash flows or creating upfront payments.

Substituted Compliance

There is a substituted compliance regime, but only in limited circumstances (s.3(5)). If the only reason that the transaction has to be cleared is because the local counterparty guaranteed affiliate category applies, then the local counterparty can submit it for clearing under the law of a foreign jurisdiction that is listed in Appendix B of the rule (or in Quebec, on the list published by the AMF). CFTC and ESMA rules regarding mandatory clearing are considered equivalent.

A local counterparty may still be required to clear by the laws of multiple jurisdictions if, for example, it is organized under the laws of Canada, but is subject to a clearing requirement in a country where it conducts business. There is no substituted compliance regime in that case, but an exemption could be applied for if it was not possible to comply with both (if, for example, different clearing agencies are recognized).

Other requirements of the Clearing Rule do apply however, including record keeping. The exemption relates to the submission for clearing only.

Proposed Timelines for Submitting Derivatives for Clearing

The transaction must be submitted for clearing no later than the end of the business day on which it is executed, or the next day if entered into after business hours of the regulated clearing agency (s. 3(2)). The Clearing CP states that the transaction is to be submitted as “soon as practicable”.

There is a transitional period for compliance where the applicable counterparty criteria is based on gross notional amount. In that case the party has 90 days from the date it first met the criteria to begin clearing transactions executed on or after that 90th day (s.3(3)).

Proposed Exemptions

There are four principal proposed exemptions from the clearing requirement. Though there is no end-user exemption, one should not be necessary given the counterparty criteria.

Intragroup Exemption (s. 7)

The clearing requirement does not apply to an "intragroup transaction" if

  • the transaction is between a counterparty and its affiliated entity if their financial statements are prepared on a consolidated basis in accordance with certain acceptable accounting principles (e.g. Canadian or US GAAP, or IFRS for entities with a parent entity in Canada).
  • both parties agree to rely on this exemption,
  • the transaction is subject to a centralized risk management program reasonably designed to assist in monitoring and managing the risks associated with the derivative between the counterparties through evaluation, measurement and control procedures, and
  • there is a written agreement setting out the terms of the transaction between the parties.

To rely on this exemption the local counterparty must submit a Form 94-101F1 Intragroup Exemption to the local securities regulator within 30 days of first relying on the exemption. The form has been clarified so that it only must be delivered once for each pair of counterparties and can apply to all transactions between them. A party must correct inaccuracies within 10 days. The information will be kept confidential generally, but the regulators may require public disclosure of a summary of the information if it considers that disclosure to be in the public interest.

The Clearing CP states that an ISDA Master Agreement between the parties applicable to the cleared transactions would satisfy the written agreement requirement. Other types of transaction agreements are also acceptable. It also warns against abusing the exemption for structuring transactions simply to avoid the clearing requirement.

Government Counterparties (s. 6)

The clearing requirement does not apply if one of the counterparties is the Government of Canada, the government of a province or territory, the government of a foreign jurisdiction (both sovereign and sub-sovereign), a crown corporation for which the government of the relevant jurisdiction is responsible for all or substantially all the liabilities, an entity wholly owned by one or more governments that are responsible for all or substantially all of the entity’s liabilities, the Bank of Canada, a central bank of a foreign jurisdiction, the Bank for International Settlements or the International Monetary Fund.

Multilateral Portfolio Compression (s. 8)

The clearing requirement does not apply to a mandatory clearable derivative that results from a multilateral portfolio compression exercise if:

  • the resulting transaction is entered into as a result of more than two counterparties changing or terminating and replacing existing transactions
  • the existing transactions do not include a transaction entered into after the effective date on which it became a mandatory clearable derivative
  • the existing transactions were not cleared by a clearing agency or clearing house;
  • the counterparties are the same, and
  • the multilateral portfolio compression exercise is conducted by an independent third-party.

Exemptive Relief (s. 11)

The regulatory authorities may grant exemptions in whole or part on application. An exemption granted in one jurisdiction applies in the others (except for Ontario and Alberta).

Record Keeping

A local counterparty relying on the intragroup or compression exercise exemption must maintain for seven years (eight in Manitoba) from the date the transaction expires or terminates, records of all documentation demonstrating that it is eligible to benefit from the relevant exemptions (s. 9(1)). The records must be kept in a safe and durable form. The Clearing CP sets out that the parties should keep full and complete records of any analysis undertaken by the local counterparty relying on the exemption.

Designation of Cleared Derivatives

Clearing agencies will be required to submit electronic information on new clearing services for derivatives or classes of derivatives to the regulator within 10 days after providing the new service (s. 10). Also, prior to May 4, 2017, each regulated clearing agency will be required to submit information for all derivatives it provides services for as of April 4th (s. 12).

Based on this information, the regulators will determine by rule or otherwise which derivatives or classes of derivatives will be subject to the mandatory clearing rule. Regulators may also determine by rule or otherwise which derivatives or classes of derivatives will be subject to the requirements through a top-down approach.

The Clearing CP sets out the factors the regulators will consider (paraphrased):

  • the availability of clearing on a regulated clearing agency;
  • the level of standardization;
  • the effect of central clearing of the derivative on the mitigation of systemic risk;
  • whether the derivative would bring undue risk to the clearing agency;
  • the outstanding notional exposures, liquidity and availability of reliable and timely pricing data;
  • the existence of third party vendors providing pricing services;
  • the existence of an appropriate rule framework, and the availability of capacity, operational expertise and resources, and credit support infrastructure to clear the derivative on terms that are consistent with the material terms and trading conventions on which the derivative is then traded;
  • whether the clearing agency would be able to risk manage the additional derivatives that might be submitted due to the clearing requirement determination;
  • the effect on competition, taking into account appropriate fees and charges applied to clearing, and if the proposed clearing requirement determination could harm competition;
  • alternative derivatives or clearing services co-existing in the same market; and
  • the public interest.

Clearing agencies have a few other obligations:

  • The regulated clearing agency must immediately notify the local counterparty if a transaction has been rejected for clearing (s. 4) and its rules must provide for such notification.
  • A clearing agency is required to post on its website a list of all derivatives and classes of derivatives it clears and identify whether each is a mandatory clearable derivative (s. 5). There must be no cost to access the list and it must be available to the public.

Timing

The rule is slated to come into effect on April 4, 2017 for participants in clearing agencies and October 4, 2017 for their affiliates and local counterparties meeting the thresholds.