On 18 April 2013 the Canadian Securities Administrators (“CSA”) Derivatives Committee (the “Committee”) published the CSA Consultation Paper 91-407 Derivatives: Registration (“CSA Consultation Paper 91-407”) requesting comment. According to the Committee, CSA Consultation Paper 91-407 is intended to provide an overview of the Committee’s proposal for the regulation of key derivatives markets participants through the implementation of a registration regime.
This statement by the Committee as its executive summary in the Notice/News Release introducing CSA Consultation Paper 91-407 gives the impression that there had been dialogue and engagement with stakeholders along the way to these proposals and input from market participants had been sought by the Committee. However, the fact is, the proposals in CSA Consultation Paper 91-407 is the Committee’s first consultation/publication introducing the discussion for the regulation of key derivatives market participants through the implementation of a registration regime.
For this reason, to provide an overall assessment of CSA Consultation Paper 91-407, it is important to first ask the following questions:
- Does the CSA Consultation Paper 91-407 align with supporting Canada meet its G20 commitments to reform the over-the-counter (“OTC”) derivatives market to improve transparency, mitigate systemic risk, and protect against market abuse or does it go further than the objectives enumerated by the Canadian OTC Derivatives Working Group (the “Working Group”)1, chaired by the Bank of Canada, as published on 26 October 2010 in the Discussion Paper: Reform of Over-the-Counter (OTC) Derivatives Markets in Canada2 (the “Discussion Paper”)?
- What is the rationale behind CSA Consultation Paper 91-407 and what issues is the CSA Consultation
Paper 91-407 intending to address?
These initial questions will be discussed in turn below. Following this discussion, this assessment will briefly summarize CSA Consultation Paper 91-407, investigate CSA Consultation Paper 91-407 and highlight the questions posed by the Committee regarding its proposals.
Does the CSA Consultation Paper 91-407 align with supporting Canada meet its G20 commitments to reform the OTC derivatives market?
In the Discussion Paper, the Working Group set out preliminary recommendations for implementing Canada's G20 commitments related to OTC derivatives and the recommendations covered five areas of reform, as follows: i) capital incentives and standards; ii) standardization; iii) central counterparties and risk management; iv) trade repositories and v) trading venues. Before making these five recommendations, the Working Group stated that it viewed the initiatives for reform of OTC derivatives markets contained in the G20 commitments3 as important to the resilience and stability of the Canadian financial system and concluded that these five recommendations would be enough to implement all elements of the G20 commitments. Specifically, the Working Group stated that “reforms should be designed with a view to their potential unintended adverse consequences, including those associated with regulatory arbitrage”.
Nowhere in the Discussion Paper did the Working Group mention or discuss the need to regulate key derivatives market participants through the implementation of a registration regime.
On 2 November 2010, the Committee published its first Consultation Paper 91-401 on Over‐the‐Counter Derivatives Regulation in Canada4 (“CSA Paper 91-401”). CSA Paper 91-401 set out high-level proposals for the regulation of OTC derivatives. In CSA Paper 91-401, the Committee did not discuss the issue of the applicability of registration exemptions and the scope of registration requirements was not covered in CSA Paper 91-401. The Committee stated that it will be the subject of future consultation.
It is baffling that though the Working Group did not mention or discuss a need to regulate key derivatives market participants through the implementation of a registration regime in the Discussion Paper and the Committee postponed discussing the applicability of registration exemptions and the scope of registration in its over-arching paper CSA Paper 91-401 until after further consultations, the Committee has now published CSA Consultation Paper 91-407 with recommendations of implementing a registration regime for key derivatives market participants.
What is the rationale behind CSA Consultation Paper 91-407?
In its previous consultation papers for the regulation of OTC Derivatives, the Committee explained the rationale of each of the consultation papers by either citing that it is an important component of derivatives market reform, or that it supports Canada’s G20 commitments.
The Committee stated in CSA Consultation Paper 91-407 that in developing this paper, it considered rules and proposals specific to the regulation of key derivatives market participants in a number of foreign jurisdictions, particularly the United States (“U.S.”) and Europe and in addition, the Committee stated that it had considered the existing CSA registration regime for securities as well as existing regulatory requirements applicable to derivatives market participants in each CSA jurisdiction. What the Committee did not state or clarify was the rationale behind its proposals in CSA Consultation Paper 91-407.
To track the Committee’s rationale behind its proposals in CSA Consultation Paper 91-407, the Committee’s statements in Consultation Paper 91-401 must be revisited. In CSA Paper 91-401, the Committee outlined its proposals relating to the regulation of OTC derivatives in Canada, “including proposals to impose obligations on certain participants in the OTC derivatives market”. The Committee went further and said “to implement those regulatory proposals the Committee believes that it is necessary to impose registration requirements on key derivatives market participants (including participants that represent significant risks to the market because of their derivatives exposure and persons in the business of trading in derivatives or providing advice in relation to derivatives). These requirements, to the degree practical, should be harmonized across all CSA jurisdictions and impose requirements that will not result in an unnecessary regulatory burden”.
Since the Committee has stated that it believes it is necessary to impose registration requirements on key derivatives market participants (including participants that represent significant risks to the market because of their derivatives exposure and persons in the business of trading in derivatives or providing advice in relation to derivatives), it would be logical that the Committee, in order that its regulation does not result in an unnecessary regulatory burden for market participants, would have explained why it believes it is necessary to impose registration requirements on key derivatives market participants and clarify what it considers to represent significant risks to the market because of their trading exposure and further define what constitutes the business of trading in derivatives or providing advice in relation to derivatives.
The Committee did not provide any explanation for believing that it is necessary to impose registration requirements on key derivatives market participants. It only went on to state that CSA Consultation Paper 91-407 provides an overview of its proposal for the regulation of key derivatives market participants through the implementation of a registration regime and this gives the impression that a discussion of the rationale (i.e. consultation) has already occurred and the Committee is now appropriately mandated to take the next steps and outline its proposals related to the implementation of a registration regime.
The first logical reaction of Canadian derivatives market participants to this statement is when did this consultation and discussion take place? The second logical reaction is, what is the need for this registration regime and why is not stated in the paper?
To answer these questions, we suggest looking to the Discussion Paper wherein it is stated; “Reforms” [to the OTC derivatives market] “are therefore important to i) reduce systemic risk, ii) improve market efficiency, and iii) improve market integrity and investor protection”. To reiterate, the Working Group stated that “reforms should be designed with a view to their potential unintended adverse consequences, including those associated with regulatory arbitrage”.
The questions for the Committee are then as follows: Are the proposals in CSA Consultation Paper 91-407 important to reduce systemic risk, improve market efficiency and improve market integrity and investor protection? And if so, are they the underlying reasons why the Committee believes imposing registration requirements on key derivatives market participants are necessary? Do they support Canada’s G20 commitments?
If the Committee can answer these questions in the affirmative, the next question is then: Have they designed the proposals in CSA Consultation Paper 91-407 with a view to their potential unintended adverse consequences, including those associated with regulatory arbitrage?
As a point to note, in the background of CSA Consultation Paper 91-407, the Committee stated that it considered the rules and regulations in other foreign jurisdictions such as the U.S. and Europe to develop the paper and it begs the question if the Committee reviewed the rationale behind the rules and proposals of these foreign jurisdictions before developing the proposals in this paper.
The U.S. Dodd–Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) established a statutory framework to reduce risk, increase transparency and promote market integrity within the U.S. financial system by, among other things:
- providing for the registration and regulation of swap dealers and major swap participants;
- imposing clearing and trade execution requirements on standardized derivative products;
- creating record-keeping and real-time reporting regimes; and
- enhancing the Commissions’ (U.S. regulatory agencies) rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commissions’ oversight.
The Dodd-Frank Act limited the scope behind the new registration regime for all registered entities and intermediaries based on a rationale to “focus on whether a person engages in particular types of activities involving swaps or security-based swaps”.
The European Union’s (“EU”) regulation is documented in its Markets in Financial Instruments Directive (“MiFID”), which has been in place long before the financial crisis of 2008 and the G20 commitments to reform the OTC derivatives markets. MiFID was passed in April 2004 came into effect on 1 November 2007. It is a directive dealing with the buying and selling of shares, bonds, money market instruments, units in collective investment undertakings and derivatives, and the regulation of the markets where financial instruments are traded. MiFID is part of the EU’s Financial Services Action Plan which is aimed at integrating Europe’s capital markets to bring down the cost of capital and facilitate enhanced growth and employment.
The EU published the text of its regulation on OTC derivatives, CCPs and Trade Repositories (“EMIR”) on 27 July 2012. While the EMIR regime, in addition to the existing rules under the MiFID, envisage registration and conduct of business rules for dealers, EMIR applies to financial counterparties and non-financial counterparties. Non-financial counterparties are subject to some of the same requirements as financial counterparties where derivative activities that are not objectively measurable as reducing the risks of the commercial activities or of the treasury financing activity of their group exceed a clearing threshold to be set by European Securities Market Authority. Financial counterparties includes banks, investment firms, insurance companies, registered funds (UCITS), pension funds and private funds (e.g. hedge funds and private equity funds), where authorized in accordance with relevant EU Directives. Non-financial counterparties include any other undertaking established in the EU.
The Committee also examined the International Standards for Derivatives Market Intermediary Regulation published by the International Organization of Securities Commissions (“IOSCO”) on 6 June 2012, in which IOSCO stated its intent for recommending these standards, is to further the objectives of the G20 leaders to reform the OTC derivatives market to improve transparency, mitigate systemic risk and protect against market abuse. IOSCO provision of these high-level international standards for the regulation of market participants is intended for market participants that “are in the business of dealing, making a market or intermediating transactions in OTC derivatives”. IOSCO recommended that the focus of this regulation should be on OTC derivatives intermediaries (“DMIs”) given their type and level of involvement within the OTC derivatives market, and the regulation of DMIs “should be primarily focused on areas where capital, counterparty or client money and public confidence may be at most risk”.
What are the issues CSA Consultation Paper 91-407 is intending to address?
The Committee does not state the issues CSA Consultation Paper 91-407 is intending to address. It only states that it “believes that the most appropriate method to regulate key derivative market participants is to impose standard registration requirements based on the activity conducted by the participants”.
SUMMARY OF CSA CONSULTATION PAPER 91-407
Categories of Registration
The Committee proposes that the registration regime for key derivatives market participants would have three distinct categories: i) derivatives dealers; ii) derivatives advisers; and iii) large derivative participants.
The Committee proposes that derivatives dealers to be “persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business will be required to be registered as derivatives dealers in each Canadian province and territory where they conduct derivatives trading business”.
The Committee proposes that derivatives advisers to be “persons carrying on the business of advising others in relation to derivatives, or who hold themselves out to be in that business in any Canadian jurisdiction, will be required to be registered as a derivatives adviser in each Canadian province and territory where they conduct derivatives advising business”.
Large Derivative Participant
The Committee proposes that large derivative participants (“LDPs”) “will include entities, other than derivatives dealers, that have a substantial aggregate derivatives exposure. The Committee recommends that additional analysis be completed to establish registration thresholds for LDPs that are appropriate for Canadian financial markets”.
For each of the registration categories, the Committee recommends that an individual would register where the individual is:
- the ultimate designated person5, chief compliance officer or chief risk officer of the registrant6;
- involved in providing clients with advice relating to derivatives;
- involved in providing trading services to clients as an intermediary to a trade; or
- involved in a trade with a counterparty that is a non-qualified party that is not represented by an independent derivatives adviser.
The Committee also recommends that individual registration requirements apply to both frontline staff that deal with clients and persons who manage or supervise such staff.
Before further analyzing the Committee’s proposals regarding each of the categories, It is pertinent to mention that the Committee did not define what it deems to be a “derivative” in the context of CSA Consultation Paper 91-407. However, the Committee noted that the definition of a derivative is not is not consistent across Canada. The Committee then referenced CSA Consultation Paper 91-301 - Model Provincial Rules – Derivatives: Product Determination and Trade Repositories and Derivatives Data Reporting 7 that provided the Committee’s recommendations on the type of instruments that will be considered derivatives as it relates to trade reporting as a source of insight into what types of instruments that the Committee may recommend to be considered derivatives for the purposes of triggering registration as a derivatives dealer.
The Committee recommends that all registrants (derivatives dealers, derivatives advisers and LDPs) be subject to the following registration requirements:
- Proficiency – all individuals who are directors, partners, officers, employees or agents of a derivatives registrant who are involved in trading in or advising on derivatives should be subject to minimum proficiency requirements.
Financial and Solvency – all registrants should be subject to financial and solvency requirements, including the following:
- minimum Capital Requirements;
- margin Requirements;
- insurance Requirements; and
- maintenance of Financial Records and Periodic Financial Reporting.
- Compliance Systems and Internal Business Conduct – all registrants should have adequate systems in place to ensure compliance with regulatory requirements and manage risks relating to derivatives positions.
- Honest Dealing – all registrants should have an obligation to act honestly and in good faith when trading in or advising.
- Holding Client/Counterparty Assets – obligations relating to the care of collateral posted by clients or counterparties have been or will be addressed in other consultation papers issued by the Committee.
In addition to the above-noted registration requirements, the Committee also recommends that derivatives dealers and derivatives advisers will be subject to the additional registration requirements of acting as gatekeepers and business conduct requirements including know your client/ counterparties obligations; suitability obligations; conflict of interest identification and management; and fair dealing obligations.
The Committee also stated that it is considering two alternatives for the regulation of derivatives dealers trading as principal with non-qualified parties 8: “that the non-qualified party obtain advice from an independent derivatives adviser before trading; or that the derivatives dealer inform the counterparty of a conflict of interest and provide details of the conflict in writing and advise the counterparty that it has the right to obtain independent advice”. With the second alternative the Committee proposes the derivatives dealer would be subject to the market conduct requirements just mentioned. In the case where the derivatives dealer trading for a client or trading as principal with a non-qualified party that is not represented by an independent derivatives adviser, the Committee is recommending additional registration requirements such as the provisions of pre-trade reports; provision of trade confirmations and provision of account statements.
Exemptions based on Equivalent Regulation
The Committee recommends that registrants may be exempted from certain registration requirements (as opposed from the requirement to register) in certain circumstances. Specifically, if the market participant is: i) already a regulated person by an acceptable regulator in Canada; ii) are foreign derivatives dealers and advisers subject to equivalent registration requirements in their home jurisdiction and iii) are foreign LDPs, where they are subject to equivalent regulatory requirements in their home jurisdictions.
In the last two instances, the Committee is recommending that these entities will be required to register in each Canadian jurisdiction where they carry on business and will only be exempt from certain registration requirements.
Exemptions from Registration
The Committee recommends that the following parties be exempted from the requirement to register:
- Registered dealers providing advice should be exempted from the obligation to register as a derivatives dealer when providing advice, where the provision of advice is incidental to trading services.
- Governments (Canadian federal, provincial and municipal) should not be subject to an obligation to register or be subject to registration requirements in any circumstances. Federal and Crown corporations whose obligations are guaranteed by the federal and provincial governments will not be required to register or be subject to registration requirements only when dealing with qualified parties and not intermediating any trades for clients.
- Recognized or Exempted from Recognition Clearing Agencies
- Entities transacting with Affiliated Entities
INVESTIGATING CSA CONSULTATION PAPER 91-407
Having already analyzed the Committee’s lack of clarification vis-à-vis its belief that the most appropriate method to regulate key derivatives market participants is to impose standard registration requirements based on the activity conducted by the market participants; this analysis would deal with the specific assessment of the components of the Committee’s proposals.
Firstly, whilst the Committee recognizes that derivatives markets (and in this paper, the Committee does not specify the OTC derivatives market that is the subject of the G20 reform) are different from securities markets, the Committee concluded that “it is desirable to subject all types of derivatives to a consistent regime regardless of the nature of the underlying asset”. The Committee continued on to state that it “believes that an exemption from registration under the derivatives regime for these categories of derivatives market participants would result in confusion and would result in different regulatory requirements for derivatives that have similar risks”.
As both the Working Group and the Committee have stated that the majority of the OTC derivatives transactions are cross-border, it would be beneficial for the Committee to differentiate the asset classes of OTC derivatives especially as it relates to energy derivatives transactions and the unique characteristics of such transactions. It would also be beneficial if the Committee treated the different asset classes of OTC derivatives transactions like they are treated in the U.S... For example, how energy forward contracts are excluded from the Dodd-Frank Act.
Secondly, the Committee recognizes that participants in the derivatives market include a variety of entities. In the U.S. the Dodd-Frank Act makes it illegal to trade in swap with any entity that is not an eligible contract participant (“ECP”), separating the treatment of retail participants (i.e. small entities that have little experience in trading derivatives) from qualified parties who enter into hedging transactions for commercial purposes.
Thirdly, unlike in the U.S., the Committee fails to distinguish and clarify between dealing and trading in OTC derivatives and how key derivatives market participants would be regulated if they are dealing or trading or doing both.
Fourthly, the Committee recommends the creation of the LDPs by referencing the new U.S. category of major swap participants created under the Dodd-Frank Act, that has been further defined by the U.S. Commodity Futures Trading Commission and the U.S. Securities Exchange Commission (the “U.S. Regulators”) as “a person that maintains a ‘substantial position’ in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan”; “a person whose outstanding swaps create ‘substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets’ “; and “any ‘financial entity’ that is ‘highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency’ and that maintains a ‘substantial position’ in any of the major swap categories”.
The U.S. Regulators further defined what is considered to be a “substantial position” using objective numerical criteria, which promote the predictable application and enforcement of the requirements governing major swap participants.
Since the Committee feels it is necessary to copy the U.S. and recommend the creation of this registration category, it should consider emulating the U.S. in setting criteria that clarifies what it would deem to be positions in derivatives that represent or could represent systemic risk.
In addition, the U.S. Regulators in their definition of a major swap participant position, excluded positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan. The Committee on the other hand, recommends that “entities can be categorized as LDPs, and subject to regulation regardless of whether their derivative trading activity is for hedging purposes or for speculative purposes”, and this begs the question; Why is the Committee not clarifying why it feels the need to expand the LDP category beyond the U.S. major swap participant definition?
QUESTIONS POSED BY THE COMMITTEE REGARDING ITS PROPOSALS
The Committee posed 23 questions in different parts of CSA Consultation Paper 91-407 to drive its request for comments and to invite market participants to provide input on the issues outlined in this CSA Consultation Paper 91-407. The comment period ends 17 June 2013.
We invite market participants and other stakeholders to discuss any comments and the Committee’s questions with us. If you require assistance in providing your comments to the Committee or answering the Committee’s applicable questions as it affects your operations, we are able to assist you.
Please see the Committee questions below.
Regarding Part 6 on Registration Requirements and Categories of Registration, the Committee asked:
- Should investment funds be subject to the same registration triggers as other derivatives market participants? If not, what registration triggers should be applied to investment funds?
- What is the appropriate standard for determining whether a person is a qualified party? Should the standard be based on the financial resources or the proficiency of the client or counterparty? If the standard is based on financial resources should it be based on the net assets of the client or counterparty, gross annual revenues of the client or counterparty, or some other factor or factors?
- Should registration as a derivatives dealer be subject to a de minimis exemption similar to the exemption adopted by U.S. regulators? Please indicate why such an exemption is appropriate.
- Are derivatives dealer, derivatives adviser and LDP the correct registration categories? Should the Committee consider recommending other or additional categories?
- Are the factors listed the correct factors that should be considered in determining whether a person is in the business of trading derivatives? Please explain your answer.
- The Committee is not proposing to include frequent derivatives trading activity as a factor that we will consider when determining whether a person triggers registration as a derivative dealer. Should frequent derivatives trading activity trigger an obligation to register where an entity is not otherwise subject to a requirement to register as a derivatives dealer or a LDP? Should entities that are carrying on frequent derivatives trading activity for speculative purposes be subject to a different registration trigger than entities trading primarily for the purpose of managing their business risks?
- Is the proposal to impose derivatives dealer registration requirements on parties providing clearing services appropriate? Should an entity providing these clearing services only to qualified parties be exempt from regulation as a derivatives dealer?
- Are the factors listed above the appropriate factors to consider in determining whether a person is in the business of advising on derivatives?
- Are the factors listed for determining whether an entity is a LDP appropriate? If not what factors should be considered? What factors should the Committee consider in determining whether an entity, as a result of its derivatives market exposures, could represent a serious adverse risk to the financial stability of Canada or a province or territory of Canada?
- Is the Committee’s proposal to only register derivative dealer representatives where they are dealing with clients or when dealing with counterparties that are non-qualified parties appropriate?
Regarding Part 7.1, on Requirements of Derivatives Dealers, Derivatives Advisers and LDPs, the Committee asked:
- Is it appropriate to impose category or class-specific proficiency requirements?
- Is the proposed approach to establishing proficiency requirements appropriate?
- Is the Committee’s proposal to impose a requirement on registrants to “act honestly and in good faith” appropriate?
- Are the requirements described appropriate registration requirements for derivatives dealers, derivatives advisers and LDPs? Are there any additional regulatory requirements that should apply to all categories of registrants? Please explain your answers.
Regarding Part 7.3, Additional Regulatory Requirements Applicable only to Derivatives Dealers, the Committee asked:
- Should derivatives dealers dealing with qualified parties be subject to business conduct standards such as the ones described in part 7.2(b)(iii) above? If so, please explain what standards should apply.
- Do you have a preference between the two proposals relating to the regulation of a derivatives dealer trading with counterparties that are non-qualified parties? Is there another option to address the conflict of interest that the Committee should consider? Please explain your answer.
- Are the recommended requirements appropriate for registrants that are derivatives dealers? If not please explain. Are there any additional regulatory requirements that should apply to registered derivatives dealers?
- Are the recommended requirements appropriate for registrants that are derivatives advisers? If not please explain. Are there any additional regulatory requirements that should apply to registered derivatives advisers?
Regarding Part 8, Exemptions from Registration or Registration Requirements, the Committee asked:
- The Committee is recommending that foreign resident derivative dealers dealing with Canadian entities that are qualified parties be required to register but be exempt from a number of registration requirements. Is this recommendation appropriate? Please explain.
- Is the Committee’s recommendation to exempt foreign resident derivatives dealers from Canadian registration requirements where equivalent requirements apply in their home jurisdictions appropriate? Please explain.
- Should foreign derivatives dealers or advisers not registered in Canada be exempt from registration requirements where such requirements solely result from such entities trading with the Canadian federal government, provincial governments or with the Bank of Canada?
- Is the proposal to exempt crown corporations whose obligations are fully guaranteed by the applicable government from registration as a LDP and, in the circumstances described, as a derivatives dealer appropriate? Should entities such as crown corporations whose obligations are not fully guaranteed, foreign governments or corporation owned or controlled by foreign governments benefit from comparable exemptions? Please provide an explanation for your answer.
- Are the proposed registration exemptions appropriate? Are there additional exemptions from the obligation to register or from registration requirements that should be considered but that have not been listed?