Consultation Paper 91-407 Derivatives: Registration published by the Canadian Securities Administrators (CSA) Derivative Committee (Committee) provides an overview of the proposed regulation of key market participants in the over-the-counter (OTC) derivatives market.
In the consultation paper, the Committee notes its belief that derivatives registrants should be subject to regulatory requirements, including requirements relating to capital and collateral, reporting, internal controls, risk management and interactions with counterparties and clients so as to:
- protect participants in the derivatives markets from unfair, improper and fraudulent practices;
- protect the soundness of financial markets by requiring key market participants to manage risks relating to their participation in derivatives markets;
- impose specific requirements on registrants when trading with counterparties and trading on behalf of clients; and
- reduce risks resulting from the derivatives activities of key market participants.
The consultation paper outlines the Committee’s proposals relating to:
- the categories of registration and the type of activities that would trigger registration;
- the registration requirements; and
- exemptions from registration requirements.
What are the proposed categories of registration?
The consultation paper identifies three proposed categories of registration:
The first proposed category of registration is derivatives dealer. In the consultation paper, the Committee notes its belief that persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business should be required to be registered as derivatives dealers in each Canadian province and territory where they conduct derivatives trading business. The Committee considers the following activities to be “trades in derivatives”:
- entering into or making a material amendment to a derivatives contract;
- assigning rights under a derivatives contracts;
- terminating a derivatives contract; and
- other activities in the furtherance of such trades.
The Committee provides the following guidance on the types of activities that may constitute being “in the business” of trading in derivatives:
- Intermediating trades – providing broker services, i.e., the intermediation of trades between counterparties to derivative contracts, will generally be considered to be a trading business activity;
- Acting as a market maker – making a market in derivatives (e.g., taking or making an effort to take both a long and a short position in a derivative) would also generally be considered to be trading for a business purpose;
- Trading with the intention of being remunerated or compensated – any form of compensation for carrying on derivatives trading activity received or expected, would indicate a business purpose;
- Directly or indirectly soliciting – soliciting derivatives trades will typically indicate a business purpose;
- Providing clearing services to third parties – providing clearing services for derivatives trades to third parties would be considered a trading business activity; and
- Engaging in activities similar to a derivatives dealer – a business that carries on activities related to trading of derivatives (e.g., promoting a strategy for trading derivatives) may be considered to be in the business of trading derivatives.
The Committee notes in the consultation paper that the above list is not a complete list and that the existence of any one of these factors, on its own, is not determinative as to whether an individual or firm is in the business of trading in derivatives.
The second proposed category of registration is derivatives adviser. In the consultation paper, the Committee notes 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, should be be required to be registered as a derivatives adviser in each Canadian province and territory where they conduct derivatives advising business.
The Committee considers a person to be “advising” in relation to derivatives where the person provides another person with any advice or direction relating, either directly or indirectly, to trading derivatives, such as:
- managing a portfolio of derivatives; or
- using derivatives as an investment strategy, including hedging.
The Committee identifies the following factors to be considered when determining whether a person is “in the business” of providing derivatives advice:
- Directly or indirectly providing advice about derivatives trading activity with repetition, regularity or continuity – providing advice in relation to derivatives transactions or in relation to the ongoing management of a portfolio of derivatives frequently or on a regular basis, regardless of whether or not such activity is the sole or primary endeavour for the person;
- Being, or expecting to be, remunerated or compensated – any form of compensation received or expected for providing advice about derivatives;
- Directly or indirectly soliciting – soliciting business relating to advising in derivatives trades; and
- Engaging in activities similar to a derivatives adviser – carrying on a business that provides persons with advice in relation to derivatives trading activity, such as promoting a derivatives trading strategy or offering software in relation to derivatives.
Large Derivative Participant
The third proposed category of registration is large derivative participants (LDPs). The Committee notes that LDPs would include entities, other than derivatives dealers, that have a substantial aggregate derivatives exposure. The Committee indicates that additional analysis is needed to establish registration thresholds for LDPs that are appropriate for Canadian financial markets.
What are the proposed registration requirements?
In the consultation paper, the Committee recommends that registrants be subject to the following registration requirements:
- Proficiency – 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;
- Compliance systems and internal business conduct – registrants should have adequate systems in place to address regulatory requirements and manage compliance risks relating to derivatives positions;
- Honest dealing – the requirement to act honestly and in good faith, when trading in or advising on derivatives, should be imposed on all registrants;
- Holding client/counterparty assets – obligations relating to the care of collateral posted by clients or counterparties should be imposed on registrants; and
- Financial and solvency – financial and solvency requirements, including the following should apply to registrants:
- minimum capital requirements;
- margin requirements;
- insurance requirements; and
- maintenance of financial records and periodic financial reporting.
The Committee also notes that derivatives dealers and derivatives advisers should also be subject to the following additional registration requirements:
- Gatekeeper – obligations to obtain sufficient information relating to their clients to allow them to act as a gatekeeper with the objective of ensuring market integrity as well as in the case of dealers, to allow the dealer to assess its counterparty risks; and
- Business conduct – obligations in respect of business conduct, including:
- know your client/counterparties obligations;
- suitability obligations;
- conflict of interest identification and management; and
- fair dealing obligations.
The consultation paper notes that the Committee is considering two alternatives for the regulation of derivatives dealers trading as principal with non-qualified parties. With respect to the first alternative, the regulator would require that the non-qualified party obtain advice from an independent derivatives adviser before trading. The second alternative would instead require 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. The second alternative would also require that the derivatives dealer be subject to the market conduct requirements described above.
The following additional requirements would also apply to derivatives dealers trading for a client or trading as principal with a non-qualified party that is not represented by an independent derivatives adviser:
- Pre-trade reports – provide a pre-trade report to the client describing the terms of the proposed trade and the costs that it will incur to execute the trade;
- Trade confirmations – provide a confirmation of each trade describing the principal financial terms of the client; and
- Account statements – deliver regular statements describing the client’s positions relating to trades executed with the derivatives dealer.
What are the proposed exemptions from the registration requirements?
The Committee set out two categories of exemptions from registration that may be available. The first category would be based on equivalent regulation and the second category would be based on the nature of the activity or type of entity.
Exemptions based on Equivalent Regulation
The Committee notes that registrants may be exempted from certain registration requirements in circumstances where there is equivalent regulation:
- Canadian regulated persons – persons triggering registration as a derivatives dealer, a derivatives adviser or large derivatives participants who are subject to equivalent regulatory requirements that are appropriately monitored and enforced by an acceptable regulator in Canada;
- Foreign derivatives dealers and advisers – foreign derivatives advisers and derivatives dealers that are subject to equivalent requirements in their home jurisdictions should be exempted from specific regulatory requirements in Canada. However, these entities would still be required to register in each Canadian jurisdiction where they carry on business; and
- Foreign LDPs – foreign entities triggering the obligation to register as a LDP should be exempted from specific registration requirements where they are subject to equivalent regulatory requirements in their home jurisdictions. However, these entities will be required to register in each Canadian jurisdiction where they carry on business.
Exemptions based on Activity or Type of Entity
The consultation paper also discusses registration exemptions for the following parties:
- Dealers providing advice – registered derivatives dealer should be exempted from the obligation to register as a derivatives adviser when providing advice incidental to trading services;
- Governments – Canadian federal, provincial and municipal governments should not be subject to registration requirements in any circumstances. Federal and provincial crown corporations whose obligations are guaranteed by the federal and provincial government should not be subject to registration requirements when dealing only with qualified parties and not intermediating any trades for clients;
- Clearing agencies – recognized or exempt clearing agencies should not be subject to a registration requirement where the obligation to register results solely from carrying on the ordinary business as a clearing agency; and
- Transactions with affiliated entities – a person that trades only with or on behalf of or provides derivatives-related advice to a person that is their affiliate should not be subject to registration requirement applicable to a derivatives dealer or derivatives adviser.
The CSA have indicated that they intend to publish for comment proposed registration rules in the fall of 2014.