On December 31, 2013, two new OSC rules came into force which create obligations to report non-exchange traded derivative transactions. Reporting commences on July 2, 2014 for derivatives entered into on or after that date, while many pre-existing derivatives in effect on that date must be reported by December 31, 2014. The new reporting obligations are part of the response of international securities regulators to the 2008/2009 financial crisis and are intended to provide greater transparency to reduce systemic risk, as well as a platform for further regulation.
Which derivatives are covered?
The purpose of OSC Rule 91-506 Derivatives: Product Determination (the Scope Rule) is to define a subset of derivatives that are subject to the reporting requirements in OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting (the Reporting Rule). In doing so, some instruments that technically fall within the broad definition of "derivative" in the Ontario Securities Act are excluded (most notably, any exchange-traded instrument). As well, the Scope Rule generally excludes instruments which can be both a "security" and a "derivative" (such as linked notes, asset-backed securities and securities of investment funds). Instruments that clearly are derivatives under the Scope Rule include:
- Typical transactions under an ISDA agreement (such as swaps and forward transactions)
- Derivatives that are traded through a derivatives trading facility that is not an exchange (such as a swap execution facility)
The Scope Rule makes no distinction whether a derivative is used for hedging or non-hedging purposes. It also is irrelevant whether the derivative is cash settled or physically settled (though certain physically settled currency and commodity derivatives are excluded under the Scope Rule).
The Scope Rule currently has no impact on any securities legislation in Canada other than the Reporting Rule. However, this will change in the future.
What is reported?
The information required to be reported is both detailed and complex. In some cases, it requires specific expertise in derivatives (such as industry conventions), as well as access to terminology utilized by the International Swaps and Derivatives Association, Inc. The prescribed information is set out in Appendix "A" to the Reporting Rule.
Who reports it?
The Reporting Rule attempts to place the reporting obligation on the most sophisticated counterparty to the derivative who is more likely to have the reporting infrastructure in place. For example:
- If one of the parties to the derivative is a clearing agency, the clearing agency will be the reporting counterparty.
- If the derivative is between a derivatives dealer and a non-derivatives dealer, the derivatives dealer will be the reporting counterparty.
- In all other cases, the Ontario counterparty will be the reporting counterparty.
Does the reporting requirement apply to derivative transactions outside Ontario?
The reporting requirement applies only to derivatives where at least one counterparty has a sufficient connection to Ontario (a local counterparty). Currently, the Reporting Rule defines a "local counterparty" as any one of the following:
- A person (other than an individual) organized under Ontario law, or having its head office or principal place of business in Ontario.
- A person registered in Ontario as a derivatives dealer or in an alternate category as a consequence of trading in derivatives.
- A person not in Ontario if all of that person's obligations are guaranteed by someone organized under Ontario law, or having its head office or principal place of business in Ontario. This category is intended to capture offshore special purpose vehicles set up for derivatives trading by a person (typically a financial institution) in Ontario.
On this basis, where neither counterparty to the derivative is organized in Ontario or has its head or principal office in Ontario, the reporting requirement will not apply. However, once the derivatives dealer registration requirement is created, the mere fact that one counterparty is an Ontario-registered derivatives dealer will be sufficient to trigger the reporting requirement, even if no activity relating to that derivative occurs in Ontario. This appears to be a significant departure from the current reach of the Ontario Securities Act which only regulates trading in securities if the trade (or an act in furtherance of the trade) occurs in Ontario. OSC staff are taking the position that this extended reach is justified in order to monitor for any credit risk of the derivatives dealer that could jeopardize Ontario investors dealing with that derivatives dealer. However, this would seem to be a matter more properly addressed through the derivative dealer's ongoing registration requirements rather than a rule of general application to all derivatives.
According to OSC staff, the reference to an "alternate category as a consequence of trading in derivatives" is meant to include only the upcoming new derivatives-related registration categories, not existing securities-related registration categories.
Who is a "derivatives dealer"?
A "derivatives dealer" is a new concept and is defined as a person that meets the business trigger test of carrying on the business (or holding themselves out as carrying on the business) of trading in derivatives. This category is directed mainly at dealers and other intermediaries, but may include individual issuers and investment funds. According to OSC staff, issuers that frequently utilize derivatives in a manner ancillary to their core business (such as energy and resource companies in respect of the commodities they sell) are not intended to be derivatives dealers.
Currently, there are no consequences of being labelled a derivatives dealer (other than reporting under the Reporting Rule) since no legislation currently exists to register as a derivatives dealer. However, this will change in the future.
When are reports filed?
For new derivatives where the reporting counterparty is a derivatives dealer, the initial creation data report must be filed in "real time" but no later than the end of the business day following the date of the trade. This reporting commences for trades on or after July 2, 2014.
For new derivatives where the reporting counterparty is not a derivatives dealer, the same "real time" reporting deadline applies, except reporting commences on September 30, 2014. This is intended to provide less sophisticated counterparties with more time to develop their reporting procedures.
For all pre-existing derivatives in effect on July 2, 2014 and not expiring until after December 31, 2014, the creation data report must be filed by the reporting counterparty by December 31, 2014. This delay is to enable parties to make their initial filings for the backlog of existing derivatives. The exclusion of derivatives that expire by December 31, 2014 effectively results in no reporting of short-term income recharacterization transactions that were extended or renewed after the March 2013 Federal Budget.
OSC staff is taking the view that the December 31, 2014 filing deadline for reporting pre-existng derivatives applies only to derivatives in effect on July 2, 2014. Accordingly, if a local counterparty that is not a derivatives dealer is required to report a new derivative entered into between July 2, 2014 and September 30, 2014, the filing deadline for that derivative will be "real time" on September 30, 2014 but no later than the end of the business day following September 30, 2014.
When any change occurs to the information previously reported in respect of a derivative (referred to as a life-cycle event), an update report must be filed by the end of the business day following the date on which the change occurred. Life-cycle events include, for example, a change to the name of a party to the derivative and a change to the notional amount (e.g. upsize or partial settlement).
The mark-to-market value of each derivative also must be updated and reported on a daily basis (if the reporting counterparty is a derivatives dealer) or within 30 days after each calendar quarter (if the reporting counterparty is not a derivatives dealer).
Obligations of non-reporting counterparties
The Reporting Rule requires that the non-reporting counterparty notify the reporting counterparty of any errors or oversights in reporting of which the non-reporting counterparty is aware. The Reporting Rule also requires the non-reporting counterparty to file the creation data report if the reporting counterparty is not connected to Ontario and fails to report on time.
Where are reports sent?
Reports must be sent to a designated trade repository approved by the OSC. Currently, DTCC Data Repository (U.S.) LLC is the entity that has applied for such status. Where the derivative lacks certain connections with Ontario, the reporting counterparty is permitted to instead report the derivative to an equivalent agency in a foreign jurisdiction approved the OSC (though, to date, the OSC has not yet identified any approved foreign jurisdictions).
Who can access the reported information?
A counterparty to a derivative will be granted access to the information on file with the designated trade repository to which the derivative was reported. However, such access likely will be easier if the counterparty is a participant of that designated trade repository.
The OSC will be granted unfettered access to the filed information on a continuous basis.
Aggregated information, as well as transaction-specific information which does not identify the parties, will be available to the public.
Do I require any new registrations?
The Canadian Securities Administrators have published a consultation paper which proposes to introduce three new categories of registration:
- Derivatives Dealer will apply to any person that meets the business trigger test of carrying on the business (or holding themselves out as carrying on the business) of trading in derivatives. This category is directed mainly at dealers and other intermediaries.
- Derivatives Adviser will apply to any person that meets the business trigger test of carrying on the business (or holding themselves out as carrying on the business) of advising with respect to derivatives. This category will capture any portfolio manager that trades in derivatives on behalf of its managed accounts.
- Large Derivative Participant will apply to any market participant that has aggregate derivatives exposure exceeding a specified threshold. The threshold has not yet been determined, but is intended to capture market participants who pose systemic risk should they fail to satisfy their derivatives obligations. Depending on the criteria selected by the Canadian Securities Administrators, it could capture frequent users of derivatives (such as investment funds and energy and resource companies).
Draft rules concerning these new categories have yet to be published.
What is happening in other provinces?
The securities regulators in several other provinces are working are equivalent legislation in their jurisdictions. The OSC has indicated that all such legislation is expected to be harmonized.
What should I do next?
- Get a Legal Entity Identify (LEI). LEIs are issued solely through the Global Legal Entity Identifier System developed by the G20 Financial Stability Board. Each issuer (including each investment fund) will have its own unique LEI that must be included in all reports under the Reporting Rule. The processing time for issuing an LEI is 1-3 weeks. Failure to have an LEI could preclude you from entering into a new derivative on or after July 2, 2014 because of the inability to submit the creation data.
- Determine whether you (or any investment funds you manage) are a derivatives dealer. If so, you may be primarily or joint responsible for reporting under the Reporting Rule. The definition of a derivatives dealer uses the business trigger test described above. Further guidance concerning the business trigger can be found in the CSA Consultation Paper 91-407.
- Identify all current derivatives that must be reported by December 31, 2014. Using this information, you should contact all counterparties to these transactions to confirm who will submit the creation data by December 31, 2014. If it is you, begin establishing your procedures for filing the creation data by December 31, 2014, and for filing updates thereafter for life-cycle events and valuation data.
- Identify the types of reportable derivatives transactions you expect to continue making after July 1, 2014. With this information, you should contact your regular counterparties and confirm who will be the reporting counterparty commencing July 2, 2014 and what further information needs to be exchanged (such as LEIs) to facilitate future trades.
- Develop new compliance procedures for the Reporting Rule. These new procedures may include: obtaining an LEI for each entity that may transact reportable derivatives; identifying whether counterparties are derivatives dealers; confirming that creation data reports were filed by the deadline by the reporting counterparty if you are not the reporting counterparty; and developing systems for gathering and reporting the prescribed creation data, valuation data and life-cycle events when you are the reporting counterparty.
- Consider revising your present and future derivatives documentation to address reporting requirements. If you are not the reporting counterparty under the Reporting Rule, you nonetheless will become the reporting counterparty if the other party is not connected to Ontario and fails to report on time. Should this occur, you may wish to have a clear entitlement to reimbursement of your expenses for fulfilling the reporting requirement.