Registration categories for derivatives market participants
Specific issues and concerns for existing securities registrants
Foreign derivatives participants
Exemptions under proposed regime
Ongoing concerns with the proposals
On April 18 2013 the Canadian Securities Administrators (CSA) Derivatives Committee released Consultation Paper 91-407 Derivatives: Registration.(1) This paper is part of a series of eight consultation papers that expand on the proposals for the regulation of over-the-counter (OTC) derivatives set out in Consultation Paper 91-401.(2)
Consultation Paper 91-407 provides an overview of the committee's proposal for the regulation of key derivatives market participants through the implementation of a registration regime and details recommendations on issues such as:
- the activities that will trigger derivatives registration;
- the categories of derivatives registrant;
- the obligations of the derivatives registrants; and
- proposed exemptions from registration.
The comment period for Consultation Paper 91-407 expired on June 17 2013.
Registration of firms
The proposed registration regime has three distinct registration categories for firms:
- Derivatives dealer – an entity or person in the business of, or holding itself out as being in the business of, trading derivatives;
- Derivatives adviser – an entity or person in the business of, or holding itself out as being in the business of, advising others on derivatives; and
Large derivative participant – an entity, other than a derivatives dealer, that has a substantial aggregate derivatives exposure. Consultation Paper 91-407 states that registration as a large derivative participant will not be subject to the same 'business trigger' as dealers and advisers. Instead, a market participant will be required to register as a large derivative participant where the entity is:
- a Canadian resident entity that maintains a substantial position in a derivative or a category of derivatives; or
- a foreign resident entity that holds a substantial position in a derivative or category of derivatives with Canadian resident counterparties; and
- the entity's exposure in Canadian derivatives markets results in counterparty exposure that could pose a serious risk to Canadian financial markets or the financial stability of Canada or a province of territory of Canada.
Registration of individuals
In addition to the firm registration categories, the committee recommended registration for the following:
- the ultimate designated person, chief compliance officer or chief risk officer of the firm;
- individuals providing clients with advice relating to derivatives;
- individuals providing trading services to clients as an intermediary to a trade; and
- individuals trading with a counterparty that is a 'non-qualified party' that is not represented by an independent derivatives adviser.
The committee recommended that individual registration requirements apply to both frontline staff that deal with clients and persons who manage or supervise such staff.
General registration requirements
The committee further recommended that all derivatives registrants be subject to registration requirements and ongoing obligations, including:
- proficiency requirements for all individuals who are directors, partners, officers, employees or agents of a derivatives registrant who are involved in trading in or advising on derivatives;
- financial requirements, including minimum capital, insurance and periodic financial reporting;
- margin requirements;
- maintenance of certain books and records;
- adequate compliance systems;
- obligation to act honestly and in good faith when trading in or advising on derivatives; and
- obligations relating to the care of collateral posted by clients or counterparties.
In addition to the general registrant requirements above, derivatives dealers and derivatives advisers will also be subject to additional registration requirements, including know-your-client and suitability obligations, conflict of interest identification and management and fair-dealing obligations.
The committee's recommendations mean that a person registered under securities legislation as a dealer or adviser who also trades or advises on derivatives will also be subject to the derivatives registration regime. For currently registered investment dealers and portfolio managers, much of Consultation Paper 91-407 will read as substantially similar to the requirements with which they already comply under National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations and the Investment Industry Regulatory Organisation of Canada rules – which begs the question, why the need for a separate derivatives registration regime?
The committee discussed what it sees as the uniqueness of derivatives as opposed to 'securities' – that securities trading is typically for investment purposes and derivatives are typically contracts entered into for the transfer of risk and often involve leverage. However, the same distinctions are not present when comparing exchange-traded futures contracts, which in many provinces are already regulated as securities, and the derivatives discussed in the consultation paper. It is unclear whether Consultation Paper 91-407 is in fact the contemplated registration regime for all derivatives (including exchange-traded contracts) or limited to OTC derivatives. Registrants that are currently trading in or advising on exchange-traded derivatives will have to pay close attention to the final scope of these rules.
For existing securities registrants that will be caught under the new derivatives registration regime, the following are among the unique registration requirements outlined in the consultation paper:
- Chief risk officer – this is a proposed new category of individual registration. The chief risk officer will be responsible for the development and ongoing operation of a risk-management framework that can effectively identify, measure, monitor and manage derivatives related risks. The committee stated that individuals acting as chief compliance officers and chief risk officers will be subject to proficiency requirements, but did not prescribe what those requirements shall be.
- Need for an independent adviser to advise on dealer trades for non-qualified parties – the committee concluded that a conflict of interest exists where a derivatives dealer enters into a transaction with a counterparty that is a non-qualified party that relies on that derivatives dealer for direction or advice in relation to the trade. The committee put forth two proposals for addressing this conflict. The first option would preclude all derivatives dealers from entering into trades with counterparties that are non-qualified parties unless those counterparties receive advice from an independent registered derivatives adviser. The second option, which the committee has already indicated in the consultation paper may be an ineffective alternative, is that a derivatives dealer provide details of the conflict of interest in writing (and have the clients acknowledge receipt of the disclosure) and inform the counterparty that it has the right to obtain independent advice before entering into the transaction.
For investment fund managers, the consultation paper clearly states that investment fund managers should continue to be regulated under the securities registration regime, regardless of the nature of the investment fund or the assets held by the fund. However, the committee also noted that some investment funds may conduct derivatives trading activity that could trigger registration requirements as a derivatives dealer. The committee understood that under its proposal, investment funds will often rely on their investment fund managers to fulfil the fund's registration requirements; however, it confirmed that the responsibility to meet registration requirements will remain with the fund.
Consultation Paper 91-407 states that a person in the business of trading or advising on derivatives in Canada that is resident outside Canada will still be subject to an obligation to register and be required to comply with registration requirements, even if that dealer does not have an office or other place of business in Canada or if the activity was unsolicited.
Consultation Paper 91-407 discusses an exemption from specific regulatory requirements in Canada, but not from registration as a whole, where foreign participants are subject to equivalent regulatory requirements in their home jurisdictions.
Consultation Paper 91-407 proposes as follows:
- No de minimis exemption recommended – the paper does not provide an exemption from dealer registration – similar to that available under US regulation – for persons who engage in a de minimis quantity of derivatives dealing activity with or on behalf of customers. The committee believes that participants in the derivatives market should be subject to the same protections, regardless of the size or the total derivatives exposure of the dealer.
Two types of exemption recommended – the paper describes two types of registration exemption:
- exemptions based on equivalent regulation; and
- exemptions from registration generally (primarily for governments and clearing agencies).
As part of the first type of exemption, Consultation Paper 91-407 provides for a potential exemption where participants are subject to regulation by other entities with regulatory responsibilities. On first blush, it appears that the committee may contemplate a registration carve-out for existing securities registrants that are already in compliance with securities legislation, and therefore substantially similar requirements as proposed in Consultation Paper 91-407. However, the reference in the paper is as follows:
"The Committee recommends that Canadian securities regulators analyse existing regulatory regimes, including requirements, compliance monitoring and enforcement, imposed by other Canadian regulatory authorities to determine whether those regimes impose regulatory requirements that are, in their outcome, equivalent to those that would be implemented by securities regulatory authorities. The Committee further recommends that exemptions from registration requirements be adopted where equivalent regulatory regimes are in place."
While not explicitly articulated, it is presumed that this exemption is primarily for financial institutions regulated by the Office of the Superintendent of Financial Institutions. The committee noted throughout the consultation paper its intention not to subject persons to redundant requirements. However, this concern seemed to be focused only on financial institutions and foreign players – any redundancy of regulation for existing securities registrants is not noted as a concern or the basis for an exemption.
While it is appreciated that the committee has had a mammoth task in developing an OTC derivatives regulatory regime, there still remain significant gaps – as evidenced by the substantial number of specific questions posed by the committee in Consultation Paper 91- 407 – in key principles that make it difficult to discuss the overall impact of the proposals. For example, it remains unclear as to what types of derivative will trigger registration as a derivatives participant. The recently published CSA Staff Consultation Paper 91-301(3) provides certain recommendations on the types of instrument that will be considered as derivatives, but this is for trade reporting purposes only. While it is presumed that this will be adopted more broadly, this remains uncertain. Consultation Paper 91-407 leaves a number of questions unanswered – it does not establish thresholds for registration as a large derivative participant, nor does it provide recommendations for minimum capital, margin or insurance requirements. In addition, the definition of 'qualified parties' (and therefore 'non-qualified parties') is left vague (primarily, a party with adequate resources to absorb losses from derivatives trades), with a specific definition to be established in future regulation.
For further information on this topic please contact Carol E Derk, Julie Mansi or Prema KR Thiele at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org).
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