The Canadian Securities Administrators’ (CSA) proposed National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (the Clearing Rule), which was published by the CSA for comment on February 12, 2015, is set to introduce significant changes to the Canadian over- the-counter derivatives landscape, as it will require the clearing of certain derivatives. If you don’t want to be late to the party, comments on the Clearing Rule, and its related companion policy, are due by May 13, 2015. The CSA expects that the Clearing Rule will be finalized and in place by the end of 2015 or the beginning of 2016.
The Clearing Rule has its genesis in the proposed model provincial rule on mandatory central counterparty clearing of derivatives published by the CSA on December 19, 2013 (the Draft Rule). As we noted in our earlier bulletin, the Draft Rule was intended to be a model provincial rule, meaning that each provincial and territorial securities regulator could have infused the model provincial rule with local flavour. The CSA, in response to concerns raised about the lack of harmonization, decided that the Clearing Rule will be a national instrument.
While the Clearing Rule remains substantively similar to the Draft Rule, certain proposed changes are discussed below in the context of the two general rule-making areas of the Clearing Rule.
A) Rules relating to mandatory central counterparty clearing for certain derivatives (including the proposed end-user and intragroup exemptions)
Section 5 of the Clearing Rule requires that a local counterparty to a transaction in a mandatory clearable derivative (MCD) must submit, or cause to be submitted, that transaction to a regulated clearing agency (the Clearing Requirement). This requirement remains substantively unchanged from the Draft Rule. What has changed (somewhat) are the two exemptions available from the Clearing Requirement.
i) The End-User Exemption
The end-user exemption, found in section 9 of the Clearing Rule (the End-User Exemption), continues to be available to a counterparty that is not a financial entity and that is entering into the transaction for the purpose of hedging or mitigating commercial risk. While these concepts have not substantively changed, the Clearing Rule expands the list of risks that may be hedged. While the CSA declined to provide additional guidance on these concepts in the Clearing Rule, it notes that hedges meeting the stricter accounting standards should be sufficient to meet the conditions of the End-User Exemption.
An end-user can have an affiliated entity act on its behalf in connection with its derivative transactions and still rely on the End-User Exemption, provided that the affiliated entity is not subject to, registered under, or exempted from, the registration requirement under the securities legislation of a jurisdiction of Canada. As formulated in the Clearing Rule, there does not have to be a formal agency relationship between an end-user and its affiliated entity (as was the case in the Draft Rule). The Clearing Rule also includes a new section on the interpretation of the term “affiliated entity”.
There is no requirement to apply for the End- User Exemption or to submit any documents to the securities regulators in order to rely on this exemption. Counterparties relying on the End- User Exemption are no longer required to obtain board approval (and retain documentation of such approval) before they rely on this exemption.
ii) The Intragroup Exemption
The intragroup exemption set out in section 10 of the Clearing Rule (the Intragroup Exemption) applies where affiliated entities (if their financial statements are prepared on a consolidated basis), or counterparties prudentially supervised on a consolidated basis, enter into a transaction in a MCD. The CSA notes that “prudentially supervised on a consolidated basis” refers to counterparties that are supervised on a consolidated basis either by the Office of the Superintendent of Financial Institutions (Canada), a government department or a regulatory authority of Canada or a province or territory of Canada responsible for regulating deposit-taking institutions.
The Intragroup Exemption is only available if: (a) both counterparties agree to rely on the exemption; (b) the transaction is subject to centralized risk evaluation, measurement and control procedures reasonably designed to identify and manage risks; and (c) there is a written agreement setting out the terms of the transaction between the counterparties. A counterparty that relies on the Intragroup Exemption must file a Form 94-101F1 Intragroup Exemption (Form 1) in electronic format within 30 days after its reliance on the exemption. If any information on Form 1 becomes inaccurate, then an updated Form 1 must be filed within 10 days. The Clearing Rule does away with the requirement proposed in the Draft Rule of filing a Form 1 every year.
The CSA has removed from the Clearing Rule the power of a securities regulator to direct that a local counterparty submit a transaction for clearing if the securities regulator determines that either the End-User Exemption or the Intragroup Exemption was improperly relied on.
B) Rules relating to the determination of derivatives subject to the Clearing Requirement
The Clearing Rule requires that a regulated clearing agency notify the securities regulator of all derivatives and classes of derivatives for which it provides or offers clearing services as of, and after, the date that the Clearing Rule comes into force. After receiving notification by the clearing agency, the securities regulators will determine whether such derivative or class of derivatives should be made a MCD. The factors that the CSA will look at include the standardization of the derivative or class of derivatives, its risk profile, and the liquidity and characteristics of its market. The CSA’s goal is to harmonize, to the greatest extent appropriate, the determination of MCDs both across Canada and with international standards.
Phased-in Clearing Requirements
The CSA is proposing a phasing-in of the Clearing Requirement, similar to the approach taken in the United States and the European Union. This phase- in will be staggered based on market participant categories, with a proposed six month grace period between each category, as follows:
First Phase-in Category: This phase would capture clearing members of a regulated clearing agency that provide clearing for a MCD. Entities in this phase would be subject to clearing once a derivative is determined to be a MCD.
Second Phase-in Category: Six months after a derivative is determined to be a MCD, financial entities above a specified (yet to be determined) threshold would be subject to the Clearing Requirement. The CSA is seeking comments on the appropriate basis and value for this threshold.
Third Phase-in Category: Twelve months after a derivative is determined to be a MCD, all other financial entities would be subject to the Clearing Requirement.
Fourth Phase-in Category: Eighteen months after a derivative is determined to be a MCD, all remaining counterparties would be subject to the Clearing Requirement.