On October 1, 2012, Canadian federal and provincial regulatory authorities issued a statement (the Statement) announcing that Canadian market participants will be permitted to clear over-the-counter (OTC) derivative contracts through any central counterparties (CCPs), including global CCPs, that are recognized or exempted from recognition by Canadian authorities.
Although securities regulators had previously acknowledged that Canadian market participants would require access to foreign CCPs to clear derivatives trades entered into with non-Canadian counterparties, there remained uncertainty as to whether domestic clearing would be required for trades between Canadian counterparties for certain asset classes such as Canadian dollar interest rate swaps. Establishing a Canadian CCP could be a costly endeavour that could introduce inefficiencies that would outweigh the benefits regulators see in having primary oversight and jurisdiction over an onshore CCP.
Due in part to the methods which CCPs use to calculate margin posting requirements on a portfolio basis as well as CCP connectivity and membership costs, it is generally less efficient for a market participant to have derivatives of the same class cleared by different CCPs or by CCPs that clear only a small portion of a swap book. In the absence of a regulatory requirement mandating domestic clearing of certain classes of OTC derivatives, and assuming that U.S. and European CCPs meet the demands of Canada's market participants and regulators, it would be difficult for a domestic CCP to attract a substantial share of the Canadian OTC derivatives market.
The Statement was issued by both the Bank of Canada and the Canadian Securities Administrators – which represents the provincial and territorial securities regulatory authorities – and is stated to also reflect the views of the Office of the Superintendent of Financial Institutions, which is the federal regulator of the Canadian banks, and the Canadian Department of Finance.
Recognition Process for Foreign CCPs
The Statement indicates that a global CCP will "provide a safe, robust and resilient environment for clearing OTC derivatives" if it complies with both the Principles for Financial Market Infrastructures published by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) and the following four safeguards identified by the Financial Stability Board (FSB):
- Fair and open access by market participants to CCPs
- Co-operative oversight arrangements for CCPs between relevant authorities
- Resolution and recovery regimes that aim to ensure the core functions of CCPs are maintained during times of crisis
- Appropriate emergency liquidity arrangements for CCPs in currencies in which they clear.
Taken on its face, this might suggest that Canadian authorities will permit global CCPs to clear Canadian market participants' derivatives if uniform international standards are respected, which would be a significant step towards meeting the FSB's instruction from June 2012 "to achieve by end-2012 the commitment to centrally clear all standardized OTC derivatives" even though, as the FSB noted, Canada's provinces have taken only the first steps in this regard. However, it appears that Canadian securities regulators will require each CCP with Canadian clearing members to apply for local recognition (or an exemption) and meet Canadian requirements rather than granting any blanket exemptions to G20-recognized CCPs. Shortly after the FSB's June 2012 progress report was issued, the CSA published for comment Consultation Paper 91-406 on Derivatives: OTC Central Counterparty Clearing which reaffirmed that "recognition of non-Canadian CCPs will require that Canadian regulators are comfortable that they can exert appropriate and effective regulatory powers over the foreign CCP, which in many cases will require Canadian regulators to develop co-operative regulation regimes with regulators outside of Canada".
It remains to be seen whether there is any conflict between the CSA's desire for regulatory powers over foreign CCPs and the scope of the co-operative oversight arrangements referred to by the FSB. The CSA Consultation Paper noted that: "Work on developing memoranda of understanding with these non-Canadian regulators needs to be undertaken immediately to ensure that Canadian regulators receive the information and co-operation required to oversee the non-Canadian CCPs that they have recognized or exempted from recognition." In addition, it is conceivable that the Bank of Canada may take on a more extensive regulatory recognition and oversight role in connection with foreign CCPs.
The Canadian regulators also indicated in the Statement that they "are satisfied with the direction and pace of the international efforts on the four safeguards, including with regard to implementation at global CCPs serving the Canadian market". Since March 2011, a recognition order (or an exemption from recognition) under the Securities Act (Ontario) has been required to carry on business as a clearing agency in Ontario. A few global CCPs, including LCH.Clearnet and the Chicago Mercantile Exchange, have obtained interim exemptions that permit operations while the CCPs complete more detailed applications and the regulatory requirements develop. The Canadian Derivatives Clearing Corporation (CDCC) also received an interim exemption which permits CDCC to clear interest rate and equity futures and options traded on the Montréal Exchange, as well as a limited number of OTC equity options and repurchase (repo) transactions on specified government bonds.
Background Concerning Central Clearing and Canada's G20 Commitments
Direct clearing of OTC derivatives entered into between members of a clearing house involves each party to the bilateral trade agreeing to have the CCP act as its counterparty to the transaction. Upon acceptance by the CCP of a transaction submitted for clearing, the CCP becomes an intermediary for all obligations under the transaction, becoming "the buyer to every seller and the seller to every buyer", and each counterparty thereafter owes its obligations solely to the CCP and may only look to the CCP for performance of the counterparty's obligations. If the CCP's risk controls are properly structured, including its calculation of appropriate levels of collateral required to be posted for all transactions by the clearing members that it faces, then the systemic risk posed by the failure of a major swap market participant such as Lehman Brothers, which left the market uncertain as to the size of unsecured swap exposures of other market participants, can potentially be replaced by an orderly unwinding of an insolvent party's net positions with general market confidence that other market participants will not have significant unsecured swap exposures to the insolvent party (and for uncleared swaps, additional rules will impose collateral posting obligations).
The Bank of Canada's June 2011 Financial System Review described this policy basis for central clearing: "The use of CCPs with proper risk-management controls reduces the systemic risk by centralizing counterparty risk – thereby making its management more uniform and transparent – and by lowering system-wide exposures to counterparty risk through multilateral netting and risk mutualization. As a result, greater use of CCPs should reduce uncertainty regarding exposures and the likelihood that a default will propagate across the network of major market participants."
Canada, together with other members of the G20, committed in 2009 at the Pittsburgh Summit of the G20 to require the trading of all standardized OTC derivative contracts on exchanges or electronic trading platforms their clearing through CCPs where appropriate, and their reporting to trade repositories by the end of 2012. Canada reaffirmed this commitment at the Toronto Summit of the G20 in 2010.
Most or all of the large banks that play a central role in Canadian derivatives markets will have the resources and creditworthiness sufficient to permit them to become direct clearing members of global CCPs. As discussed in recent CSA Consultation Papers, other financial institutions and market participants – other than "end-users" that use derivatives solely for hedging purposes – will likely soon be required to indirectly clear derivatives through clearing members. (These matters are discussed in CSA Consultation Paper 91-404 Derivatives: Segregation and Portability in OTC Derivatives Clearing dated February 10, 2012 and CSA Consultation Paper 91-405 Derivatives: End-User Exemption dated April 13, 2012).
Market participants that are not large banks may not universally welcome the advent of mandatory central clearing, but they may agree with the elimination of anticompetitive barriers that could have disrupted access to foreign CCPs and offshore indirect clearing. However, that access may entail very significant operational and contracting challenges in order to establish effective indirect clearing relationships. Market participants are still in the process of assessing the magnitude of collateral posting requirements under the new regulatory regime and the potential uncertainty concerning the credit exposure arising from such posting obligations.