The federal government and the governments of British Columbia, New Brunswick, Ontario, Prince Edward Island and Saskatchewan (Participating Provinces) have signed a memorandum of agreement in respect of a proposed cooperative capital markets regulatory system (Cooperative System). As part of this Cooperative System, existing provincial securities and derivatives legislation will be replaced in the Participating Provinces with uniform provincial capital markets legislation, and complementary federal legislation will address matters within federal jurisdiction including the management of systemic risk in Canada’s financial system. For general background on these developments, please see our September 2014 Blakes Bulletin: Cooperative Capital Markets Regulatory System Agreement and Draft Legislation Released.
Consultation drafts of the uniform Provincial Capital Markets Act (PCMA) and the federal Capital Markets Stability Act (CMSA) were released for public comment in September 2014 (Consultation Drafts). The PCMA and CMSA will implement the Cooperative System, grant broad regulatory authority to a single jointly appointed Capital Markets Regulatory Authority (Authority) and overhaul existing securities laws in the Participating Provinces.
Given the scope of the proposed changes, Blakes is publishing a series of bulletins discussing aspects of the proposed Cooperative System. This bulletin discusses the proposed regulation of derivatives trading under the PCMA.
CURRENT DERIVATIVES REGULATORY REGIME AND IMPACT OF PCMA
Under existing provincial securities laws, over-the-counter (OTC) derivatives markets have traditionally not been subject to significant regulation as compared to securities markets. However, there has been significant movement towards full regulation of OTC derivatives markets in Canada since the G20’s 2009 Pittsburgh summit. At that summit, the G20 leaders made broad regulatory reform commitments and issued a declaration that OTC derivatives should be required to be traded on electronic trading platforms and centrally cleared where appropriate, reported to trade repositories and subject to capital and collateral requirements.
Over the past five years, the Derivatives Committee of the Canadian Securities Administrators (CSA), with contributions from federal institutions and market participants, has worked to develop a uniform national approach to implement the G20 commitments in Canada and to develop a nationally uniform registration regime for derivatives dealers and advisors that would parallel the existing national securities registration regime. Meanwhile, several provincial securities statutes have been updated to reflect these developments and permit a parallel treatment of securities and derivatives overseen by provincial securities regulators.
Adoption of the PCMA would in effect continue this process in the Participating Provinces by eliminating residual differences between their provincial rules and ensuring that these provinces are able to move forward in lock-step once resolution is reached on the specific rules that have been discussed to date by the CSA Derivatives Committee.
The PCMA will replace the existing Securities Acts of each of the Participating Provinces and, it appears, the somewhat archaic Ontario Commodity Futures Act, which currently provides a parallel regulatory regime for exchange-traded futures and options trading.
The PCMA does not provide a prescriptive codification of derivatives rules. Instead, it provides the Authority and the Authority’s chief regulator (Chief Regulator) with a great deal of latitude to use their rulemaking, investigative and supervisory authorities to achieve the PCMA’s purposes, which are to provide protection to investors from unfair, improper or fraudulent practices; foster fair, efficient and competitive capital markets in which the public has confidence; and contribute to the stability and integrity of the Canadian financial system. However, this relatively unrestrained rulemaking and supervisory latitude is seen by a number of commentators as possibly leading to regulatory overreach by an unelected body that is sheltered from democratic influence.
The potential scope of the Authority’s powers under the PCMA is illustrated by the absence of any statutory carve-outs from the broad definition of the term derivatives in the draft PCMA. The proposed definition of derivatives, which closely tracks the broad definition under provincial and federal statutes, includes any “financial or commodity contract or instrument, whose market price, value, delivery obligations, payment obligations or settlement obligations are derived from, referenced to or based on an underlying interest.” Commentary provided with the Consultation Drafts (Commentary) notes that “certain instruments, including commodity contracts entered into for purely commercial physical delivery purposes or contracts that are otherwise regulated (e.g., electricity contracts in some provinces), are not intended to be regulated under the PCMA.” Accordingly, we can expect that rules similar to the “Scope Rule,” which applies to the Ontario derivatives trade reporting rule, will be developed. However, the Authority itself will have the authority to shape such scope rules as it sees fit in order to carry out the purposes of the PCMA, and the PCMA does not provide any provisions that specifically indicate an intention to limit its scope.
Set out below is a summary of the key aspects of the derivatives regulatory platform provided in the draft PCMA and our expectations concerning key rules that will be issued by the Authority using this platform.
DERIVATIVES TRADE REPORTING, CENTRAL CLEARING AND COLLATERAL REQUIREMENTS
In line with the provincial Securities Acts, the PCMA does not itself set out any obligations of parties to derivatives transactions to report trades to trade repositories, centrally clear trades or post collateral for uncleared trades in prescribed amounts. Instead, such rules are expected to ultimately be made directly by the Authority pursuant to its specific rulemaking powers under the PCMA.
The PCMA does not specify that the Authority should issue such rules and does not provide any guidance or limitations on such rules if they are issued. Instead, the PCMA is expected to simply state that the Authority may make regulations for carrying out the purposes of the PCMA, including (presumably without limitation) the specific types of regulations that are to be listed, including regulations in respect of trading in derivatives, including recordkeeping, reporting and transparency requirements and requirements in respect of margin, collateral, capital, clearing and settlement.
Any rules developed through the CSA Derivatives Committee process would be expected to be adopted once the PCMA comes into force and the Authority will presumably continue to work on those rules that remain under development. Currently, the only relevant rule that has been finalized is the trade reporting rule that is now in force in Ontario, Manitoba and Quebec. It remains to be seen whether the coordinated CSA Derivatives Committee process will continue to be supported and effective in working towards uniform national rules notwithstanding the presumed divide between the Participating Provinces and those provinces that have elected not to join the Cooperative System.
DERIVATIVES DEALER AND ADVISER REGISTRATION REQUIREMENTS
The PCMA provides that all dealers and advisers must be registered with the Authority in accordance with regulations that have not yet been published in draft. The term “dealer” is defined to mean a person who (a) engages in, or holds itself out as engaging in, the business of trading in securities or derivatives as principal or agent or (b) acts as a securities underwriter (as defined in the PCMA). “Adviser” means a person engaging in, or holding itself out as engaging in, the business of advising others with respect to investing in, purchasing or selling securities or trading derivatives. These registration obligations and the related definitions are consistent with those applicable under the Securities Acts of a number of provinces, including British Columbia. However, the draft PCMA does not include the broad exemptions from derivatives dealer registration obligations that are currently available in such provinces for transactions between qualified parties, including most institutional sell-side and buy-side market participants. These registration obligations and definitions are also consistent with the registration obligations and related definitions that would apply under the existing Ontario Securities Act if amendments that have been passed were proclaimed in force. The expectation has been that the existing derivatives blanket orders will be withdrawn and the Ontario amendments will be proclaimed into force once a national derivatives registration regime is adopted, and accordingly the PCMA’s approach is consistent with the existing CSA approach.
Very few obligations are imposed on derivatives dealers and advisers in the draft PCMA itself other than the registration obligation and rules of general application that apply to all persons involved in trading derivatives. Instead, the Authority will make regulations under the PCMA that will set out registration application requirements, fee schedules, the ongoing obligations of registrants, conditions of registration, likely including proficiency, capital, insurance and compliance requirements, and other ongoing business conduct requirements as discussed in our November 2014 Blakes Bulletin: New Proposed Provincial Capital Markets Legislation: What It Means for Registrants and Other Market Participants.
For securities dealers and advisers, the registration categories and related obligations are expected to initially be based on the uniform regime set out in an existing national instrument. There is currently no registration regime applicable for derivatives market participants but a Consultation Paper on derivatives dealer and adviser registration requirements was issued by the CSA Derivatives Committee in April 2013, which is described in our May 2013 Blakes Bulletin: Canadian Securities Administrators Unveil Proposed Derivatives Registration Regime.
The CSA Derivatives Committee is expected in the next few months to issue a consultation draft of a derivatives registration rule that will likely be adopted as the initial derivatives dealer and adviser registration rule under the PCMA.
It is expected that this draft rule will provide an exemption from Canadian registration requirements for non-Canadian dealers and advisers that are subject to derivatives registration obligations in certain qualifying home jurisdictions upon satisfaction of prescribed conditions (similar to exemptions provided to international securities dealers and advisers from securities registration rules).
Canadian banks were also previously expected to be exempted from provincial registration obligations in light of the existing regulation of banks by the federal banking regulator, the exclusivity of federal jurisdiction over the business of banking, and the inclusion in some provincial Securities Acts of blanket registration exemptions for Canadian banks. However, the PCMA does not itself include any such exemption for Canadian banks and the CMSA provides that the federal Minister of Finance, after consultation with the Council of Ministers (which includes ministers of the Participating Provinces), may make an order assigning to the Authority the administration of any federal Bank Act provisions or regulations. The Commentary indicates that such an order “will facilitate the integration and coordination of derivatives regulations with the Authority when it becomes operational.” It is not yet clear whether registration obligations are intended to apply to Canadian banks in accordance with such an order or if the intention is just to impose on some or all Canadian banks the same trade reporting, clearing and collateral requirements that would apply if such Canadian banks were registered as dealers and also grant the Authority jurisdiction to oversee compliance with such requirements.
The Authority may issue exemptions from registration requirements to individual applicants and classes of persons if not prejudicial to the public interest to do so.
The current draft of the PCMA includes an obligation on all registrants to deal fairly, honestly and in good faith with their clients. This reflects the existing standard of conduct for securities dealers and advisers in Canada but will be a new type of obligation for derivatives market participants once they are required to register. All registrants are also required to identify, disclose and manage conflicts of interest in accordance with the regulations, but this requirement will presumably be of less relevance to derivatives dealers than to securities dealers.
MARKET CONDUCT RULES AND OTHER PCMA RULES OF GENERAL APPLICATION
The PCMA includes market conduct rules that are generally applicable to both securities and derivatives trading, and are similar to those set out in provincial Securities Acts including:
- A prohibition on making materially false or misleading statements that would reasonably be expected to have a significant effect on the market price or value of a security, derivative or the underlying interest of a derivative
- A prohibition on directly or indirectly engaging in any act or course of conduct relating to securities or derivatives that (a) results in “an unjust deprivation or a risk of an unjust deprivation of a person's money or other property or of the value of the person’s property; or (b) the person knows or reasonably ought to know perpetrates a fraud on any person”
- A prohibition on engaging in an unfair practice in relation to a trade, including (a) putting unreasonable pressure on another person to trade in a derivative; (b) entering into a transaction with another person “who is unable or does not have the capacity to reasonably protect his or her own interest because of physical or mental disability, ignorance, illiteracy, age or other inability to understand the character, nature or language of any matter relating to a decision to purchase, hold or sell a security or to trade in a derivative;” and (c) engaging in any other prescribed practice
- A prohibition on directly or indirectly engaging in any conduct that improperly influences the determination of a benchmark or contributes to the production of a false or misleading determination of the benchmark
- A prohibition on false or misleading statements about something that a reasonable investor would consider important in deciding whether to maintain a relationship with the counterparty.
Whistleblower protections are also included in the PCMA for employees who provide information to the Authority or a law enforcement agency respecting an act of the employer or its officers or employees that the employee believes is contrary to capital markets law.
The PCMA also makes it an offence to do or omit to do anything for the purpose of aiding, abetting or counselling a contravention of capital markets law or to conspire with any person to contravene capital markets law.
PRESCRIBED DISCLOSURE DOCUMENTS FOR ‘DESIGNATED DERIVATIVES’ AND TAILORED OBLIGATIONS FOR OTHER CLASSES OF DERIVATIVES
There are no requirements imposed in the PCMA to provide a prospectus or other disclosure document in respect of derivatives transactions generally, but the PCMA does provide that for trading in “designated derivatives” a disclosure document in prescribed form must be filed with the Chief Regulator and, if required by the rules, a receipt must be obtained from the Chief Regulator (similar to a receipt for a prospectus, which suggests a review and comment process).
The Authority may, if it considers it to be in the public interest, make an order designating particular derivatives or classes of derivatives to be “designated derivatives.”
The Commentary indicates that it “is anticipated that designated derivatives will include derivatives that raise investor protection concerns, but for which traditional securities regulatory requirements are not appropriate. The regulations will prescribe varying levels of disclosure depending on the specific circumstances, including the nature of the product and the identity of the parties.”
Any class of derivatives may also be designated by the Authority to be securities if the Authority considers this to be in the public interest, which would result, among other things, in prospectus obligations applying to such derivatives (subject to any applicable exemptions).
Furthermore, classes of derivatives may be made subject to any prescribed provisions of the PCMA or related regulations. The Commentary indicates that this will allow “applicable requirements to be tailored to the class of derivative and to address other relevant factors such as the type of counterparty and the method of transacting.” It will also still be open to the Authority to achieve this objective by granting exemptions which set out a customized disclosure and compliance regime for particular derivatives or activities such as those exemptions that currently permit the offering by certain investment dealers of platform-traded Contracts for Differences.
DESIGNATION OF CERTAIN CLASSES OF DERIVATIVES AS SYSTEMICALLY IMPORTANT
As we will discuss in a separate bulletin, under the CMSA the Authority may designate a class of derivatives as systemically important and regulate them nationally if, in the Authority’s opinion, the class of derivatives could pose a systemic risk related to capital markets.
REGULATION OF CLEARING AGENCIES, MARKETPLACES, TRADE REPOSITORIES AND OTHER MARKET INFRASTRUCTURES
Entities that wish to perform a core market infrastructure function that is under the oversight of the Authority must apply to be “recognized” by the Authority. This includes clearing agencies and exchanges (which term is not defined in the PCMA but would likely include traditional futures exchanges but not most other derivatives trading platforms). The Authority may grant such recognition if it is considered to be in the public interest, and the Authority may also impose conditions, restrictions or requirements on such recognition at any time upon giving the relevant entity an opportunity to make representations. The Chief Regulator may also make decisions regarding the manner in which a recognized entity carries on business and regarding derivatives trading on a recognized exchange, subject to certain rights of appeal to the Authority’s adjudicative tribunal.
Similarly, marketplaces (other than exchanges), trade repositories and certain other providers of specific services within the capital markets may apply to the Authority for a designation order under the PCMA. There are no requirements to obtain designation orders in order to carry on the relevant businesses but related regulations will require other market participants to deal with service providers that have received designation orders. For example, derivatives counterparties are required to report trades to designated trade repositories, and accordingly derivatives trade repositories in practice need to obtain designation orders in order to effectively provide the desired reporting service to Canadian market participants. As with recognition orders, the Authority may grant such recognition if it is considered to be in the public interest, and the Authority may also impose conditions, restrictions or requirements on such recognition at any time upon giving the relevant entity an opportunity to make representations. The Commentary notes that, similarly to recognition orders, the Authority will impose a number of requirements on designated entities through their designation orders and the regulations.
GENERAL REGULATORY AUTHORITY OVER MARKET PARTICIPANTS
Recognized entities and designated entities as well as registered and exempted dealers and advisers all fall within the definition of “market participants” in the PCMA. Market participants are subject to general regulatory oversight, and business and conduct review by the Chief Regulator and its designees, who will have rights to enter a market participant’s business premises to complete such reviews. Market participants that are the subject of business and conduct reviews will be required to pay the Authority such fees as may be prescribed.
In connection with the administration or enforcement of capital markets laws and the regulation of capital markets, and to permit the Chief Regulator to assist regulators in other jurisdictions with such matters, the Chief Regulator may also order a market participant to provide the Authority with any specified information, record or thing in the market participant’s possession.
The Authority may also require market participants or any other persons to provide it with such records and information as the Authority requests for the purposes of monitoring activity in capital markets, detecting, identifying or mitigating systemic risks related to capital markets, or conducting policy analysis related to the Authority’s mandate and the purposes of the PCMA. The Chief Regulator also has this authority in respect of all persons under the CMSA.
These regulatory powers are also discussed in our November 2014 Blakes Bulletin: New Proposed Provincial Capital Markets Legislation: What It Means for Registrants and Other Market Participants.
Also, as we will discuss in a separate bulletin, systemically important capital markets participants, trading facilities and clearing houses are also subject to regulation by the Authority under the CMSA.
DEADLINE FOR COMMENT
Comments on the Consultation Drafts may be submitted until December 8, 2014.