Summary

On June 20, 2012, the Canadian Securities Administrators (“CSA”), the voluntary umbrella organization of Canada’s provincial and territorial securities regulators through its Derivatives Committee (“Committee”), published for public comment a further Consultation Paper 91‐406 Derivatives: OTC Central Counterparty Clearing (“CSA Paper 91‐406”) following its initial Consultation Paper 91‐401 Over-the‐ Counter Derivatives Regulation in Canada as part of its commitment to establish a comprehensive framework for over‐the‐counter derivatives regulation and to balance the need to meet international commitments with the needs of individual market participants in Canada. In CSA Paper 91‐406, the Committee aims to meet the commitment of G20 leaders made in Pittsburgh in September 2009 that all standardized over‐the‐counter (“OTC”) derivatives contracts should be cleared through central counterparty (“CCP”) by end 2012, at latest. The general intent of the proposed requirements related to CCP clearing as outlined in CSA Paper 91‐406 is that the introduction of requirements for CCP clearing of previously bilaterally cleared or un‐cleared derivatives transactions will enhance both the transparency of derivatives markets for regulators, and to serve to mitigate the overall risk involved with derivative transactions.

The purpose of CSA Paper 91‐406 is to outline the CSA proposals relating to the CCP clearing of OTC derivatives with the overall objective that the discussion contained therein will generate the commentary and debate necessary to regulators with respect to selecting appropriate policies and rules that will eventually be implemented in the various jurisdictions of Canada. The CSA stayed true to the pattern in its previously published consultation papers within the context of the proposed Canadian derivatives regulatory regime, to highlight its analysis of what it has considered in making its recommendations for a proposed requirement of regulating derivatives then laying out some recommendations on how it proposes to accomplish this, and concluding by posing specific questions to the public asking if its recommendations are appropriate and if other issues or alternatives should be considered1.

CSA Paper 91‐406 describes the Committee’s proposals related to mandatory CCP clearing of OTC derivatives and discusses, among other things, the following:

  • issues of back‐loading pre‐existing transactions;
  • time frames for CCP clearing;
  • limited exemptions for intra‐group transactions;
  • recognition of CCPs;
  • FMI principles and risk management;
  • systems and technology;
  • protection of assets;
  • reporting; and,
  • issues related to foreign‐based CCPs and regulatory cooperation.

Mandatory CCP Clearing

The Committee proposes the mandatory clearing of all “eligible” OTC derivatives. In order to determine which derivatives are eligible for clearing by a CCP, the Committee suggests a twopronged approach: the “bottom‐up approach” and the “top‐down approach”.

  1. Bottom‐up Approach

The bottom‐up approach refers to a process whereby a CCP submits OTC products that it already clears, or proposes to clear, to market regulators who would determine whether the products in question are eligible for central clearing and should be subject to mandatory clearing.

  1. Top‐Down Approach

The top‐down approach refers to the process whereby a market regulator conducts analysis of market data for the purpose of identifying derivatives or categories of derivatives that potentially should be subject to an obligation to be centrally cleared.

The Committee, in considering both the bottom‐up and the top‐down approaches, would take into account certain criteria/factors such as: standardization of the derivative; liquidity of the market; the availability of accurate pricing; the risk the derivative would bring to a CCP; the costs to the market participants and public commentary.

In proposing to use the bottom‐up and the top‐down approach on assessing the central clearing eligibility of OTC derivatives contracts, the Committee is borrowing the international approach particularly the European Union’s (“EU”) approach in its Proposed EU Regulation on OTC Derivatives.

In CSA Paper 91‐406, the Committee proposes that, should a CCP fail to accept a derivative for clearing that has been determined by the regulator to be subject to mandatory clearing, the market regulator will conduct further analysis and publish a report of its findings. The analysis may lead to the determination of minimum capital or margin requirements for the derivative that is bilaterally cleared, or other trading restrictions; the Committee does not propose that a CCP will be required to clear transactions should the CCP decline to clear based on its own risk analysis.

In addition to the two‐pronged approach described above, the Committee also proposes that market regulators maintain a register of those derivatives that which have been determined eligible for central clearing and subject to mandatory CCP clearing.

Back‐loading of Pre‐Existing Transactions

The Committee takes the position that pre‐existing derivative transactions that are un‐cleared, or that were cleared bilaterally, may benefit from being “back‐loaded” in the CCP clearing process. Given the complexity of back‐loading, pre‐existing transactions should only be backloaded voluntarily; the Committee is cognisant that the costs of back‐loading must be weighed against the benefits. However, if such pre‐existing transactions become subject to novation or assignment (effectively making them new trades), they should be subject to the new applicable clearing obligation(s). The Committee further suggests that market regulators conduct reviews of trade repositories2 (once appropriately established) and other sources to determine whether additional back‐loading obligations are appropriate.

In this regard, though the Committee is considering a voluntary back‐loading of un‐cleared bilateral derivatives transactions, the Committee is still going further than what the EU and the United States require in the Proposed EU Regulation on OTC Derivatives and in the US Dodd‐ Frank Act3, which requires only that un‐cleared derivatives be reported to a registered trade repository.

The Committee has requested certain comments from the public and interested stakeholders on the above proposals, as follows:

  1. Do you consider that product characteristics of any OTC derivative asset classes make them eligible for CCP clearing based on the factors set out herein? If so, what asset classes would you exclude, and for what reasons?
  2. For which asset classes do you consider CCP clearing is inappropriate or not currently feasible based on the factors described herein, and for what reasons?
  3. What are the costs and risks involved in moving particular derivatives or classes of derivatives transactions to CCP clearing that regulators should consider in determining if a derivative should be subject to a CCP clearing requirement?

Time Frames for CCP Clearing

The Committee suggests that trades that are subject to mandatory clearing should be submitted to a recognized CCP no later than the close of business on the day of execution. The CCP should then be required to review such a submitted transaction in order to ensure that it complies with the CCP rules and does not present an inappropriate risk to the CCP. Communication of acceptance or rejection of the transaction should be provided to the submitting party following the analysis of the CCP and no later than the end of the CCP business day.

With respect to trades that are cleared voluntarily (i.e. trades that are not subject to a mandatory clearing requirements and are not executed on an approved trading venue), the Committee recommends that if they are submitted to the CCP promptly (i.e. prior to the end of the close of business on the day of execution), the CCP would be subject to the same requirement to accept or reject the transaction by the end of its business day.

Finally, the Committee proposes that those derivatives which are both subject to mandatory clearing and are traded on a recognized trading venue, be submitted to the CCP as soon as possible. It is the Committee’s preference that the submission process would be fully automated.

The Committee has requested certain comments from the public and interested stakeholders on the above proposals, as follows:

  1. Does a deferred submission, be it measured in minutes, hours or days, engender significant counterparty or other risks that would make the imposition of a strict timeframe for submission to a CCP, and the acceptance by the CCP necessary?

Intra‐group Transactions

In very broad terms, intra‐group transactions are essentially transactions between two related affiliates or associated entities. Unlike proponents in both the United States and the EU, the

Committee does not support a broad exemption for intra‐group transactions from the CCP clearing obligation. The Committee is concerned that such an exemption would result in a situation where some intra‐group transactions could result in increased risk to the market or to a third‐party.

The Committee has requested certain comments from interested stakeholders on the above proposals, as follows:

  1. The Committee asks whether an exemption from mandatory CCP clearing for intra‐group transactions is appropriate, including a description of the risks that they could pose to the marketplace and the costs of migrating such transactions to a CCP.

Recognition of CCPs

The Committee proposes the market regulators provide for recognition and regulation of CCPs. In Canada currently, only Ontario and Quebec require the recognition, or exemption from recognition, of CCPs.

Though the Committee states in CSA paper 91‐406 that in Alberta, recognition or exemption from recognition is required, this is not yet the case. In Alberta the Securities Act has been amended to require recognition of a clearing agency, but these particular sections of the legislative bill have not yet been proclaimed and are not yet in effect4.

The Committee recognizes that such recognition (or exemption from recognition) is not limited to the CCP physical presence, as a CCP located in one province or in a foreign country can carry on business in other Canadian jurisdictions where it offers services to persons residing in a jurisdiction or registered to carry on business in that jurisdiction.

FMI Principles and Risk Management

The Committee suggests that prior to 2012 the global standard for CCP structure and oversight was contained in two papers: Core Principles for Systemically Important Payment Systems5 and Recommendations for Central Counterparties6. Early in 2010 these standards were reviewed. This review resulted in a consultative report being issued in March 2011 and then, in April 2012, the final FMI principles were published.

The FMI principles describe the risks faced by financial market infrastructures (“FMI”), including CCPs. The FMI principles are intended as broad but flexible guidance for addressing risks and efficiencies in FMI and discuss aspects of risk mitigation to areas including, but not limited to: segregation and portability; tiered participation; general business risk; governance; fees; participant access; and CCP rules.

Generally, the Committee proposes to incorporate the FMI principles when developing requirements applicable to CCPs recognized in Canada. Specifically, the Committee proposes development and implementation of a robust risk management program, in accordance with FMI principles, which includes:

  • an effective, multi‐level contingency structure including liquidity analysis and member margining, a default waterfall, required contributions and further financial backstops and/or insurance;
  • a method of analysis for all relevant risks and appropriate risk management procedures;
  • appropriate risk limits on individual clearing members;
  • a method to inform regulator(s) as to when a clearing member is at risk of default and when any default procedures are triggered;
  • undertaking periodic testing and review of clearing systems;
  • maintenance and utilization of accurate pricing and valuation procedures;
  • maintenance and utilization of product approval procedures to ensure that new clearing products do not bring undue risk to the CCP and its members;
  • utilization of a chief risk officer who reports to the CCP board or directors or risk management committee;
  • certain subject risk management models;
  • a method to provide regulators with periodic reports relating to the risks applicable to the CCP (and a description of how the risks are managed); and
  • a method to provide regulators with financial reports relating to the CCP, including aggregate risk exposures.

The Committee has requested certain comments from the public and interested stakeholders on the above proposals, as follows:

  1. Is it appropriate to ensure that Canadian market participants have meaningful input into operational decisions of a CCP operating in Canada?
  2. Do the Committee’s proposals relating to corporate governance of a CCP address potential issues relating to conflicts of interest that may arise in the operation of a CCP? If not, what other measures would address such conflicts of interest?
  3. The Committee seeks public comment on the relevance of developing rules allowing for access to CCPs regardless of trading venue. Is this of concern in the Canadian marketplace at this time or in the future?

Systems and Technology

The Committee acknowledges National Instrument 21‐101 respecting Marketplace Operation and recommends that comparable regulations be developed for CCPs. The Committee proposes that a program of risk analysis and oversight be implemented in order to identify and minimize sources of operational risk, in particular systems and technology.

Protection of Assets

CSA Paper 91‐406 indicates that the mandatory clearing of OTC derivatives will require that certain market participants need to clear their OTC derivatives through intermediaries. The Committee, in its consultation paper 91‐404 Derivatives: Segregation and Portability in OTC Derivatives Clearing, propose that effective segregation and portability mechanisms at CCPs will help to ensure that indirect clearing is done in a manner that protects customer positions and collateral, and potentially improves CCPs resilience to a clearing member default.

Reporting

In addition to proposed collection of information by trade repositories7, the Committee also proposes that each market regulator seek the legislative authority to require the CCP to transmit relevant information to the market regulator required for oversight purposes. Such information may include, but not be limited to: transaction level details; margin requirements; guarantee fund contributions; financial statements; risk modes; financial resources that must be available for a market stress situation; board decisions and reports; rule and procedural modifications; information regarding outsourcing arrangements and details or any emergency or disciplinary actions.

The Committee has requested certain comments from the public and interested stakeholders on the above proposals, as follows:

  1. The Committee asks for comment on the type of information that a CCP should provide and that should be made publicly available.

Foreign‐based CCPs and Regulatory Co‐operation

The Committee suggests that the review and recognition (or exemption from recognition) of foreign‐based CCPs is a priority, as a majority of counterparties to derivatives trades entered into by Canadian participants are resident outside of Canada.

The Committee has requested further comments from the public and interested stakeholders on the above proposals, as follows:

  1. Generally, the Committee has endeavoured to follow international recommendations in the development of the recommendations for Canada in this paper. Are there recommendations that are inappropriate for the Canadian market?
  2. Are there changes to the existing regulatory framework that would be desirable to accommodate a move to CCP clearing?
  3. Do you consider that any changes need to be made to Canadian law to facilitate the efficiency of OTC derivatives clearing, either through a domestic or a foreign CCP? If so, what changes and for what reasons?

CSA Next Steps and Seeking of Public Comments

The Committee encourages market participants and the public to submit comments addressing any issues or questions they have raised in CSA Paper 91‐406. The deadline for submitting comments is September 21, 2012. The Committee will consider the comments and finalize the rule‐making guidelines, and each province will then begin the rule‐making process. The Committee will also be releasing the remaining three consultation papers on Exchange and Platform Trading (OTC Derivatives); Registration (Derivatives); and Capital and Collateral (OTC Derivatives) in coming months.