The Canadian Securities Administrators “CSA”) recently published Proposed National Instrument 93-101 ‑ Derivatives: Business Conduct and Proposed Companion Policy 93-101CP ‑ Derivatives: Business Conduct (the “Proposed Rules”) which would establish a comprehensive regime for regulating the business conduct of participants in the over-the-counter (“OTC”) derivatives markets.
The Proposed Rules include a number of prescriptive requirements relating to fair dealing, conflicts of interest, know-your-client (“KYC”), suitability, safeguarding of counterparty assets, mandatory disclosure and reporting to counterparties, record-keeping and compliance. Many of the requirements set out in the Proposed Rules are similar to existing market conduct requirements for registered securities dealers and securities advisers prescribed by National Instrument 31-103 - Registration Requirements, Exemptions & Ongoing Registrant Obligations.
Comments on the Proposed Rules may be submitted until September 1, 2017.
The CSA recently announced that it will also publish for comment, likely later this year but after September 1, 2017, a separate set of proposed derivatives registration rules (the “Registration Rules”) for derivatives dealers, derivatives advisers and potentially other derivatives market participants. While the comment period on the Proposed Rules will not overlap with the comment period on the Registration Rules, the CSA will consider further comments on the Proposed Rules received after September 1, 2017, if they arise from a review of the draft Registration Rules.
Scope of the Proposed Rules
Derivatives advisers and derivatives dealers
The Proposed Rules apply to persons or companies that engage in or hold themselves out as engaging in:
- the business of advising others as to transacting in derivatives (“derivatives advisers”); and
- the business of trading in derivatives as principal or agent (“derivatives dealers”).
Under the Proposed Rules, derivatives dealers and derivatives advisers are collectively referred to as “derivatives firms”. “Derivatives parties” generally include all of the counterparties, customers, and other persons or companies that a derivatives firm may deal with or advise.
In addition, the Proposed Rules also apply to any other person or company required to be registered as a derivatives firm “under securities legislation” of a jurisdiction of Canada.
The Proposed Rules apply to derivatives firms regardless of whether they are registered or exempted from the requirement to be registered in a jurisdiction.
Complete exclusions from the Proposed Rules exist in some cases
The Proposed Rules do not apply to any of the following:
- regulated clearing agencies;
- Canadian and foreign governments;
- the Bank of Canada or a central bank of a foreign jurisdiction;
- the Bank for International Settlements or the International Monetary Fund;
- persons or companies when dealing with or advising an affiliated entity;
- derivatives “end-users”, being persons or companies who trade in derivatives for their own account for commercial purposes, but do not deal with or advise other derivatives parties, subject to certain conditions; and
- persons or companies who would otherwise be subject to the Proposed Rules applicable to derivatives advisers, if they provide only general advice in respect of derivatives that is not tailored to the needs of any particular party receiving the advice (e.g., analysis published in mass media), subject to certain conditions.
Minimum business conduct standards under the Proposed Rules apply in all cases
If a person or company is subject to the Proposed Rules, the following requirements apply in all cases when a derivatives firm deals with or advises a derivatives party, regardless of the level of sophistication or financial resources of the derivatives party:
- fair dealing;
- conflicts of interest;
- general KYC;
- segregation of counterparty assets;
- delivery of transaction confirmations;
- compliance; and
Certain Proposed Rules do not apply to dealings with sophisticated derivatives parties
The following Proposed Rules requirements do not apply if a derivatives firm is dealing with or advising certain sophisticated counterparties referred to as “eligible derivatives parties”:
- specific KYC;
- referral arrangements;
- complaint handling;
- tied selling;
- fair terms and pricing;
- use and investment of derivative party assets;
- pre- and post-trade disclosures;
- disclosures regarding borrowed money and delivery of non‑resident notices to derivative parties; and
- derivative party statements.
Under the Proposed Rules, the definition of “eligible derivatives parties” includes, among other persons:
- Canadian financial institutions;
- regulated pension funds;
- derivatives dealers and derivatives advisers registered in any Canadian jurisdiction;
- securities investment dealers and securities advisers registered in any Canadian jurisdiction;
- government entities; and
- corporate entities with net assets of at least $25 million and individuals who own financial assets with a net value of at least $5 million, provided in each case, they represent that they have the requisite knowledge and experience to evaluate the information about the derivative, the suitability of the derivative for them and the characteristics of the derivative.
Subject to certain exceptions, a derivatives firm would automatically receive the benefit of the above exclusions when dealing with or advising an eligible derivatives party that is not an individual. When dealing with an eligible derivatives party that is an individual, a derivatives firm would only receive the benefit of the exclusions if such individual has provided a written waiver.
Exemptions from specific requirements available for certain foreign derivatives dealers and advisers
The Proposed Rules provide, under certain conditions, exemptions from specific requirements to foreign derivatives dealers and foreign derivatives advisers that are regulated under the laws of a foreign jurisdiction whose business conduct rules are comparable to the Proposed Rules. Such foreign derivatives dealers and advisers will be exempt from some of the Proposed Rules, but the CSA has not yet completed the necessary equivalency analysis to determine what those provisions would be.
Exemptions from specific requirements available for certain Canadian financial institutions and investment dealers
A derivatives dealer that is a Canadian financial institution or a registered investment dealer that is a member of IIROC will be exempt from certain requirements of the Proposed Rules, but the CSA has not yet completed the list of these requirements.
Fair dealing, fair terms and pricing
Under the Proposed Rules, derivatives firms have a general obligation to deal fairly, honestly and in good faith with derivatives parties. As an adjunct to this general obligation, the Proposed Rules specifically require that derivatives advisers allocate transaction opportunities fairly among derivatives parties. Similarly, the Proposed Rules require that derivatives firms acting as agents in transactions with derivatives parties endeavour to obtain the most advantageous terms reasonably available, and that derivatives firms acting as principals in transactions with derivatives parties provide a price that is fair and reasonable taking into consideration all relevant factors.
Conflicts of interest, tied selling and referrals
Under the Proposed Rules, a derivatives firm is required to take reasonable steps to identify existing material conflicts of interest and material conflicts that the derivatives firm reasonably expects to arise between the derivatives firm and their derivatives parties. In connection with this obligation, a derivatives firm is required to:
- disclose to a derivatives party any such conflict of interest that a reasonable derivatives party would expect to be informed of; and
- respond reasonably to any such conflict of interest by either avoiding, controlling or disclosing the conflict, as appropriate under the circumstances.
A derivatives firm is also prohibited from engaging in certain tied-selling practices, whereby a derivatives firm makes the provision of a product or service to a derivatives party conditional on the provision of another product or service to such derivatives party, and is required to disclose this prohibition to its derivatives parties. Similarly, a derivatives firm is required to disclose any referral arrangements to its derivatives parties, whereby the derivatives firm accepts or makes referrals to other persons, and accepts or pays fees in connection therewith.
The Proposed Rules require a derivatives firm to collect a variety of information from a derivatives party, including information necessary to comply with applicable federal and provincial legislation (such as anti-money laundering and anti-terrorist financing legislation) and information relating to the identity of such derivatives party (such as information about its business and its control persons). A derivatives firm is also obligated to make inquiries into the reputation of a derivatives party if it has any concern about the identity of such derivatives party, based on the information it has collected.
The Proposed Rules require a derivatives firm to take reasonable steps to ensure that a proposed transaction is suitable for a derivatives party, before recommending such transaction to such derivatives party, or accepting instructions to carry out such transaction from such derivatives party. In connection with this obligation, a derivatives firm is required to collect additional “client-specific KYC information” that would assist with the suitability assessment, including information on a derivative party’s specific needs and objectives, its financial circumstances and its risk tolerance. A derivatives firm is required to take reasonable steps to obtain and periodically update information about its derivatives parties. If a derivatives firm receives instructions to carry out a derivatives transaction for a derivatives party, and has determined that such transaction is not suitable for such derivatives party, then the derivatives firm is required to inform such derivatives party of its opinion in writing before acting on such instructions.
Safeguarding of counterparty assets
The Proposed Rules include several requirements related to the holding and use of a derivative party’s assets. Under the Proposed Rules, a derivatives firm is required to hold all of the assets of a derivatives party separate and apart from its own assets, in a segregated account with a prescribed depository institution. A derivatives firm is generally not permitted to use a derivative party’s assets other than for purposes of securing the obligations of the derivatives party; provided, however, that a derivatives firm is permitted to invest such assets in certain permitted investments.
Mandatory disclosure to counterparties
The Proposed Rules require a derivatives firm to provide a derivatives party with a variety of information prior to engaging in transactions with such derivatives party, including the information around conflicts of interest discussed above, as well as other information relating to the derivatives party’s relationship with the derivatives firm, the products and services that the derivatives party may obtain from the derivatives firm, and the costs associated therewith. In addition, before engaging in a transaction with a derivatives party, a derivatives firm is required to advise a derivatives party about the material characteristics and risks relating to that transaction.
Reporting to counterparties
Under the Proposed Rules, a derivatives firm is required to provide ongoing reports to derivatives parties, including confirmations following the completion of transactions. In addition, a derivatives firm is required to provide derivatives parties with monthly statements containing information on the transactions conducted by such derivatives parties and the positions maintained by such derivatives parties. Finally, a derivatives firm is required to provide derivatives parties with a daily valuation of their positions.
The Proposed Rules contain extensive record-keeping obligations that require a derivatives firm to keep a variety of records relating to its business and transactions, including records of compliance matters, records of communications with derivatives parties, records enabling accurate trade reconstructions, records of execution activities, and records of pre- or post-transaction activities. Under the Proposed Rules, records and supporting documentation relating to a particular transaction would need to be kept in a readily accessible location for a period of at least seven years following the termination or expiry of such transaction. Records more general in nature that do not relate to any particular transaction must be kept for a period of at least seven years following the termination or expiry of a derivative party’s last transaction.
The Proposed Rules require a derivatives firm to implement a system of controls and supervision that is designed to ensure compliance with applicable securities laws and to manage the risks relating to its business activities. Under the Proposed Rules, compliance is generally effected by “senior derivatives managers”, being the individuals responsible for managing different derivatives business units. Senior derivatives managers are responsible for supervising activities conducted by employees in their business unit, and for promoting and ensuring compliance within such unit. As part of their responsibilities, senior derivatives managers are required to submit an annual compliance report to a derivatives firm’s board of directors, containing a certification as to material compliance with applicable laws and regulations, and identifying any circumstances of non-compliance. In addition, senior derivatives managers are required to report to securities regulatory authorities in circumstances where they have identified non-compliance.