The Canadian government and the governments of British Columbia, New Brunswick, Ontario, Prince Edward Island and Saskatchewan (Participating Provinces) have signed a memorandum of agreement to formalize the terms and conditions of a proposed cooperative capital markets regulatory system (Cooperative System). For more information on this, 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 complementary federal Capital Markets Stability Act (CMSA), which implement the Cooperative System, were released for public comment in September 2014 (Consultation Drafts). The PCMA and CMSA grant broad regulatory authority to a single jointly appointed Capital Markets Regulatory Authority (Authority), overhaul existing securities laws in the Participating Provinces and create new national regulatory powers related to systemic risk. Given the scope of the new proposed legislation at both the federal and provincial levels, Blakes is publishing a series of bulletins regarding various aspects of the proposed Cooperative System.
This bulletin focuses on the CMSA’s regulatory regime directed at protecting the stability and integrity of Canada’s financial system through the management of systemic risk related to capital markets. The CMSA provides the Authority with broad new powers to impose regulations addressing systemic risk on capital markets intermediaries, market infrastructure entities and classes of securities and derivatives that the Authority considers to be systemically important. In addition, the Authority is provided with new powers to make orders it considers necessary to address serious and imminent systemic risks related to capital markets. Such orders may apply to any person and may prohibit any action specified by the Authority.
These broad powers under the CMSA to regulate capital markets in connection with systemic risk could lead to significant requirements and controls being imposed by the Authority on a broad range of market participants.
GENESIS OF A FEDERAL CAPITAL MARKETS LAW FOCUSED ON SYSTEMIC RISK
In 2011, the Supreme Court of Canada rendered a unanimous decision (Supreme Court Decision) that a proposed federal Securities Act was not constitutional on the basis that, when viewed in its entirety, it exceeded the federal government’s trade and commerce power to make laws addressing trade and commerce matters of genuine national importance and scope in a way that is distinct from provincial concerns. In doing so, the court stopped the federal government's previous initiative to establish a single national securities regulator. See our December 2011 Blakes Bulletin: Supreme Court Finds Against National Securities Regulator for more details. However, the Supreme Court Decision did recognize that certain aspects of securities regulation would likely fall within federal jurisdiction. In particular, the federal government would likely have the authority to make securities laws aimed at managing systemic risk and preserving the stability of Canada’s financial system.
The draft federal CMSA adheres closely to the jurisdictional analysis set out in the Supreme Court Decision by only addressing the management of systemic risk in Canada’s financial system, national data collection and criminal law matters. This restricted focus is also reflected in the CMSA’s purposes which are specified to be, “as part of the Canadian capital markets regulatory framework, (a) to promote and protect the stability and integrity of Canada’s financial system through the management of systemic risk related to capital markets; and (b) to protect capital markets against the commission of financial crimes.”
The global financial crisis resulted in an international re-evaluation of perceived weaknesses in capital markets regulation, which were previously not effectively focused on monitoring and mitigating systemic risk. The powers proposed for the Authority in the CMSA to address threats to financial stability reflect the international initiatives to introduce risk-focused regulation on entities and products that may pose systemic risk. The breadth of these powers also recalls the very serious measures that were taken by various governments and governmental institutions such as the United States Department of the Treasury during the depth of the crisis.
Under the CMSA and the terms of the Cooperative System, the federal government will delegate all regulatory authority arising under the CMSA in respect of systemic risk to the Authority, subject to the oversight and approval of the Council of Ministers which oversees the Authority. However, as discussed below, the federal Minister of Finance will retain authority to direct how the Authority exercises the proposed power to make any urgent orders that are considered necessary to address serious and immediate systemic risks and will maintain a veto over orders of the Authority that may be imposed on systemically important capital markets intermediaries in respect of serious imminent risks.
DESIGNATION OF ENTITIES, PRODUCTS AND BENCHMARKS AS SYSTEMICALLY IMPORTANT
Under the CMSA, the Authority may designate certain capital markets intermediaries, securities and derivatives trading facilities, clearing agencies and credit rating organizations, as well as specific classes of securities and derivatives (products) and specific benchmark prices, estimates, rates, indexes or values (benchmarks) to be “systemically important;” and the Authority may also designate certain market practices to be “systemically risky.” The specific tests for making such designations in each case turns on whether “in the Authority’s opinion . . . a systemic risk related to capital markets” could be posed by the relevant capital markets intermediary, trading facility, clearing agency, rating organization, benchmark, product or market practice.
Each test for making such a designation also includes enumerated factors that are to be considered by the Authority. Before designating any entity to be systemically important, the Authority must notify the Council of Ministers and give the relevant entity “an opportunity to make representations.” No such notice or specific opportunity for impacted parties to make representations applies in respect of designations of products, practices or benchmarks.
The CMSA defines “systemic risk related to capital markets” (systemic risk) to mean a threat to the stability or integrity of Canada’s financial system that originates in, is transmitted through or impairs capital markets and that has the potential to have an adverse effect on the Canadian economy. For the purposes of this definition, “integrity of the financial system” is defined to mean “the structural integrity of all or any significant part of that system, including: (a) its continuous and orderly operation without disruption; (b) its soundness, cohesion and resilience; (c) the avoidance of its structural impairment; and (d) the maintenance of public confidence in its structural integrity.”
Once such a designation order is made, the relevant person, benchmark, product or practice becomes subject to all regulations made by the Authority that apply to the relevant class of systemically important persons or the relevant product, practice or benchmark. There are no specific restrictions on the type or scope of regulations that may be made by the Authority in respect of such categories of persons or the relevant product, practice or benchmark other than that the regulations should be made in order to address systemic risk. The draft legislation does however include particular types of regulations that might be made for each such category of designated persons and in respect of individual products, practices or benchmark.
Regulations under the CMSA are generally subject to a minimum notice and public comment period (generally 90 days) and after such period a regulation must be submitted to the Council of Ministers for approval. However, in certain circumstances the notice and comment period is not required, including where the Authority considers that there is an urgent need to address systemic risk.
Canadian securities legislation has generally not previously provided explicit blanket authority to regulate specific classes of securities and derivatives, specific “practices” or specific benchmarks. This extension of regulatory powers would provide the Authority with clearer powers to prevent, mitigate and respond to systemic risks such as risks revealed by the failure in 2007 of Canada's non-bank-sponsored asset-backed commercial paper market. Ultimately, the broad wording of all of the Authority’s powers will potentially give the Authority substantial scope to regulate any markets, market participants or market activities that it considers to be systemically important.
Regulation of Systemically Important Capital Markets Intermediaries
The Authority may designate capital markets intermediaries to be systemically important if the activities or material financial distress of the capital markets intermediary could pose a systemic risk.
“Capital markets intermediaries” is defined as “any person that, as a significant part of its business, trades in securities or derivatives or provides services related to trading or holding securities or derivatives” and the definition also specifically includes securities dealers and derivatives dealers—regardless of whether registered or exempt—as well as pension funds, investment funds and other issuers whose primary purpose is to invest money provided by its securityholders, and managers of such funds and issuers.
Large Canadian banks could potentially be considered to be systemically important but the CMSA provides that the Authority may not designate any Canadian financial institutions, including chartered banks and federally and provincially incorporated trust, loan and insurance companies, to be systemically important capital markets intermediaries. Accordingly, the Authority will presumably focus on attempting to identify—and potentially impose prudential regulations on—other systemically important capital market intermediaries, including possibly those in the shadow banking system.
When designating a capital markets intermediary to be systemically important, the Authority is required to consider certain enumerated factors including the entity’s “vulnerability to material financial distress or insolvency resulting from, among other things, its leverage, liquidity, off-balance-sheet exposure or reliance on short-term funding;” the entity’s size and the volume and value of its trading; the nature, interconnectedness and mix of the entity’s activities; the complexity of the entity’s business, structure or operations; and “any other risk-related factors that the Authority considers appropriate.”
Some of these enumerated factors recall specific types of entities that failed or were subject to significant stress during the financial crisis, including certain commercial paper and securitization conduits, structured investment vehicles, highly leveraged investment dealers, subprime mortgage lenders and highly leveraged swap providers. Commentary provided with the Consultation Drafts (Commentary) does not provide any guidance as to what types of entities the Authority intends to consider for regulation under these powers. Large Canadian pension funds, hedge funds and money market mutual funds might also expect that they could be subject to some regulatory scrutiny under the CMSA under these new powers.
As noted above, there are no restrictions imposed on the scope of regulations that the Authority may impose on designated entities other than the requirement that the regulations be made in order to address systemic risk. The CMSA also provides a list of types of requirements and restrictions that might be imposed on systemically important capital markets intermediaries, including in relation to capital, leverage, financial resources and liquidity, public disclosure obligations, policies and procedures for risk management, governance matters related to risk management, and business continuity, recovery and winding up plans, as well as relating to activities that pose systemic risk.
Regulation of Systemically Important Trading Facilities
The Authority may designate a securities or derivatives trading facility to be systemically important if the activities or material financial distress of the trading facility or the failure of or disruption to its functioning could pose a systemic risk. “Trading facility” is defined as a person that operates a system that facilitates trading in securities or derivatives by bringing together the orders for securities or derivatives of multiple buyers and sellers in order for those orders to be matched.
The CMSA’s list of regulations that might be imposed on systemically important trading facilities includes requirements and restrictions in relation to capital, leverage, and financial resources; policies and procedures for risk management; governance matters related to risk management; and business continuity, recovery and winding up plans; as well as regulations in relation to trading rules and related controls on trading facilities or their participants and the transparency of trades. Trading facilities operating in Participating Provinces will also be subject to regulation under the PCMA if they are exchanges or have been designated under the PCMA as marketplaces.
Regulation of Systemically Important Clearing Houses
The Authority may designate a securities or derivatives clearing house to be systemically important if the activities or material financial distress of the clearing house or the failure of or disruption to its functioning could pose a systemic risk. “Clearing house” is defined as a person that provides clearing or settlement services for trades in securities or derivatives and includes a central counterparty, but the definition excludes Canadian financial institutions as well as authorized foreign banks listed in Schedule III to the Bank Act and the Canadian Payments Association.
The concurrence of the Bank of Canada is required before the Authority issues any order designating any clearing house as systemically important or makes any regulations in respect of systemically important clearing houses. This provision reflects the fact that the Governor of the Bank of Canada already has authority under the federal Payment Clearing and Settlement Act (PCSA) to designate a clearing and settlement system, including a securities or derivatives clearing system that clears or settles related payment obligations, to be subject to the Bank of Canada’s oversight and its limited rulemaking power under the PCSA if the clearing and settlement system may be operated in a manner that poses a systemic risk (as defined in the PCSA). The Commentary notes that “The Authority may, with the concurrence of the Bank of Canada, regulate systemically important clearing houses under the CMSA. The Bank of Canada will continue to oversee designated payment and clearing systems under the Payment Clearing and Settlement Act.” This statement is not entirely clear but it may suggest that in the future the Bank of Canada will retain regulatory authority over payment systems and payment clearing but will cede primary regulatory authority over systemically important securities and derivatives clearing houses to the Authority.
The CMSA’s list of regulations that might be imposed on systemically important clearing houses includes requirements and restrictions in relation to capital and financial resources, policies and procedures for risk management, governance matters related to risk management and business continuity, recovery and winding up plans, as well as regulations in respect of transparency of clearing or settlement activities and risk exposures, the timeliness of the clearing or settlement of trades, margin and collateral, and policies and procedures for defaults by clearing house members or counterparties. Securities and derivatives clearing houses operating in Participating Provinces will also be subject to regulation under the PCMA as clearing agencies.
Regulation of Systemically Important Credit Rating Organizations
The CMSA’s list of regulations that might be imposed on systemically important credit rating organizations includes requirements and restrictions in relation to public disclosure obligations and policies and procedures for risk management as well as regulations in respect of governance, compliance mechanisms and accountability procedures related to the determination of credit ratings, conflicts of interest, and policies, procedures and standards for developing and applying ratings methodologies.
Credit rating organizations that have qualified to be designated under the PCMA will also be subject to related PCMA regulatory requirements.
Regulation of Systemically Important Products
A class of securities or derivatives (products) may be designated to be systemically important if, in the Authority’s opinion, the trading in, the holding of positions in or the direct or indirect dealing with the products could pose a systemic risk.
When making such a designation, the Authority must consider certain enumerated factors including the characteristics of the products, their terms, their complexity, the degree of standardization and the structure under which the products are created or issued, the value of outstanding products and the volume of trading in them, the number and type of persons that trade in, hold positions in or deal with the products, the purposes for which the products are used, the extent to which the trading in the products could transmit risks through the capital markets or financial system and any other risk-related factors that the Authority considers appropriate.
The CMSA’s list of regulations that might be imposed on systemically important products includes requirements and restrictions in relation to trading on a trading facility, clearing and settlement, disclosure to the public of information whose disclosure is not otherwise required, the transparency of trades, and the method used to price the products, as well as requirements in respect of capital, leverage and financial resources, liquidity, margin, collateral, credit protection and position limits and the retention of credit or investment risk.
In cases where a number of individual entities do not each individually create systemic risks but the entities each use similar investment strategies that collectively give rise to systemic risk, one might expect such entities would not necessarily all be designated as systemically important capital market intermediaries. Instead, the entities could be regulated indirectly through the designation of the relevant products or practices as systemically important or systemically risky, as applicable.
Regulation of Systemically Important Benchmarks
The Authority may designate a benchmark to be systemically important if impairment to the benchmark’s reliability or a loss of public confidence in its integrity or credibility could pose a systemic risk. “Benchmark” is defined as “a price, estimate, rate, index or value that is (a) determined from time to time by reference to an assessment of one or more underlying interests; (b) made available to the public, either free of charge or on payment; and (c) used for reference for any purpose, including (i) determining the interest payable, or other sums that are due, under a security or a derivative, (ii) determining the value of a security or a derivative . . . and (iii) measuring the performance of a security or a derivative.”
The CMSA’s list of regulations that might be imposed in respect of systemically important benchmarks includes requirements and restrictions in relation to submissions of information for the purpose of determining benchmark values, their design, determination and dissemination, plans for continuity, recovery and cessation, governance, compliance and accountability, and any other aspects of benchmark administration.
The Commentary does not suggest which benchmarks might be designated as systemically important but the list of potential candidates is presumably very short. The most likely candidates would be the core benchmark Canadian Dollar Offered Rates (CDOR) for Canadian banks’ banker’s acceptances. If CDOR was designated as systemically important, then this regulatory power could be used to require changes in CDOR methodology in order to supplement the guidelines recently issued by the Office of the Superintendent of Financial Institutions requiring new controls over CDOR submissions by Canadian banks.
Prohibitions on manipulation of benchmarks are also included in both the CMSA and PCMA, which apply without regard to whether the benchmark is systemically important. These new criminal and provincial offences may be sufficient to address benchmark-rigging concerns that have been identified internationally.
Regulation of Systemically Risky Practices
The Authority’s proposed powers to regulate “practices” that it considers to be systemically risky is very loosely defined.
The term “practices” is not defined in the CMSA and the Commentary does not provide direction as to which specific practices are expected to be designated and regulated, but some of the factors that the Authority is required to consider when making such a designation provide an indication of the types of practices that may be viewed as contributing to systemic risk.
These factors include the financial effect or consequences of engaging in the practice, the manner in which the practice makes use of maturity transformation, liquidity transformation, credit risk transfer or leverage, the extent to which the practice could transmit risks through the capital markets or financial system, the type of persons who are engaging in the practice and the extent to which they are regulated as systemically important capital markets intermediaries or otherwise regulated under capital markets or financial legislation in Canada or elsewhere, and any other risk-related factors that the Authority considers appropriate.
The CMSA’s list of regulations that might be imposed on systemically risky practices includes requirements and restrictions in relation to public disclosure and transparency, capital, leverage, and financial resources, policies and procedures for risk management, governance matters related to risk management, and margin, collateral, credit protection and position limits.
ORDERS ADDRESSING SYSTEMIC RISKS AND INVESTIGATIVE ORDERS
In addition to its general rulemaking powers described above, the CMSA also provides the Authority and the Tribunal (the Authority’s adjudicative branch) with powers to make certain orders necessary to address serious and imminent systemic risks or to protect the stability or integrity of Canada’s capital markets or the financial system.
The Chief Regulator also has certain investigative powers under the CMSA for the purpose of inquiring into matters relating to compliance with the CMSA and foreign capital market laws, including powers to conduct business and conduct reviews of any person for the purpose of verifying compliance with the PCMA (including the regulations thereunder). For a discussion of investigative powers and the Tribunal’s powers under the CMSA and PCMA, and concerning the general enforcement regime under the Cooperative System, please see our December 2014 Blakes Bulletin: New Cooperative Capital Markets Regulatory System: Proposed Changes to Regulatory and Criminal Enforcement.
Orders in Respect of Serious Imminent Risks Involving Capital Markets Intermediaries
In order to address a systemic risk that the Authority considers “serious and about to be realized,” the Authority may make an order imposing on a systemically important capital markets intermediary any of the following types of obligations: (a) to dispose of a security, derivative or other asset, (b) to increase its capital or financial resources, (c) not to enter into a merger or business combination, (d) to terminate or restrict its activities, (e) to implement its plans for business continuity, recovery or winding up, or (f) to do anything else that is necessary to address the risk.
The capital markets intermediary must be given an opportunity to make submissions to the Authority in respect of any proposed order and the federal Minister of Finance’s approval is required for any such order.
Urgent Orders to Address Serious and Immediate Systemic Risks
The CMSA provides the Authority with the power to make an urgent order if the Authority considers it “necessary to address a serious and immediate systemic risk.” Under this power, if the Authority considers it necessary to address the risk, the urgent order may (a) prohibit or restrict a person from trading in a security or derivative, reducing the person’s capital or financial resources, engaging in a practice or doing anything else; (b) suspend or restrict trading in particular securities or derivatives; or (c) suspend or restrict trading on a trading facility.
Urgent orders may take effect immediately without prior notice to any person and may remain in effect for a period of up to 15 days, subject to a possible one-time extension for an additional period of up to 15 days. Furthermore, the Authority is not required to give anyone an opportunity to make representations in respect of such an order if doing so would undermine the effect of the order or is not practicable or appropriate.
The federal Minister of Finance also has the power—after consultation with the Authority and members of the Council of Ministers representing the major capital markets jurisdictions—to direct the Authority to make, amend or repeal an urgent order.
By way of example, this proposed CMSA power could potentially restrict termination rights under derivatives agreements to address a systemic risk or could be used to implement short-selling bans on shares of financial companies such as was ordered as a temporary measure during the financial crisis.
The potential breadth of orders restricting rights of any specified persons or classes of persons under this power is very broad. Notably, the CMSA power to prohibit a person from “engaging in any practice or doing anything else” goes beyond the existing regulatory powers set out in the Ontario Securities Act (and proposed to be included in the PCMA) to make an order in the public interest suspending trading of specified securities or derivatives if the regulator considers that there is an extraordinary circumstance involving a major market disturbance or disruption that requires immediate action to be taken to restore order to the market or address the disruption.
The Tribunal may, if it considers it necessary to protect the stability or integrity of Canada’s capital markets or financial system, make certain specific orders including orders: (a) that a person comply with the CMSA, (b) that trading cease in respect of any security or derivative or class thereof, (c) that a person cease trading in specified securities or derivatives, or (d) that an issuer of systemically important securities, a party to systemically important derivatives, or a systemically important capital markets intermediary or market infrastructure entity make changes to its practices and procedures.
Such an order may only be issued after the Tribunal conducts a hearing except that for orders not in respect of specific designated entities and products, the Tribunal may make temporary orders without prior notice or prior hearing if it considers that the delay required to conduct a prior hearing could be prejudicial to the stability or integrity of Canada’s capital markets or financial system.
The Tribunal also has the authority to make certain “freeze orders” that it considers expedient for the administration of the CMSA or to assist in the administration of a foreign jurisdiction’s capital markets legislation. A freeze order can require any person to retain any funds, securities, derivatives or other property of another person or to refrain from withdrawing any funds, securities, derivatives or other property from another person. The Commentary states that freeze orders are intended to prevent the dissipation of assets during an investigation or proceeding.
Court-Ordered Receivership or Liquidation under the CMSA
The CMSA also includes a provision permitting the Chief Regulator to apply to a court for an order appointing a receiver, receiver-manager, sequestrator, trustee or liquidator of all or any part of the property of a capital markets intermediary, clearing house or trading facility which, in each case, has been designated to be systemically important. The court may make such an order only if it is satisfied that the appointment is necessary to address a systemic risk related to capital markets.
This provision of the CMSA does not provide a comprehensive insolvency or receivership regime and no authority is specifically granted in the CMSA, giving the court making such an order any related authority typically provided in insolvency statutes to stay proceedings against the relevant entity or limit counterparties’ rights to terminate or close out contracts. However, a court could conceivably exercise existing inherent jurisdiction to make such orders, and in addition any such proceeding could presumably result in other existing insolvency, receivership or reorganization regimes coming into play.
DEADLINE FOR COMMENT
Comments on the Consultation Drafts may be submitted until December 8, 2014.