The Canadian Securities Administrators OTC Derivatives Committee published on December 6, 2012 two model rules (the “Model Rules”) concerning the classification of derivatives for provincial securities law purposes, as well as reporting obligations in respect to certain of those identified derivatives. The Model Rules are the first elements of a framework currently under development to regulate the derivatives market in Canada following the global economic and financial crisis of 2007-2009 (the “Financial Crisis”).
The publication of the Model Rules follows upon the October 1, 2012 announcement of the Canadian Securities Administrators (“CSA”) and the Bank of Canada that they were committed to clearing standardized over-the-counter (“OTC”) derivatives (subject to appropriate exemptions) through central counterparties (“CCP”), including foreign CCPs, provided such counterparties are recognized by Canadian authorities and meet four safeguards identified by the Financial Stability Board (“FSB”).
The unregulated nature of the global OTC derivatives market is often cited as a major contributor to, if not a key cause of, the Financial Crisis. While the precise value of the OTC derivative market is unclear (due to a lack of any uniform global reporting requirements) – some estimates placing it as high as US$648 trillion – what is clear is that the notional value of the market is enormous. The unregulated nature of OTC derivatives means that they do not trade through central CCPs with publicly visible prices, and counterparties to trades are not subject to strict collateral requirements or otherwise required to implement prudent risk controls. Some liken OTC derivatives trades to “gentlemen’s bets”, agreed to in private between sophisticated counterparties such as banks and hedge funds, with nothing beyond the agreement itself to back the trade. Being unregulated, the OTC derivatives market allowed participants to amass large concentrations of OTC derivative risk, that risk being that one party to the contract may default prior to the expiration of the trade or agreement, and thus expose the other party to a loss. As the Financial Crisis deepened, and market participants such as Lehman Brothers and AIG found themselves in increasingly difficult financial condition, the opaque nature of the derivatives market made it impossible for market participants to evaluate the true financial health of their counterparties. As a result, to protect themselves, many market participants reacted by moving their trades to what they viewed as more stable counterparties, which in turn hastened the downfall of those participants perceived as financially weak, thereby creating a downward spiral in the economy at large as market participants with huge derivatives exposures on their books either failed or found themselves in deep financial trouble.
3. Key Concepts
A derivative is a financial instrument formed by contract, with its price based upon or “derived” from the value of an underlying asset, basket of assets, index or other acceptable reference. The risk associated with trading derivatives occurs as a result of the fluctuation in value of the underlying asset, examples of which include interest rates, foreign exchange, equities and commodities. Derivatives are often used as an instrument to hedge risk, but can also be used for speculative purposes. Futures, forwards, options and swaps are all examples of derivative contracts.
Exchange-traded derivatives are traded through a central exchange with publicly visible prices. By contrast, OTC derivatives are traded and negotiated between two parties (who are generally sophisticated market participants, such as banks and hedge funds) which enter into a bilateral contract. Because there is no central exchange or other intermediary involvement, participants’ exposure to counterparty risk is increased and the trades are less transparent. Standardized OTC derivatives refer to those derivatives governed by standardized documentation and master agreements that tend to improve efficiency and transparency over their non-standardized counterparts. Examples include interest rate and currency swaps using the International Swaps and Derivatives Association (ISDA) documentation architecture. Non-standardized OTC derivatives are those tailored to reflect more precise risk exposures, and they often do not lend themselves to standardization because the potential market in trading that particular exposure is perceived to be small.
The market for OTC derivatives is significantly larger than for exchange-traded derivatives and, as noted above, has historically been largely unregulated. During the Financial Crisis, lack of transparency in the OTC derivatives market caused trading to grind to a halt because market participants were unsure of which parties were exposed to what risks, causing widespread disruption. A CCP acts as an intermediary between market participants. Each party to a derivatives transaction enters into a contract with the CCP as counterparty, resulting in the CCP being counterparty to two opposing contracts for the same transaction. Therefore, each party effectively passes the risk of the other party defaulting to the CCP, and the CCP mitigates this risk by instituting appropriately structured risk controls, including requiring suitable levels of collateral to be posted by counterparties.
According to the Bank of Canada in its June 2011 Financial System Review, “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.”
4. Regulatory Reform
Toward the end of the Financial Crisis, the G-20 leaders, among others, recognized the need for reform that included effective regulation of the OTC derivatives market.
Specifically, in April 2009, the G-20 leaders announced the creation of the FSB as successor to the Financial Stability Forum and with a broadened mandate to promote financial stability. The FSB is tasked with coordinating the work of national financial authorities and international standard-setting bodies, and developing and promoting the implementation of effective regulatory, supervisory and other financial sector policies. The FSB counts among its member institutions the relevant financial and regulatory authorities of the G-20 and certain other economies (which, for Canada, are the Bank of Canada, the Office of the Superintendent of Financial Institutions (“OSFI”) and the Department of Finance), international organizations including the IMF, OECD and World Bank, as well as international standard-setting bodies. Mark Carney, Governor of the Bank of Canada, currently serves as Chairman of the FSB.
Recognizing that OTC derivatives trading played a major role in the Financial Crisis, at their September 2009 Pittsburgh summit, the G-20 leaders agreed that (1) all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, (2) standardized OTC derivatives should be cleared through central counterparties by end-2012 at the latest, and (3) all OTC derivative contracts should be reported to trade repositories. Furthermore, the G-20 leaders requested that the FSB and its relevant members regularly assess implementation and whether the above-mentioned measures were sufficient to (i) improve transparency in the derivatives markets, (ii) mitigate systemic risk, and (iii) protect against market abuse.
In April 2010, the FSB formed a working group of international standard-setting bodies and authorities, led by representatives of the Committee on Payment and Settlement Systems (“CPSS”), the International Organization of Securities Commissions (“IOSCO”) and the European Commission. In October 2010 the CPSS-IOSCO Working Group published a report setting out 21 recommendations for OTC derivatives market reform, including regarding central clearing. Through June 2012, the FSB published three progress reports on the implementation of OTC derivatives market reform, dated April 2011, October 2011 and June 2012. At the time of the June 2012 progress report, it was noted that the EU, Japan and the US (the jurisdictions with the largest markets in OTC derivatives) were expected to have regulatory frameworks in place by the end of 2012. In addition to the progress reports, the FSB in January 2012 identified four safeguards for a resilient and efficient global framework for central clearing (the “Four Safeguards”). Finally, in April 2012, CPSS-IOSCO published the Principles for Financial Market Infrastructures (the “Principles”). The Four Safeguards and the Principles are discussed in detail below.
Since December 2009, the CSA, the Bank of Canada, OSFI and the Canadian Department of Finance have coordinated their efforts to reform Canada’s OTC derivates market and make good on Canada’s G-20 commitment that all standardized OTC derivatives be cleared through CCPs by the end of 2012. Canadian authorities, however, had to deal with the issue of there being no CCP in Canada for the OTC derivatives market. Bank of Canada Deputy Governor Timothy Lane noted in 2011 that Canada’s OTC market was systemically important and that the absence of CCPs was a glaring weakness in its regulatory framework. In November 2010, the CSA published a consultation paper on derivatives regulation in Canada in which it recommended mandatory central clearing of standardized OTC derivatives, but noted that further input and study was required regarding whether Canadian or international CCPs should be used. A further CSA consultation paper published in June 2012 (the “June 2012 CSA Paper”) focused on central counterparty clearing for OTC derivatives, and concluded that “it is clear that Canadian market participants will require access to foreign CCPs to clear at least some OTC derivatives transactions,” and that “the review and recognition … of foreign-based CCPs is a priority to ensure that Canada meets its G20 commitments.” Finally, in October 2012, the CSA and the Bank of Canada separately announced that Canadian authorities would accept the clearing of standardized OTC derivatives through any CCP, including foreign CCPs, provided that such counterparties are recognized by Canadian authorities and meet the Four Safeguards.
The Four Safeguards
The following are the Four Safeguards identified by the FSB in response to requests from some member jurisdictions for guidance to help them make informed decisions about the form of CCPs to use for central clearing:
(a) fair and open access by market participants to CCPs, based on transparent and objective criteria; (b) cooperative oversight arrangements between all relevant authorities, both domestically and internationally, that result in robust and consistently applied regulation and oversight of global CCPs; (c) resolution and recovery regimes that ensure the core functions of CCPs are maintained during times of crisis and that consider the interests of all jurisdictions where the CCP is systemically important; and (d) appropriate liquidity arrangements for CCPs in the currencies in which they clear.
Principles for Financial Market Infrastructures
The Principles consist of 24 principles covering nine topics: general organization, credit and liquidity risk management, settlement, central securities depositories and exchange-of-value settlement systems, default management, general business and operational risk management, access, efficiency and transparency, in addition to setting out five responsibilities of central banks, market regulators, and other relevant authorities for financial market infrastructures. In a letter to the G-20 finance ministers and central bank governors dated April 16, 2012, FSB Chairman Carney noted that the Principles “set international standards that will go a long way to achieving” the Four Safeguards.
5. Clearing of Standardized OTC Derivatives Contracts
In their October 1, 2012 Statement by Canadian Authorities on Clearing of Standardized OTC Derivatives Contracts (the “Statement”), the CSA and the Bank of Canada separately announced that Canadian authorities (including OSFI and the Department of Finance) were committed to the clearing of standardized OTC derivatives (subject to appropriate exemptions) through CCPs, including global CCPs, provided such counterparties are recognized by Canadian authorities and meet the Four Safeguards.
The Statement notes that Canadian authorities have determined that global CCPs will provide a “safe, robust and resilient environment for clearing OTC derivatives,” provided that they comply with the Principles and meet the Four Safeguards.
In the Statement, the CSA and the Bank of Canada confirmed that they are “satisfied with the direction and pace of the international efforts on the four safeguards, including with regard to implementation of global CCPs serving the Canadian market.”
The Statement appears to indicate that CCPs with Canadian members would need to apply for recognition from Canadian regulators, or an exemption, in order to operate within the contemplated framework. However, recognition of foreign CCPs raises issues regarding effective regulatory powers and cooperation. The June 2012 CSA Paper stated 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.” Although it appears that a limited number of derivatives CCPs with Canadian members have obtained interim exemptions to operate from Canadian authorities, precisely what is required to be “recognized by Canadian authorities” will remain unclear until the Canadian regulatory framework becomes more fully developed.
6. Current Developments
The FSB published its latest progress report on the implementation of OTC derivatives market reforms on October 31, 2012. In the report, the FSB stated that: (i) the market infrastructure for clearing standardized OTC derivatives through CCPs is in place and the development of such infrastructure does not appear to be an impediment to further progress in meeting the year-end deadline, (ii) the international policy work on the Four Safeguards is substantially completed and implementation is proceeding at a national level, and (iii) it is regulatory uncertainty that remains the most significant impediment to further progress and to comprehensive use of market infrastructure.
Indeed, differences between European, Asian and US swaps rules have made compliance difficult for the financial industry, and progress on discussions between regulators has been slow. Central to the regulatory uncertainty is the proposed cross-border guidance released in late-June 2012 by the US Commodity Futures Trading Commission (“CFTC”), itself facing a year-end deadline to implement rules mandated by the US Dodd-Frank Act of 2010. Under the proposed guidance, the US purports to regulate swaps activities in other countries if they impact US commerce or financial stability. This position was received unfavourably by both the public and private sector. The European Commission, the UK, France, Switzerland and Japan asked the CFTC to reign in the reach of its proposed derivatives rules amid signs that the global derivatives market is already fragmenting. These and other international regulators called for better coordination and enhanced mutual recognition for the regulatory schemes being developed in other jurisdictions.
In the private sector, at least two international banks - Singapore’s DBS and Sweden’s Nordea Bank - have recently announced that they will not register in the US to trade swaps, choosing to forgo making the investment necessary to comply with the proposed new US rules. Following these developments, at the G-20 meeting in Mexico on November 5, 2012, FSB Chairman Carney conceded that the year-end deadline would not be met: “We are going to use all the time that is left in 2012 to get as much done in 2012 and then take stock instead of what remains to be done in a reasonable time frame.” Two days later, following a meeting in Washington of the CFTC’s Global Markets Advisory Committee (the “GMAC Meeting”) with the US Securities and Exchange Commission (which oversees securities-based derivatives), international regulators (including from Canada) and industry representatives, CFTC Chairman Gary Gensler indicated that he expected further guidance from the CFTC by the end of 2012.
Against this backdrop, advances in the central clearing of standardized OTC derivatives have been made. As of November 1, Japan became the first G-20 country to begin the compulsory clearing of interest rate swaps. On November 13, Deutsche Boerse launched a new interest rate swap clearing service called Eurex Clearing, and two days later announced that 16 banks, including Goldman Sachs, Morgan Stanley, JP Morgan, Barclays and Credit Suisse, were backing the CCP, which plans to expand its services to other OTC derivatives in the future. In addition, ICE Clear Europe clears credit default swaps for European clients of US-owned InterContinental Exchange.
7. Looking Ahead
Despite overshooting the G-20 economies’ “end-2012” deadline, progress has been made in the clearing of standardized OTC derivatives through CCPs. Canadian regulators’ decision to allow standardized OTC derivatives trading through foreign CCPs was to a great extent anticipated due to (i) indications that Canadian market participants would require access to international CCPs to clear some OTC derivatives transactions, and (ii) widespread belief that the costs of establishing a Canadian CCP for OTC derivatives would outweigh the benefits. Nevertheless, the official announcement was welcomed by market participants for its flexibility and potential cost savings.
On an international scale, there has been some movement in the creation or re-tooling of CCPs for the centralized clearing of a portion of the global derivatives market. Furthermore, it is hoped that recent discussions between the CFTC, international regulators and industry representatives will continue, resulting in a cooperative international framework for the trading of standardized OTC derivatives in the near future.
While the specific regulations which will apply in Canada to central clearing parties have yet to be articulated, Canadian authorities have made progress in other areas of derivative regulation, most notably in the Model Rules published by the Canadian Securities Administrators OTC Derivatives Committee (the “Committee”) which were published for a 60-day comment period on December 6, 2012.
The Model Rules consist - at this stage - of two rules referred to as “Derivatives: Product Determination” (the “Scope Rule”), and the “Trade Repositories and Derivatives Data Reporting Rule” (the “TR Rule”). The Scope Rule attempts to bring some clarity to the use of the terms “derivatives” and “securities” under provincial securities legislation, but most importantly, aims to identify certain derivatives (and securities), the use of which triggers other obligations under the Model Rules. One such other obligation is the reporting requirement stipulated under the TR Rule, which mandates the reporting of data concerning derivative use by market participants to trade repositories which meet the operational requirements specified in the TR Rule.
It is clear from the consultation paper (No. 91-301) with which the Model Rules were published that further “model” rules are forthcoming and will each be published for a consultation period of 60 days, after which time the Committee will evaluate and amend, if determined to be appropriate, the proposed model rules. After that process is complete the model rules will be referred to the individual securities regulatory authorities in each province to create the province-specific versions of the model rules, reflecting the non-uniform nature of securities legislation in Canada, and requiring in many cases, legislative action. So, while the rule making process has begun, it is quite possible that this process will continue on for many months and possibly years.
What is clear about the future of derivative regulation is that, although the landscape is evolving more rapidly now than at any time since the regulatory process began in 2009, significant challenges remain and regulatory frameworks are still a work-in-progress.