The Canadian Securities Administrators (CSA) have published the first of eight consultation papers on OTC derivatives reform and, if the industry comment letters on this first paper are anything to judge by, there is a lot of work left to be done by Canadian regulatory authorities to implement Canada’s G-20 commitments on Over-the-Counter Derivatives Regulation. Consultation Paper 91-402 considers the subject of reporting of OTC derivatives trades to trade repositories.
At the G-20 meeting in Pittsburgh in September 2009, Canada committed to require that all OTC derivatives contracts be reported to trade repositories. On June 23, 2011, the CSA Derivatives Committee published Consultation Paper 91-402 – Derivatives: Trade Repositories. It set out a framework for proposed rules for the reporting of OTC derivatives transactions to, and the operation of, trade repositories and sought public comment on a number of issues relating to OTC derivatives transaction reporting and the regulation of trade repositories, including whether a “made-in-Canada” solution is necessary or appropriate. The public comment period closed on September 12, 2011. The CSA received twenty one comment letters from interested parties, many of which were quite lengthy and detailed and raised many questions and considerations for the regulators. The CSA will have much to think about in taking this proposal to the next stage.
The CSA Derivatives Committee identified trade repositories, which are centralized facilities for the collection of OTC derivatives data, and the related availability and transparency of transaction and aggregate market data for market and prudential regulators, central banks and the public as one of the most important components of OTC derivatives regulatory reform.
There are currently no requirements for Canadian market participants to report their OTC derivative transactions and positions. Therefore, Canadian regulators and the Bank of Canada do not have formal access to data regarding the size and composition of the Canadian OTC derivatives market, the activities of Canadian market participants and “Canadian referenced derivatives” entered into by foreign participants.
Trade Repository Requirements
The CSA Derivatives Committee recommends that trade repositories operating in Canada should:
- be required to meet internationally accepted governance and operational standards recommended by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) including standards relating to legal framework, governance, market transparency and data availability, operational reliability, access and participation, safeguarding of data, timely recordkeeping and communication procedures and standards,
- have boards of directors with appropriate independent representation,
- have a chief compliance officer and robust operational risk management capabilities,
- provide fair and open access to market participants,
- be required to accept all trades for each asset class for which they accept trade data,
- safeguard confidential data, and
- prevent any data use that could represent a conflict of interest.
The CSA Derivatives Committee also recommends that Canadian provincial securities and derivatives laws should be amended to include approved trade repositories in the definition of market participant.
What is not clear from the recommendations is whether a trade repository, whether domestic or foreign, would have to become registered or recognized in each province in which it accepts trade data from market participants. Hopefully, registration or recognition in (and regulation by) thirteen different provincial and territorial securities regulators can be avoided, especially for non-Canadian trade repositories.
The comment letter from the Canadian Market Infrastructure Committee (CMIC) submitted that the federal authority over systemic risk and banking means that the Bank of Canada should be at the centre of trade repository regulation (i.e., not the provincial securities regulators) within harmonized federal and provincial approval processes. The framework should be designed to provide federal authorities with the appropriate data for their systemic risk purposes and provincial securities regulators with the appropriate data for their market conduct purposes. The legislative approach that should be followed is the developent by federal authorities of federal legislation that would focus on the Bank of Canada’s trade repository requirements for systemic risk monitoring purposes, albeit in consultation with both provincial securities regulators and industry participants to ensure that the scheme of the federal legislation is consistent with the market conduct responsibilities of provincial securities regulators.
A Made-in-Canada Solution?
The CSA Derivatives Committee recommends studying whether a “made-in-Canada” solution is necessary and the requirements for foreign-based trade repositories. While there are efficiency arguments for a single global trade repository, at least for each asset class, there are of course reasons why Canadian regulators (federal and provincial) may prefer a local trade repository, including the possibility that foreign trade repositories may not develop systems that accept trade data from Canadian market participants for all types of OTC derivatives entered into domestically by Canadian counterparties or that Canadian regulators may not have sufficient access to foreign trade repositories holding trade data in respect of trades by Canadian counterparties or Canadian referenced derivatives or that such access might be interrupted in the future.
What is clear from the comment letters is that if Canada does pursue a domestic trade repository, the format and parameters of the data that are required must be the same as used by other trade repositories globally so that trade data feeds between market participants and trade repositories work efficiently.
OTC Derivatives Transactions Reporting Requirements
The consultation paper recommends that provincial market regulators mandate the reporting of all OTC derivatives transactions, both cleared and non-cleared, to an approved trade repository. This mandatory reporting includes the reporting of pre-existing OTC derivatives which should be reported within 180 days from the effective date of the new rules except for existing transactions which terminate or expire within one year of the effective date of the new rules. The CSA heard from industry in the comment letters that 180 days from the effective date of the new rules for the reporting of pre-existing OTC derivatives may be too short a period. Not only may it not be practical from an operational perspective for many market participants to meet that timeline, but data does not necessarily exist within organizations in the format that it would be required to be reported.
Who Must Report OTC Derivatives Transactions
The consultation paper proposes that one counterparty to each OTC derivative transaction should be required to report the transaction and any related post execution events to an approved trade repository. However, counterparties should be able to delegate reporting to a third-party service provider including a central counterparty clearing house. Financial intermediaries should bear the reporting onus in transactions with end users. Transaction counterparties should be permitted to elect the reporting party for transactions between two financial intermediaries or two end users. A foreign counterparty may assume reporting obligations provided that the transaction is reported to a trade repository approved in Canada.
OTC Derivatives Transaction Information Required to be Reported
The consultation paper recommends that the reported data include not only the principal economic terms, but also the full executed legal agreements entered into between the counterparties and should be reported in accordance with international standards for data reporting which would include unique identifiers for legal entities, transactions and product types. In addition, “continuation data” should be reported throughout the life of an OTC derivative transaction. Many comment letters state that the requirement to submit all legal documentation to a trade repository is too onerous for the institutions and in any event would not provide regulators with any additional useful information beyond the principal economic terms of the transaction. Also, the full legal documentation for some trades is often not executed until long after the trade date and, in the case of many bespoke trades, the full legal documentation can be voluminous. Also, not all parties use FpML confirmations so reporting the transaction documentation electronically is not always feasible.
Timing of Reporting
The CSA Derivatives Committee proposes that transaction reporting to trade repositories should be completed in real time once feasible for Canadian market participants and within one business day until real time reporting is implemented. Once real time reporting is implemented, large trades meeting a to-be-determined block trade threshold should be subject to a delayed reporting requirement in order to preserve the anonymity of market participants and ensure that there is no detrimental impact on market liquidity or function.
This real time reporting requirement engendered many comments, as it has in other jurisdictions. The need for real time reporting into a database that is not itself a market is questioned. While timely information is necessary, reporting time frames should depend on the level of data required to be reported, the complexity of the transaction and the availability of the required technology systems on a global basis.
The question of a block trade threshold is also addressed in many of the comment letters. For example, the International Swaps and Derivatives Association (ISDA) recommends that the analysis to determine appropriate minimum block trade threshold levels should be undertaken separately for the Canadian OTC derivatives market, different asset classes within the market and different products within each asset class as the appropriate threshold levels for different asset classes and products within assets classes in the Canadian market will be different. A uniform block trade threshold is too simplistic and would be damaging to liquidity. Also, all block trade thresholds should be reviewed periodically in light of current market conditions and there should be a mechanism for the immediate reassessment of thresholds during periods of market stress.
An appropriate publication delay for block trades should reflect the time it takes to hedge the exposure without unduly impacting the market and in light of liquidity in the particular market. Liquidity in many Canadian markets may be quite different from liquidity in some foreign markets. Many large Canadian market participants comment that the publication of block trade data should be delayed for at least a quarter as the public reporting of block trade data runs the risk of inadvertent disclosure of confidential information, potentially enables reverse-engineering strategies and runs the risk that the small number of relatively large participants in the Canadian markets would have the ability to figure out the individual positions of one another.
Access to Confidential Trade Repository Information
The consultation paper also raises a number of concerns relating to access to confidential information, including whether it is necessary for provincial regulators to enact legislation that expressly permits the disclosure of confidential information to and by trade repositories, that amendments to legislation should be enacted to ensure that confidential trade repository data is not made publicly available pursuant to public disclosure laws and that Canadian regulators and the central bank should establish cooperation agreements with foreign jurisdictions that have equivalent legal and supervisory frameworks to facilitate cross border access to trade repository data.
Availability of Information to Public
Another controversial proposal is that trade repositories should make available to the public aggregate data, including information on positions, transaction volumes and average prices. Anonymous post-trade transaction level data should also be made public provided that it would not be detrimental to market liquidity or function. The comment letters urge that the release of data to the public be studied thoroughly, because the publication of such data may compromise the positions of counterparties depending upon the size of the market and the level of aggregation of the data.
Inter-Affiliate Transactions and End User Exemptions
The consultation paper does not deal with the question of inter-affiliate trades. Should inter-affiliate trades be excluded from the reporting requirement (and possibly other aspects of OTC derivatives regulatory reform)? It has been argued that transactions between affiliates merely represent transfers of risk within a corporate group and should not be subject to the same reporting requirements as inter-affiliate transaction data will not provide any valuable information to regulators from either a systemic risk or market conduct perspective. Reporting of inter-affiliate trades will also increase the costs and burden for corporate groups that choose to consolidate their hedging activities in a single entity.
Nor does the consultation paper contemplate exemptions from the reporting requirements for hedging end users. The CSA will have to consider whether such exemptions should be made available for end users that are hedging risks (particularly in the commodities and energy markets) where they do not pose any systemic risk. Perhaps exemptions of this nature will be discussed by the CSA Derivatives Committee more broadly in its anticipated Consultation Paper 91-405 - Exemptions (Derivatives).