On December 19 2013 the Canadian Securities Administrators (CSA) published the proposed Model Provincial Rule on Mandatory Central Clearing of Derivatives and related explanatory guidance as CSA Staff Notice 91-303. The rule describes the proposed requirements for central counterparty clearing of over-the-counter (OTC) derivative transactions, and is intended to improve the transparency of the derivatives market to both the regulators and the public, to enhance the overall mitigation of risks. The rule is divided into two broad rule-making areas:
- those relating to the mandatory clearing of derivatives; and
- those relating to the determination of derivatives that will be subject to mandatory clearing.
Comments on the rule should be submitted to the CSA OTC Derivatives Committee by March 19 2014. Following the comment period, provincial rules will be published that address any specific provincial features. However, the intent is that, to the greatest extent possible, the provincial rules will be harmonised with international standards and will be consistent across Canada.
The rule establishes a duty on a local counterparty to submit, or cause to be submitted, for clearing to a clearing agency each clearable derivative transaction that it enters into. A local counterparty in a province is:
- a person organised under the laws of that province;
- a person that has its head office or principal place of business in that province; or
- an affiliate of such person, if such person is responsible for the liabilities of that affiliate.
For purposes of the rule, the applicable clearing agencies are only those that are recognised, or that are exempt from recognition, by the relevant provincial securities regulator.
The rule also includes an end-user exemption from the clearing requirement. In order to qualify for the exemption, the counterparty cannot be a financial entity and must be entering into the transaction to hedge or mitigate commercial risk related to the operation of its business. An end user can have an affiliate act as its agent in connection with these derivative transactions and still rely on the end-user exemption, provided that the affiliate is not a registrant under securities legislation. The end-user exemption is not available to any financial entity, which includes banks, trust companies, insurance companies, credit unions, pension funds, investment funds and all registrants under securities legislation, even if the transactions are entered into only for hedging purposes.
The rule provides that a derivative is held for hedging purposes generally when it:
- establishes a position that is intended to reduce risks relating to the commercial or treasury financing activity of the counterparty or of an affiliate;
- covers the risks arising from a change in the value of assets, services, inputs, products, commodities or liabilities that either the counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs; and
- is not held for a purpose that is in the nature of speculation.
The interpretation of the phrase "hedge or mitigation of commercial risk" is key to an end user's ability to rely on the exemption, and the explanatory guidance provides some insight into how the committee views this requirement. The rule and the related discussion in the explanatory guidance appear to provide end users with more latitude than the definition of 'hedging' currently applied to investment funds in National Instrument 81-102.
The rule also includes an exemption for intra-group transactions, which are transactions between affiliated entities, under certain conditions. Affiliates that wish to rely on this exemption will be required to file electronic reports with the applicable securities regulator. The reports must be filed within 30 days following the execution of the first transaction made under the exemption and cover all transactions between such affiliates for one year.
Any counterparty relying on an exemption from the clearing requirement must keep certain key records, including:
- documentation of its hedging strategy or programme;
- evidence of any necessary approvals of its reliance on the exemption; and
- appropriate supporting documentation for each transaction for which the end user relies on the exemption.
When a clearing agency makes clearing services available for a derivative or class of derivatives, the rule requires the agency to file a form with the applicable securities regulator. The information provided by the clearing agency will help the regulator to determine whether that derivative should be subject to mandatory clearing. Currently, no derivatives or classes of derivatives have been determined to be cleared centrally.
For further information on this topic please contact Carol E Derk at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email (firstname.lastname@example.org). The Borden Ladner Gervais website can be accessed at www.blg.com.