On January 29, 2015, the Canadian Securities Administrators (“CSA”) Derivatives Committee published for comment Consultation Paper 92-401 – Derivatives Trading Facilities (the “Consultation Paper”), its seventh in a series of high-level consultation papers examining reform options for Canada’s over-the-counter (“OTC”) derivative markets. The Consultation Paper proposes a new regulatory framework for so-called “derivatives trading facilities” (“DTFs”), being organized platforms for the trading of OTC derivatives. Among other things, the Consultation Paper would require that certain classes of OTC derivatives be executed over DTFs, and would require that DTFs comply with strict organizational and governance requirements in facilitating these transactions. The CSA invited members of the public to provide comments on 31 specific questions set forth in the Consultation Paper. The comment period closed on March 30, 2015.
Definition of Derivatives Trading Facility
The Consultation Paper introduces a new concept of a “derivatives trading facility”, which is a platform for executing OTC derivatives transactions. The Consultation Paper defines a DTF as a “person or company that constitutes, maintains, or provides a facility or market that brings together buyers and sellers of OTC derivatives, brings together the orders of multiple buyers and multiple sellers, and uses methods under which the orders interact with each other and the buyers and sellers agree to the terms of trades”. The Consultation Paper acknowledges that the definition of DTF is broad and would capture a range of execution processes and venues; however, the definition is not so broad that it would capture every execution process or venue. Significantly, the Consultation Paper limits the definition of DTF to platforms that facilitate many-to-many transactions between multiple dealers and multiple customers. Under the proposed definition, a single-dealer platform that facilitates one-to-many transactions would not appear to be considered a DTF. Similarly, the proposed definition would not appear to be intended to capture facilities and venues that do not provide for the execution of transactions, such as bulletin boards, post-trade confirmation services, or post-trade portfolio compression services.
Permitted Execution Methods
The Consultation Paper recommends that a DTF not be forced to adopt any particular model for executing OTC derivatives transactions, but rather have the flexibility to select from a variety of execution models. Among the various possibilities, the Consultation Paper highlights that a DTF may use: (i) an order book system, where participants have the ability to enter multiple bids and offers, observe bids and offers entered by other market participants and choose to transact on such bids and offers; (ii) a request for quote (“RFQ”) system, where participants can request a bid or offer from one or more market makers and choose to transact with a responding market maker; (iii) a request for stream system, where participants can “click-to-trade” on a firm quote that has been provided by a market maker for a predefined period of time; or (iv) a hybrid system, which blends the functionality of one or more of the foregoing execution models.
Organizational and Governance Requirements
Under the Consultation Paper’s proposed regulatory framework, a DTF would be required to obtain authorization from the local securities regulator in each jurisdiction in which it intends to operate. In connection with this authorization, a DTF would need to satisfy a number of basic organizational and governance requirements comparable to those imposed on stock exchanges, relating to such areas as financial resources, systems, personnel, rules, monitoring, record-keeping and conflicts of interest. In addition, the Consultation Paper recommends that further organizational and governance requirements be imposed on a DTF that exercises discretion in the execution of OTC derivatives transactions, such as determining when to place an order for a participant, which participants to contact with client RFQs and which orders or RFQs to match with other orders or quotes. For a DTF that exercises discretion, the Consultation Paper recommends that the DTF be required to behave in a manner similar to a derivatives dealer and be subject to a duty to act fairly, honestly and in good faith, proficiency requirements for individual representatives and suitability requirements.
Pre- and Post-Trade Transparency
Pre-trade transparency refers to the ability of participants to observe orders and quotations prior to entering transactions. The Consultation Paper does not generally impose any pre-trade transparency requirements in connection with the execution of OTC derivatives transactions, but rather recognizes that requiring a DTF to publish pre-trade information for OTC derivatives that are not sufficiently standardized and liquid could have adverse and unintended consequences. The Consultation Paper also recognizes that different levels of pre-trade disclosure will be inherent in the different types of permitted execution models. For OTC derivatives that are mandated to trade on a DTF, however, the Consultation Paper states that a DTF would be required to provide pre-trade disclosure of current bid and offer prices and market depths to all users of its facilities.
Post-trade transparency refers to the dissemination of price and volume information for completed transactions. The Consultation Paper recommends that a DTF be required to report to the public transactions executed on the DTF in as close to real-time as technically feasible. The Consultation Paper notes that the CSA has yet to determine whether such public disclosure should be made directly by a DTF, or indirectly through a trade repository. Deferred publication would be permitted in certain circumstances, such as block trades. The Consultation Paper also contemplates a DTF providing additional reports to the public at no charge and on a delayed basis (e.g. the next business day).
The Consultation Paper suggests that certain classes of OTC derivatives would be subject to a requirement to be traded exclusively through a DTF. In determining the classes of OTC derivatives to be subject to a DTF trading mandate, the Consultation Paper states that regulators would consider, among other things, whether a class of derivatives is: (i) subject to a clearing obligation; (ii) sufficiently liquid to trade exclusively through a DTF; (iii) traded by a sufficient number of market participants; (iv) mandated to trade on a regulated venue in other jurisdictions; and (v) already trading through the facilities of a DTF. With respect to the liquidity consideration, the Consultation Paper notes that the CSA does not currently have sufficient data regarding liquidity in the Canadian OTC derivatives markets, and that it will only be in a position to assess liquidity after trade reporting and clearing obligations have been in effect for a period of time.
The Consultation Paper recommends that foreign DTFs that provide Canadian participants with direct access to their trading platforms, including swap-execution facilities (“SEFs”) operating under Dodd-Frank and Organized Trading Facilities (“OTFs”) operating under EMIR, be authorized in each jurisdiction in Canada in which they operate, similar to domestic DTFs. The CSA indicates it would consider exemptions from authorization for foreign DTFs on a case-by-case basis, where a foreign DTF can demonstrate that the regulation and oversight in its home jurisdiction is comparable to that in Canada. However, even where a foreign DTF is exempt from certain requirements, the Consultation Paper states that the foreign DTF would likely be required to fulfill its reporting obligations to Canadian regulators with respect to services provided to Canadian participants.