On January 19, the Canadian Securities Administrators (CSA) published the final form of the segregation and portability rule relating to customer collateral for cleared derivatives. This National Instrument 94-102 Derivatives: Customer Clearing and Protection of Customer Collateral and Positions (Customer Collateral Rule) is aimed at ensuring that clearing is carried out by clearing intermediaries and clearing agencies in a manner that protects customer collateral and positions and improves the ability of a derivatives clearing agency to withstand a clearing member default. The rule will allow for different clearing models (principal to principal or FCM) and is broadly aligned with principles adopted in the US and other jurisdictions. This rule comes into effect on July 3, 2017.
Two types of entities are the focus of the Customer Collateral Rule: clearing intermediaries (CI) and regulated clearing agencies (RCA).
Changes from the Draft Rule
This rule has been through two comment periods already, one in 2014 and one in 2016. The primary changes from last year’s version are:
- Exclusion of options on securities (for consistency with the US and Europe)
- Removal of duplicative record keeping between clearing agencies and clearing intermediaries
- Providing more flexibility on the customer consent requirement where transfers take place in a default scenario
- A broader application of substituted compliance where the intermediary or clearing agency is regulated under US or European law, although with certain residual obligations under the rule still applying
- Allowing customer collateral reports to regulators to be on an aggregate, not individual customer, basis, but not extending substitute compliance to this reporting requirement
Regulated Clearing Agencies and Clearing Intermediary Definitions
For Ontario, BC and Manitoba, an RCA is a clearing agency that is registered as such or has an exemption from registration in the province. For Quebec, Alberta, Saskatchewan, the three Territories and the four Maritime provinces, it includes a clearing agency that is registered in or exempted by another province or territory.
A CI can be a “direct intermediary” or an “indirect intermediary”. A direct intermediary is an entity that is a participant in the relevant RCA, directly provides clearing for a customer or on a customer’s behalf and requires, receives or holds the customer’s collateral in providing those services. An indirect intermediary is an entity that provides those services but is not the RCA participant with respect to the transaction.
CIs and RCAs are subject to rules related to the treatment of customer collateral, record-keeping, reporting and disclosure and the transfer of customer collateral and positions to a non-defaulting CI (i.e. porting). In addition, the Customer Collateral Rule provides for substituted compliance with respect to certain requirements. Here is a description of the key features of the rule.
Territorial Scope and Product Application (s.2)
The rule applies to CIs and to foreign RCAs only to the extent that they are clearing derivatives of local customers.
It does not apply to options on securities. Nor does it apply to derivatives that are regulated as securities and not derivatives under the relevant product determination rules in each jurisdiction.
Treatment of Customer Collateral
The heart of the Customer Collateral Rule is the segregation requirements and limits on the use of customer collateral.
- Segregation of collateral. CIs and RCAs are required to segregate customer collateral (as a whole) from their own property and that of other persons. In addition, CIs must segregate the customer collateral of the customer of an indirect intermediary from the indirect intermediary’s property. Importantly “segregation” means to separately hold “or separately account for” customer collateral and positions, meaning that segregation is very much a record-keeping matter.
- Permitted depositories. CIs and RCAs must hold all customer collateral in one or more accounts at a “permitted depository” and clearly identify such accounts as holding customer collateral. A permitted depository includes Canadian financial institutions and Schedule III banks, RCAs, the Bank of Canada or central banks of a permitted jurisdiction, registered investment dealers with respect to their clearing customers, prudentially regulated entities with respect to their clearing customers that are subject to a similar rule on customer collateral in a permitted jurisdiction, and certain foreign banks and trust companies from permitted jurisdictions with shareholders’ equity of more than $100 million.
- Initial margin. While all customer collateral may be held in omnibus accounts and variation margin calculated by an RCA on a net basis across customers of the CI, initial margin must be provided to the RCA on a gross basis by customer. The RCA may, however, calculate the initial margin requirement based on netting all of the transactions of the particular customer.
- Use - General. There is a general prohibition on RCAs or CIs using or permitting the use of customer collateral. It can, however, be used to margin, guarantee, secure, settle or adjust the cleared derivatives of the customer. No surprise there since that’s why it’s posted.
- Permitted Liens. No liens or claims are allowed on the customer’s collateral or its positions except liens securing a claim resulting from a cleared derivative in favour of: (i) the customer itself; or (ii) the RCA or relevant CI responsible for clearing the cleared derivative to which the position or customer collateral relates. The lien in favour of the customer is helpful in the context of principal to principal clearing models where the collateral, legally speaking, belongs to the CI.
- Use on CI Default. In the case of a CI’s default, the customer collateral can only be used (by a CI or the RCA) to satisfy the obligations of the CI that relate to the customer’s cleared derivatives. So for example if the customer’s positions are closed out on a CI default because they cannot be ported, the RCA can apply the collateral to the CI’s obligations that relate to the customer’s closed out derivatives.
- Excess margin. CIs and RCAs must on a daily basis identify and record the value of excess margin that it holds attributable to each customer. Excess margin is collateral delivered by or on behalf of the customer with a value in excess of the amount required by the RCA to clear and settle that customer’s cleared derivatives. Unlike the case with initial or variation margin, CIs and RCAs may use excess margin to secure or extend the credit of the customer. So, for example, it can stand as security for the customer’s futures transactions or uncleared derivatives obligations. The rules regarding the holding of customer collateral still apply to excess margin so presumably this permission does not go so far as to allow a title transfer credit support arrangement or rehypothecation rights.
- Investment. Property received as customer collateral may also be invested in a “permitted investment” – essentially cash or a highly liquid financial instrument with minimal risk. It may also be used to buy or sell permitted investments under written repo agreements with a term of no more than one business day or reversal is possible on demand, there is a written confirm and it is not entered into with an affiliate of the CI or RCA, among other conditions. Any losses on investments are borne by the CI or RCA. Transforming collateral to a form required for posting to a CI or RCA is not considered to be investment of the collateral. These investment limits apply to excess margin as well.
Qualifications of CIs
To act as a CI a person or company must meet one of the following criteria:
- Subject to and in compliance with the laws of a Canadian jurisdiction relating to minimum capital requirements, financial soundness and risk management (e.g. a federal financial institution)
- Registered as a dealer in a local jurisdictions
- Prudentially regulated entity, subject to and in compliance with the laws of a permitted jurisdiction relating to clearing services and subject to a similar seg and port rule in that jurisdiction.
A CI is not permitted to provide clearing services for a customer unless they are provided for derivatives cleared by an RCA.
Record-keeping, Reporting and Disclosure
The record-keeping, reporting and disclosure requirements are aimed at ensuring that individual customer collateral and positions are readily identifiable. They distinguish between account information and trade information.
CIs are required to keep records and supporting document that relate to the derivative for 7 years following termination or expiry of the derivatives and other records for 7 years following the date on which a customer’s last cleared derivative expired or was terminated. (8 years in Manitoba). The RCA’s record keeping requirements relate to the derivative and not the account information, which need only be kept by the CI. The record-keeping requirements range from recording on a daily basis the amount of customer collateral the CI and RCA requires to the total amount of excess margin held by the CI or RCA.
There are extensive disclosure requirements in the Customer Collateral Rule. For example, investment policies and guidelines, the treatment of collateral and the effect of bankruptcy laws on the customer’s rights are some of the disclosures CIs are required to make to the customers or indirect intermediaries it services prior to clearing any derivatives for them. Some of these disclosures are in turn required to be provided by RCAs to direct intermediaries.
Certain prescribed disclosures are required in the other direction as well: a direct intermediary must provide the RCA with information sufficient to identify the customer, the customer’s positions and the value of the customer collateral and, at least once each day thereafter, provide information that identifies the positions and collateral value. Indirect intermediaries must provide the same information to the CI through which it provides clearing services.
There is also a requirement for RCAs and CIs to make monthly collateral reports to the relevant regulatory authorities.
Transfer of customer collateral and positions
Finally, the Customer Collateral Rule contains requirements aimed at ensuring that if a CI is in default, customer collateral and positions can be transferred to one or more non-defaulting CIs without having to liquidate and re-establish the positions. The obligation is framed quite generally. If the porting is required because a CI is in default, the RCA and the defaulting CI must “facilitate” a transfer of customer positions and collateral (or their liquidation proceeds) to a non-defaulting CI. This is also required when the CI is not in default, but instigated by a customer request. These porting obligations are subject to several conditions, including that the customer’s account is not in default, there are appropriate margins to support transferred positions and the customer and receiving direct intermediary have consented to the transfer.
Where a CI is providing clearing services for an indirect intermediary it must have policies in place that facilitate porting if it is in default or if the indirect intermediary is in default or its customer requests the porting.
A substituted compliance provision has been included to ease the regulatory burden on foreign CIs and RCAs. More specifically, foreign CIs that are regulated under the laws of a foreign jurisdiction equivalent to the Customer Collateral Rule and foreign RCAs that are recognized or exempt from recognition by a Canadian securities regulatory authority and that are in compliance with the laws of a foreign jurisdiction that is equivalent to the Customer Collateral Rule can qualify for substituted compliance with respect to certain obligations under the rules. Appendix A sets out which of the foreign rules can be relied on for substitute compliance and which of the Customer Collateral Rule rules continue to apply. For example, a CFTC regulated CI must still comply with record keeping requirements in s.12 and the customer and regulator collateral report requirements.