Time to Make it Clear, Part II: The CSA Publishes Notice and Request for Comments on Proposed Rules for Mandatory Central Counterparty Clearing of OTC Derivatives

Time to Make it Clear, Part II: The CSA Publishes Notice and Request for Comments on Proposed Rules for Mandatory Central Counterparty Clearing of OTC Derivatives

On December 19, 2013, the Canadian Securities Administrators (the “CSA“) Over-the-Counter Derivatives Committee published CSA Staff Notice 91-103 – Proposed Model Provincial Rule on Mandatory Central Counterparty Clearing of Derivatives (the “2013 Rule“). The 2013 Rule set out the requirements for central counterparty clearing of over-the-counter (“OTC“) derivatives transactions. We previously commented on the 2013 Rule in a comprehensive bulletin available here.

The CSA invited public comment on the 2013 Rule and received thirty four comment letters in response. Upon reviewing the comments, the CSA made revisions to the 2013 Rule and on February 12, 2015, published a notice and request for comments regarding the new proposed National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (the “Clearing Rule“) and the proposed Companion Policy 94-101CP Mandatory Central Counterparty Clearing of Derivatives (the “Clearing CP“) (collectively the “Proposed National Instrument“).[1]

Summary of the Clearing Rule

The Proposed National Instrument arose out of the consensus of the G20 nations to reform the inherent risks in the OTC derivatives markets. Its purpose is to enhance market transparency and the overall mitigation of systemic risk. While it was originally released as a draft provincial rule, it is now structured as a national instrument. Among other things, this addresses concerns about a possible lack of harmonization across provinces and aims to ensure that market participants and derivatives each receive equal treatment across Canada.

The Clearing Rule requires a local counterparty[2] in a transaction in a mandatory clearable derivative to submit that transaction for clearing to a regulated clearing agency. The process features a “bottom-up” approach for determining when a derivative transaction will be subject to clearing. A regulated clearing agency would be required to notify the local securities regulator, in the proper form, whenever it provides clearing services for a derivative or class of derivatives. Upon receiving notice, the securities regulator would then consider various factors set out in the Clearing CP in determining whether the cleared derivatives would be mandatory clearable derivatives. Each such mandatory clearable derivative will be included in a list set out as Appendix A of the Clearing Rule. Currently, this list remains unpublished.

Comparison with the 2013 Rule

The Clearing Rule remains largely unchanged from the 2013 Rule. It is substantially similar in form and substance and most modifications merely clarify or expand on existing provisions. However, there are two new sections and some notable revisions:

• The new section 3 interprets the term “affiliated entity”, providing that corporations will be deemed to an affiliated entity of another corporation if one of them is the subsidiary of the other, if both are subsidiaries of the same corporation, or if each is controlled by the same person or corporation. The section also interprets “control” and “subsidiary”. These are all relevant considerations for determining the applicability of the intragroup exemption (discussed below).
• The new section 6 provides that the duty to submit for clearing does not apply to a transaction if any of the counterparties are: governments (Canadian, provincial or foreign); crown corporations whose obligations are guaranteed by the government of the jurisdiction in which they are established; wholly-owned government entities whose obligations are guaranteed by the government of the jurisdiction in which they are established; the Bank of Canada or a central bank of a foreign jurisdiction; or the Bank for International Settlements.
• Substitute compliance was added for a local counterparty, if that transaction was submitted for clearing in certain specified foreign jurisdictions (discussed below).
• Board approval is no longer required to rely on the Clearing Rule exemptions (discussed below).

Limited Substituted Compliance

An important feature of the Clearing Rule is substituted compliance, which will be permitted in the following two circumstances:

• If the transaction is submitted for clearing in a foreign jurisdiction listed in Appendix B, or in Quebec, that appears on a list to that effect. At this point, Appendix B is blank.
• If, in the jurisdictions of Prince Edward Island, Newfoundland and Labrador, Northwest Territories, Yukon or Nunavut, the transaction is submitted to a clearing agency or clearing house that is recognized or exempted from recognition pursuant to the securities legislation of another Canadian jurisdiction. This allows those jurisdictions to rely on the expertise of the other Canadian securities regulators to make determinations about which clearing houses are sufficiently capitalized and well-managed to operate in those jurisdictions.

Exemptions from the Clearing Rule

There are currently two proposed exemptions from the mandatory clearing requirement:

• The end-user exemption applies when one of the counterparties is not a financial entity[3] and enters into the transaction for the purpose of hedging or mitigating a commercial risk. There is no need to apply for this exemption nor is there any requirement to submit documentation to the regulator.
• The intragroup exemption applies when affiliated entities[4] or counterparties prudentially supervised by a regulator on a consolidated basis enter into a mandatory clearable derivative transaction. Compared to the end-user exemption, counterparties relying on this exemption must submit a form to the regulator, identifying the other counterparty and the basis upon which they are relying on the exemption.

Phase-in of the Clearing Requirement

The program is expected to follow a phase-in approach, which would be consistent with the approach taken in the United States and the European Union. Specifically, the CSA anticipates that the once the Clearing Rule is implemented, requirements would be phased in across four different categories of market participants, a draft list of which is available in Appendix A. As part of the process, the CSA is considering granting a cumulative 6-month grace period to financial entities (Category 2 and 3) and all counterparties that are not financial entities (Category 4). The four categories and rate of phase-in are summarized here:

• Category 1 (phase-in on a date which has not been published): a local counterparty that is a member of a regulated clearing agency that offers clearing services for the derivative or class of derivatives and subscribes to such service.
• Category 2 (phase-in 6 months after the Category 1 phase-in date): a local counterparty that is a financial entity above a specified (yet to be determined) threshold.
• Category 3 (phase-in 12 months after the Category 1 phase-in date): a local counterparty that is a financial entity, other than a financial entity below a specified (yet to be determined) threshold.
• Category 4 (phase-in 18 months after the Category 1 phase-in date): a local counterparty that is not one of the following: a member of a regulated clearing agency that offers clearing services for the derivative or class of derivatives and subscribes to such service, or a financial entity.

Market participants are asked to comment on an appropriate basis and value for the threshold that would determine whether financial entities fall under Category 2 or 3, thus benefiting from either a 6 month or 12 month phase-in, respectively.

Next Steps and Comments

The CSA is committed to implementing the Proposed National Instrument and would like to see it in place by Q4 2015 or Q1 2016. As part of the determination process, the CSA will publish for comment the derivatives being proposed to be the mandatory clearable derivatives in Appendix A and will invite interested persons to make representations in writing.

If implemented, the Proposed National Instrument would represent a significant change in the OTC derivatives market. We will closely monitor the potential costs and benefits should the Clearing Rule come into force. The CSA welcomes comments on the Proposed National Instrument, which will be accepted until May 13, 2015. McMillan expects to provide more information on the Clearing Rule as it becomes available, and we are available to assist those wishing to submit comments to the CSA.

by Shahen Mirakian & Jonathan Rajzman, Student-at-Law

1 Read the full text of the Proposed National Instrument.

2 The definition of “local counterparty” in the Clearing Rule is similar to the definition in the derivatives trade reporting rules proposed for Alberta, British Columbia, Saskatchewan, Nova Scotia and New Brunswick rather than the definition in Ontario Securities Commission Rule 91-507 or the equivalent Quebec and Manitoba rules. The definition of local counterparty in the Clearing Rule does not include a person registered as a derivatives dealer under local securities or derivatives laws.

3 As defined by the Clearing Rule in section 1. In addition to entities generally thought of as financial entities (such as banks, insurance companies, trust companies and credit unions), the Clearing Rule also considers investment funds, pension funds and entities registered or exempt from registration under securities legislation to be financial entities.

4 As interpreted by the Clearing Rule in the new section 3.

A Cautionary Note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2015