- Clearing of Derivatives Comes to Canada
- January 13, 2014
- Law Firm: Borden Ladner Gervais LLP - Toronto Office
Proposed Model Provincial Rule on Mandatory Central Clearing of Derivatives (the “Rule”) and proposed related explanatory guidance were published by the Canadian Securities Administrators as CSA Staff Notice 91-303 on December 19, 2013. The Rule describes the proposed requirements for central counterparty clearing of OTC derivative transactions and is meant to improve the transparency of the derivatives market to both the regulators and the public and to enhance the overall mitigation of risks. The Rule is divided into two broad rule-making areas: (i) those relating to the mandatory clearing of derivatives; and (ii) those relating to the determination of those derivatives that will be subject to mandatory clearing. Comments on the Rule should be provided to the CSA OTC Derivatives Committee (the “Committee”) by March 19, 2014. Following the comment period, provincial rules will be published that address any unique provincial features. However, the intent is that, to the greatest extent possible, the provincial rules will be harmonized 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 organized under the laws of that province or that has its head office or principal place of business in that province, as well as an affiliate of such person if such person is responsible for the liabilities of that affiliate. It is important to note that, for purposes of the Rule, the applicable clearing agencies are only those that are recognized, or have been exempt from recognition, by the relevant provincial securities regulator.
The Rule includes an end-user exemption from the clearing requirement. In order to qualify for the exemption, the counterparty cannot be a financial entity and it 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 is defined to include, among others, banks, trust companies, insurance, companies, credit unions, pension funds, investment funds, and all registrants under securities legislation, even if the transactions are only entered into 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, it covers the risks arising from the change in value of assets, services, inputs, products, commodities or liabilities that 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. Clearly, 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. We believe that the Rule and the related discussion in the explanatory guidance provides end-users with more latitude than the definition of hedging that is currently applied to investment funds in National Instrument 81-102.
The Rule also includes an exemption for intragroup transactions, which are transactions between affiliated entities, provided that certain conditions are met. Affiliates that wish to rely on this exemption will be required to file electronic reports with the applicable securities regulator. This report must be filed within 30 days following the execution of the first transaction made under the exemption and covers all transactions between such affiliates for one year.
Any counterparty relying on an exemption from the clearing requirement is required to keep certain key records, including documentation of its hedging strategy or program, 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 derivative, 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. At this point in time, no derivatives or classes of derivatives have been determined to be centrally cleared.