Final Customer Collateral Rule Published by CSA

Margaret Grottenthaler

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.

Substituted Compliance

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.

Final Canadian Mandatory Clearing Rule Published

Margaret Grottenthaler - 

The Canadian Securities Administrators (CSA) have published the final version of proposed National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (the Clearing Rule) and its Companion Policy 94-101 (the Clearing CP) slated to come into effect on April 4, 2017 for clearing participants and October 4 for other parties subject to the rule.  The changes from the prior version of the Clearing Rule are relatively minor.

The Clearing Rule applies to direct clearing participants of a regulated clearing agency (and their affiliates) and major swap market participants that are local counterparties (month-end gross notional above CAD 500 billion).   For a rule directed primarily at reducing systemic risk, this is a sensible and welcome approach, and one that recognizes that the Canadian market comprises a relatively small part of the global market. Initially, the products mandated to clear will be certain interest rate derivatives and forward rate agreements. In this post we review the main features of the Clearing Rule.

Summary of Changes from Prior Draft

The prior version of the rule applied to affiliated entities of clearing participants.  This has been further limited to affiliates that meet a specified notional amount threshold of CAD1 billion of gross notional.

The intragroup exemption is restricted to entities with consolidated financials.

The information required to be reported in order to rely on the intragroup exemption is simplified (ie a single form per group showing each counterparty pairing).

Proposed Basic Clearing Requirement

The basic requirement to submit a transaction for clearing to a “regulated clearing agency” is imposed on a “local counterparty” to a transaction in a “mandatory clearable derivative”, if both parties meets certain counterparty criteria (s. 3(1)). 

Counterparty Criteria

The counterparty criteria significantly limit the scope of the clearing requirement.

The clearing requirement applies only if each party at the time of execution meets at least one of the following criteria:

  • a participant subscribing to the services of a regulated clearing agency for a mandatory clearable derivative
  • an affiliated entity of such a participant if its month-end gross notional amount of outstanding derivatives exceeds CAD 1 billion, excluding transactions excluded by the intragroup exemption
  • a local counterparty in any Canadian jurisdiction that meets a specified threshold any time after the Clearing Rule comes into force

The local counterparty test is similar to the definition in the trade reporting rules (s.1(1)), namely one or more of the following describe the counterparty:

  • it is organized under the laws of the local jurisdiction or has it head office or principal place of business in the local jurisdiction, or
  • it is an affiliated entity of such a person and such person is responsible for all or substantially all of its liabilities.

A party may be a local counterparty in more than one jurisdiction. The Clearing CP contains guidance explaining that the regulators are flexible as to how market participants declare their status to each other.  An in-scope counterparty should solicit confirmation from its counterparty where there is a reasonable basis to believe it may be near or above the threshold.

The local counterparty threshold is a month-end gross notional amount under all outstanding derivatives of the local counterparty exceeding C$500,000,000,000 in any month after the instrument comes into effect. The local counterparty must include transactions entered into by affiliated local counterparties in the calculation, but not transactions excluded by the intra-group exemption (read on for a description of that exemption). 

Entities are affiliated entities if one of them controls the other or each of them is controlled by the same person or company. A trustee is controls a trust, a general partner controls a limited partnership, a 50% or more partner of an ordinary partnership controls the partnership, and the holder of securities sufficient to elect a majority of directors controls a corporation (s.1(3)).

So for example, if a foreign dealer transacts with a Canadian bank, LCH clears the particular mandatory clearable derivative as part of its SwapClear service and both parties are participants in SwapClear, then the rule will apply.  Similarly, the rule will apply if an affiliated entity of the foreign dealer is a SwapClear participant, even if the foreign dealer itself is not. The assumption, presumably, is that the foreign dealer can clear through its affiliate.  It could also apply if the parties participate in different clearing agencies both of which clear the transaction. 

A future iteration of the Clearing Rule may bring other derivatives markets participants into scope.

“Mandatory Clearable Derivative”

The mandatory clearable derivatives will be determined by the local regulatory authority but the intention is uniformity across Canada. They will be published as an appendix to the Clearing Rule. The proposed appendix is 

Interest Rate Swaps

Type

Floating

index

Settlement

currency

Maturity

Settlement
Currency
Type

Optionality

Notional

type

Fixed-to-float

CDOR

CAD

28 days to
30 years

Single currency

No

Constant or
variable

Fixed-to-float

LIBOR

USD

28 days to
50 years

Single currency

No

Constant or
variable

Fixed-to-float

EURIBOR

EUR

28 days to
50 years

Single currency

No

Constant

or

variable

Fixed-to-float

LIBOR

GBP

28 days to
50 years

Single currency

No

Constant or
variable

Basis

LIBOR

USD

28 days to
50 years

Single currency

No

Constant or
variable

Basis

EURIBOR

EUR

28 days to
50 years

Single currency

No

Constant or
variable

Basis

LIBOR

GBP

28 days to
50 years

Single currency

No

Constant or
variable

Overnight

index swap

CORRA

CAD

7 days to
2 years

Single currency

No

Constant or
variable

Overnight

index swap

FedFunds

USD

7 days to
3 years

Single currency

No

Constant or
variable

Overnight

index swap

EONIA

EUR

7 days to
3 years

Single currency

No

Constant or
variable

Overnight

index swap

SONIA

GBP

7 days to
3 years

Single currency

No

Constant or
variable


 Forward Rate Agreements

Forward
rate
agreement

LIBOR

USD

3 days to
3 years

Single currency

No

Constant

or

variable

Forward

rate

agreement

EURIBOR

EUR

3 days to
3 years

Single Currency

No

Constant

or

variable

Forward

rate

agreement

LIBOR

GBP

3 days to
3 years

Single currency

No

Constant

or

variable


The CSA has noted that the European Parliament does not currently mandate clearing of CAD interest rate swaps (IRSs), but noted local counterparties complying with European laws under the substituted compliance provision must clear CAD IRS. 

Pre-existing Transactions

The Clearing Rule does not apply to transactions that were entered into prior to the Clearing Rule coming into effect.  However, if a material amendment is made to a pre-existing transaction, it is novated or assigned or otherwise acquired or disposed of after the rule is in force, then the transaction could be subject to the clearing requirement.  A material amendment, according to the Clearing CP, is one that changes information that would reasonably be expected to have a significant effect on the derivative's attributes, including its value, the terms and conditions of the contract evidencing the derivative, transaction methods or the risks related to its use. Several factors would be relevant in this determination, such as whether the modification would result in a large change in the value of the transaction and could result in differing cash flows or creating upfront payments.

Substituted Compliance

There is a substituted compliance regime, but only in limited circumstances (s.3(5)). If the only reason that the transaction has to be cleared is because the local counterparty guaranteed affiliate category applies, then the local counterparty can submit it for clearing under the law of a foreign jurisdiction that is listed in Appendix B of the rule (or in Quebec, on the list published by the AMF). CFTC and ESMA rules regarding mandatory clearing are considered equivalent.

A local counterparty may still be required to clear by the laws of multiple jurisdictions if, for example, it is organized under the laws of Canada, but is subject to a clearing requirement in a country where it conducts business. There is no substituted compliance regime in that case, but an exemption could be applied for if it was not possible to comply with both (if, for example, different clearing agencies are recognized). 

Other requirements of the Clearing Rule do apply however, including record keeping.  The exemption relates to the submission for clearing only.

Proposed Timelines for Submitting Derivatives for Clearing

The transaction must be submitted for clearing no later than the end of the business day on which it is executed, or the next day if entered into after business hours of the regulated clearing agency (s. 3(2)).  The Clearing CP states that the transaction is to be submitted as “soon as practicable”.

There is a transitional period for compliance where the applicable counterparty criteria is based on gross notional amount.  In that case the party has 90 days from the date it first met the criteria to begin clearing transactions executed on or after that 90th day (s.3(3)).

Proposed Exemptions

There are four principal proposed exemptions from the clearing requirement.  Though there is no end-user exemption, one should not be necessary given the counterparty criteria.

Intragroup Exemption (s. 7)

The clearing requirement does not apply to an "intragroup transaction" if

  • the transaction is between a counterparty and its affiliated entity if their financial statements are prepared on a consolidated basis in accordance with certain acceptable accounting principles (e.g. Canadian or US GAAP, or IFRS for entities with a parent entity in Canada).
  • both parties agree to rely on this exemption,
  • the transaction is subject to a centralized risk management program reasonably designed to assist in monitoring and managing the risks associated with the derivative between the counterparties through evaluation, measurement and control procedures, and
  • there is a written agreement setting out the terms of the transaction between the parties. 

To rely on this exemption the local counterparty must submit a Form 94-101F1 Intragroup Exemption to the local securities regulator within 30 days of first relying on the exemption.  The form has been clarified so that it only must be delivered once for each pair of counterparties and can apply to all transactions between them. A party must correct inaccuracies within 10 days. The information will be kept confidential generally, but the regulators may require public disclosure of a summary of the information if it considers that disclosure to be in the public interest.

The Clearing CP states that an ISDA Master Agreement between the parties applicable to the cleared transactions would satisfy the written agreement requirement.  Other types of transaction agreements are also acceptable. It also warns against abusing the exemption for structuring transactions simply to avoid the clearing requirement.

Government Counterparties (s. 6)

The clearing requirement does not apply if one of the counterparties is the Government of Canada, the government of a province or territory, the government of a foreign jurisdiction (both sovereign and sub-sovereign), a crown corporation for which the government of the relevant jurisdiction is responsible for all or substantially all the liabilities, an entity wholly owned by one or more governments that are responsible for all or substantially all of the entity’s liabilities, the Bank of Canada, a central bank of a foreign jurisdiction, the Bank for International Settlements or the International Monetary Fund. 

Multilateral Portfolio Compression (s. 8)

The clearing requirement does not apply to a mandatory clearable derivative that results from a multilateral portfolio compression exercise if:

  • the resulting transaction is entered into as a result of more than two counterparties changing or terminating and replacing existing transactions
  • the existing transactions do not include a transaction entered into after the effective date on which it became a mandatory clearable derivative
  • the existing transactions were not cleared by a clearing agency or clearing house;
  • the counterparties are the same, and
  • the multilateral portfolio compression exercise is conducted by an independent third-party.

Exemptive Relief (s. 11)

The regulatory authorities may grant exemptions in whole or part on application. An exemption granted in one jurisdiction applies in the others (except for Ontario and Alberta). 

Record Keeping

A local counterparty relying on the intragroup or compression exercise exemption must maintain for seven years (eight in Manitoba) from the date the transaction expires or terminates, records of all documentation demonstrating that it is eligible to benefit from the relevant exemptions (s. 9(1)).  The records must be kept in a safe and durable form.  The Clearing CP sets out that the parties should keep full and complete records of any analysis undertaken by the local counterparty relying on the exemption. 

Designation of Cleared Derivatives

Clearing agencies will be required to submit electronic information on new clearing services for derivatives or classes of derivatives to the regulator within 10 days after providing the new service (s. 10).  Also, prior to May 4, 2017, each regulated clearing agency will be required to submit information for all derivatives it provides services for as of April 4th (s. 12).

Based on this information, the regulators will determine by rule or otherwise which derivatives or classes of derivatives will be subject to the mandatory clearing rule. Regulators may also determine by rule or otherwise which derivatives or classes of derivatives will be subject to the requirements through a top-down approach.

The Clearing CP sets out the factors the regulators will consider (paraphrased):

  • the availability of clearing on a regulated clearing agency;
  • the level of standardization;
  • the effect of central clearing of the derivative on the mitigation of systemic risk;
  • whether the derivative would bring undue risk to the clearing agency;
  • the outstanding notional exposures, liquidity and availability of reliable and timely pricing data;
  • the existence of third party vendors providing pricing services;
  • the existence of an appropriate rule framework, and the availability of capacity, operational expertise and resources, and credit support infrastructure to clear the derivative on terms that are consistent with the material terms and trading conventions on which the derivative is then traded;
  • whether the clearing agency would be able to risk manage the additional derivatives that might be submitted due to the clearing requirement determination;
  • the effect on competition, taking into account appropriate fees and charges applied to clearing, and if the proposed clearing requirement determination could harm competition;
  • alternative derivatives or clearing services co-existing in the same market; and
  • the public interest.

Clearing agencies have a few other obligations:

  • The regulated clearing agency must immediately notify the local counterparty if a transaction has been rejected for clearing (s. 4) and its rules must provide for such notification. 
  • A clearing agency is required to post on its website a list of all derivatives and classes of derivatives it clears and identify whether each is a mandatory clearable derivative (s. 5).  There must be no cost to access the list and it must be available to the public.

Timing

The rule is slated to come into effect on April 4, 2017 for participants in clearing agencies and October 4, 2017 for their affiliates and local counterparties meeting the thresholds.