Canadian Structured Finance Law : Canadian Structured Finance Law: Securitization/OTC Derivatives Blog by Stikeman Elliot Lawyers & Attorneys

Bill 7 also includes various housekeeping amendments to the Derivatives Act (Quebec) (QDA), as well as the following:

• Incorporating contracts for difference in the definition of a “derivative” regulated under the QDA.
   
• Additional requirements (not yet in force) governing the initial and ongoing business conduct of “qualified persons” as described in our other post dated today.
   
• Amendments in respect of the use of set-off related to cash posted as credit support, as more fully described in our blog post of November 18, 2011.
   
• Provisions governing the regulation of “trade repositories” as “regulated entities” subject to recognition by the AMF, consistent with the high level recommendations of the Canadian Securities Administrators in their CSA Consultation Paper 91-402 Derivatives: Trade Repositories.
   
• Changes to the exemption for over-the-counter (OTC) derivatives transactions. While activities or transactions in OTC derivatives involving “accredited counterparties” only will continue to be exempted from the derivatives registration and qualification requirements under the QDA, those transactions are no longer generally exempt from the application of various market supervision, enforcement and other procedural remedies available to the AMF and the Québec Bureau de décision et de révision.
   
• Specifying that a derivative cannot be invalidated for the sole reason that a counterparty is not an “accredited counterparty” or the derivative “otherwise departs from the Act”, unless the cause of the invalidity is set out in the terms of the derivative.
   
• Additional provisions governing the ability of the AMF to inspect market participants or compel the production of documents.
   
• Provisions governing liability for misrepresentation “about the offering or trading of a derivative”.

Impact of the Proposals

The Proposals are significant for several reasons.

First, the Proposals, if adopted, would round out the basic framework governing the regulation of both OTC and standardized derivatives first introduced in Quebec in 2009. They follow on the enactment of more detailed amendments to the “qualified persons” provisions of the QDA effective November 30, 2011, as described in our other post dated today.

Second, the Proposals represent an innovative means of regulating the offering of derivatives to persons other than eligible counterparties outside of the conventional prospectus-based framework of securities regulation which has generally been employed by regulators in other Canadian jurisdictions to regulate trades in all or certain categories of derivatives. The basic mechanics of this new qualification requirement are outlined below.

Third, and more importantly, upon the adoption of these rules, material transitional relief issued by the AMF in conjunction with the implementation of the QDA would lapse.² The effect of this change is that:

• OTC derivative transactions involving eligible “accredited counterparties” in Quebec would continue to be exempt from the derivatives registration and the qualification/authorization requirements.
   
• Market participants offering OTC derivatives to Quebec-resident persons other than qualified “accredited counterparties” would now be subject to the derivatives registration and the qualification/authorization requirements.
   
• Market participants offering standardized (listed) derivatives to any Quebec-resident person (including to “accredited counterparties”) could no longer rely on blanket and other transitional or discretionary relief previously issued by the AMF. These market participants would have to apply to the AMF for qualification/authorization within 30 days of the coming into force of the new rules and, as the case may be, comply with the derivatives registration requirement (unless an exemption is available)³, or obtain separate discretionary relief from the AMF.

The Proposals do not specify how much time, if any, will be given to the market to transition to the new “qualified persons” regime. The QDA came into force in 2009 with a six-month transition period. It is to be hoped that, in this period of intense regulatory change (particularly in the major derivatives markets outside Canada), the final rules will include a transition period at least that long. 

Key Features of the Qualification Process

As noted above, the Proposals build on recent amendments to the QDA made under Bill 7, An Act to amend various legislative provisions mainly concerning the financial sector which further flesh out the cornerstones of the qualification/authorization requirements (the “qualified persons amendments”).

The qualified persons amendments, once in force, would introduce general provisions governing the initial and ongoing business conduct of “qualified persons”, including requirements that a qualified person have an effective corporate and organizational structure with adequate personnel, financial and technological resources and appropriate business policies and procedures and governance practices; that it take the necessary measures to ensure the security and reliability of its transactions and activities; that it offer derivatives to the public through a registered dealer or register as a dealer; that it comply with initial and periodic reporting requirements; and that it comply with safekeeping and segregation requirements.

The Proposals would further provide that:

• A qualified person must participate in a contingency fund that protects the assets entrusted to it by its counterparties, or comply with minimum working capital requirements as calculated on Form 31-103F1 Calculation of Excess Working Capital⁴ or under the Joint Regulatory Financial Questionnaire and Report of the Investment Industry Regulatory Organization of Canada (IIROC). The minimum required capital would be C$20 million plus 5% of amounts due to counterparties to a derivative that a qualified person is marketing which exceed C$10 million.
   
• A qualified person must maintain proper books and records to ensure efficient operations and demonstrate compliance with the QDA.
   
• A qualified person must have an emergency and contingency plan in place to ensure business continuity.
   
• An applicant for qualification must provide documents in support of its compliance with specified requirements of the qualified persons amendments, a completed Schedule B Application for Qualification (including background organizational, business and regulatory compliance information on the applicant, and information on distribution methods, client disclosure, electronic systems and operations and audited financial information). The Schedule B application must be accompanied by a completed Form 33-109F4 Registration of Individuals and Review of Permitted Individuals for each of its “permitted individuals”(e.g., directors, the chief executive officer, the chief financial officer, the chief operating officer and individuals having beneficial ownership of, or direct or indirect control or direction over, 10% of the voting securities of the applicant) unless the Form 33-109F4 information is already on file with the AMF (e.g., as in the case of applicants which are already Quebec-registered firms).
   
• An applicant for authorization must provide a completed Schedule C Application for Authorization to Market a Derivative, including a detailed description of the derivative, and associated trading methods, prospective clients, risks and costs and fees. The AMF must make any objection to an application for authorization within 21 days after submission of the application.
   
• Designated information set out in the Schedule B and Schedule C applications must be included in the risk information document that a derivatives dealer must provide to its clients before the first trade in a derivative.
   
• A qualified person must notify the AMF “without delay” if its excess working capital or risk adjusted capital calculated as described above is less than zero or in the case of “any failure, malfunction or material delay of [its] systems or equipment”.⁵
   
• A qualified person must notify the AMF of any material change to the information provided in its applications for qualification or authorization, within 7 days of the change. The rules provide definitions of what constitutes a “material change” in respect of a qualified person or a derivative. Other changes to such information would have to be notified within 30 days following the end of the quarter in which the change occurred.
   
• A qualified person must also notify both the AMF and “the counterparties to a derivative that [it is] marketing, including counterparties waiting to trade such a derivative” of “any change that could affect the trading of such a derivative or the transactions under way in respect of such a derivative at least 10 days prior to the change”. This 10-day prior notice requirement raises a number of conceptual and practical issues, including the absence of any materiality threshold, the absence of any guidance as to the type of change that would trigger the notice requirement and the issue of changes that may arise over which a qualified person has no reasonable ability to give a 10-day prior notice, particularly in the case of a qualified person that is part of a global financial services group and in a dynamic financial markets environment. Hopefully, this requirement will be modified or further clarified through additional guidance.
   
• A qualified person must, within 90 days after the end of its financial year provide to the AMF:
  
  
  1. audited financial statements prepared in accordance with Canadian GAAP applicable to publicly accountable enterprises (there would appear to be no provision for the delivery of financial statements prepared in accordance with IFRS, U.S. GAAP or other accounting principles as contemplated in Regulation 52-107 respecting Accounting Principles and Auditing Standards), an adjustment to the Proposals which should be contemplated given the number of foreign stakeholders potentially affected by these rules;
      
  2. the number of contracts entered into in Quebec and their notional value for all derivatives offered to the public during the latest fiscal year; and
      
  3.  the percentage of contracts, for each of the latest four quarters, that were profitable for counterparties.

Interested stakeholders should consider submitting comments on these proposals by February 1, 2012.

¹ The term “regulated entity” includes exchanges, alternative trading systems, clearing houses, trade repositories and self-regulatory organizations that are subject to the requirement to be recognized by the AMF.

² In connection with the adoption of the QDA on February 1, 2009, the AMF issued a discretionary blanket decision on January 22, 2009 (the “AMF Blanket Decision”) by way of broad transitional relief (AMF decision No. 2009-PDG-0007 (January 22, 2009), as supplemented and extended by AMF notices of October 2, 2009 and September 24 2010). The AMF Blanket Decision sets out a temporary exemption from the derivatives registration requirement and the derivatives qualification requirement for specified derivatives activities carried out solely with “accredited investors” as defined under Regulation 45-106 respecting Prospectus and Registration Exemptions (45-106).

³ The Derivatives Regulation (Québec) (the “QDR”) provides an exemption (the “standardized derivatives exemption”) from the derivatives registration requirement under the QDA for a person authorized to act as a dealer or an adviser or authorized to exercise similar functions under legislation applicable in a jurisdiction outside Quebec where its head office or principal place of business is located to the extent it carries on business solely for an “accredited counterparty” and its activity involves a standardized derivative that is offered primarily outside Quebec. The standardized derivatives exemption does not, however, provide an exemption from the derivatives qualification or authorization requirements.

⁴ Regulation 31-103 respecting Registration Requirements, Exemptions and Ongoing Registrant Obligations.

⁵ The term “material” would appear to qualify the terms “failure”, “malfunction” or “delay” in the governing French language version. We would hope that this technical translation error will be rectified in the final provision.

Market Conduct Rules

To address the perceived lack of consistency in market conduct rules applicable to OTC derivatives across Canadian jurisdictions, the CSA recommend extending certain regulations pertaining to securities markets to OTC derivatives markets. Such regulations would include record keeping and audit trail requirements and prohibitions to prevent market manipulation and fraud, misrepresentations and insider trading.

Enforcement

According to the CSA, compliance, investigation and enforcement powers currently found in securities legislation should also be extended to cover trading in OTC derivatives.

Comments on the proposals are being accepted until January 25, 2012. For more information, see CSA Consultation Paper 91-403 Derivatives: Surveillance and Enforcement.

The CSA Derivatives Committee identified trade repositories, which are centralized facilities for the collection of OTC derivatives data, and the related availability and transparency of transaction and aggregate market data for market and prudential regulators, central banks and the public as one of the most important components of OTC derivatives regulatory reform. 

There are currently no requirements for Canadian market participants to report their OTC derivative transactions and positions. Therefore, Canadian regulators and the Bank of Canada do not have formal access to data regarding the size and composition of the Canadian OTC derivatives market, the activities of Canadian market participants and “Canadian referenced derivatives” entered into by foreign participants.

Trade Repository Requirements

The CSA Derivatives Committee recommends that trade repositories operating in Canada should:

• be required to meet internationally accepted governance and operational standards recommended by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) including standards relating to legal framework, governance, market transparency and data availability, operational reliability, access and participation, safeguarding of data, timely recordkeeping and communication procedures and standards,
• have boards of directors with appropriate independent representation,
• have a chief compliance officer and robust operational risk management capabilities,
• provide fair and open access to market participants,
• be required to accept all trades for each asset class for which they accept trade data,
• safeguard confidential data, and
• prevent any data use that could represent a conflict of interest. 

The CSA Derivatives Committee also recommends that Canadian provincial securities and derivatives laws should be amended to include approved trade repositories in the definition of market participant. 

What is not clear from the recommendations is whether a trade repository, whether domestic or foreign, would have to become registered or recognized in each province in which it accepts trade data from market participants. Hopefully, registration or recognition in (and regulation by) thirteen different provincial and territorial securities regulators can be avoided, especially for non-Canadian trade repositories.

The comment letter from the Canadian Market Infrastructure Committee (CMIC) submitted that the federal authority over systemic risk and banking means that the Bank of Canada should be at the centre of trade repository regulation (i.e., not the provincial securities regulators) within harmonized federal and provincial approval processes. The framework should be designed to provide federal authorities with the appropriate data for their systemic risk purposes and provincial securities regulators with the appropriate data for their market conduct purposes. The legislative approach that should be followed is the developent by federal authorities of federal legislation that would focus on the Bank of Canada’s trade repository requirements for systemic risk monitoring purposes, albeit in consultation with both provincial securities regulators and industry participants to ensure that the scheme of the federal legislation is consistent with the market conduct responsibilities of provincial securities regulators.

A Made-in-Canada Solution?

The CSA Derivatives Committee recommends studying whether a “made-in-Canada” solution is necessary and the requirements for foreign-based trade repositories. While there are efficiency arguments for a single global trade repository, at least for each asset class, there are of course reasons why Canadian regulators (federal and provincial) may prefer a local trade repository, including the possibility that foreign trade repositories may not develop systems that accept trade data from Canadian market participants for all types of OTC derivatives entered into domestically by Canadian counterparties or that Canadian regulators may not have sufficient access to foreign trade repositories holding trade data in respect of trades by Canadian counterparties or Canadian referenced derivatives or that such access might be interrupted in the future. 

What is clear from the comment letters is that if Canada does pursue a domestic trade repository, the format and parameters of the data that are required must be the same as used by other trade repositories globally so that trade data feeds between market participants and trade repositories work efficiently.

OTC Derivatives Transactions Reporting Requirements

The consultation paper recommends that provincial market regulators mandate the reporting of all OTC derivatives transactions, both cleared and non-cleared, to an approved trade repository. This mandatory reporting includes the reporting of pre-existing OTC derivatives which should be reported within 180 days from the effective date of the new rules except for existing transactions which terminate or expire within one year of the effective date of the new rules. The CSA heard from industry in the comment letters that 180 days from the effective date of the new rules for the reporting of pre-existing OTC derivatives may be too short a period. Not only may it not be practical from an operational perspective for many market participants to meet that timeline, but data does not necessarily exist within organizations in the format that it would be required to be reported.

Who Must Report OTC Derivatives Transactions

The consultation paper proposes that one counterparty to each OTC derivative transaction should be required to report the transaction and any related post execution events to an approved trade repository. However, counterparties should be able to delegate reporting to a third-party service provider including a central counterparty clearing house. Financial intermediaries should bear the reporting onus in transactions with end users. Transaction counterparties should be permitted to elect the reporting party for transactions between two financial intermediaries or two end users. A foreign counterparty may assume reporting obligations provided that the transaction is reported to a trade repository approved in Canada. 

OTC Derivatives Transaction Information Required to be Reported

The consultation paper recommends that the reported data include not only the principal economic terms, but also the full executed legal agreements entered into between the counterparties and should be reported in accordance with international standards for data reporting which would include unique identifiers for legal entities, transactions and product types. In addition, “continuation data” should be reported throughout the life of an OTC derivative transaction. Many comment letters state that the requirement to submit all legal documentation to a trade repository is too onerous for the institutions and in any event would not provide regulators with any additional useful information beyond the principal economic terms of the transaction. Also, the full legal documentation for some trades is often not executed until long after the trade date and, in the case of many bespoke trades, the full legal documentation can be voluminous.   Also, not all parties use FpML confirmations so reporting the transaction documentation electronically is not always feasible. 

Timing of Reporting

The CSA Derivatives Committee proposes that transaction reporting to trade repositories should be completed in real time once feasible for Canadian market participants and within one business day until real time reporting is implemented. Once real time reporting is implemented, large trades meeting a to-be-determined block trade threshold should be subject to a delayed reporting requirement in order to preserve the anonymity of market participants and ensure that there is no detrimental impact on market liquidity or function. 

This real time reporting requirement engendered many comments, as it has in other jurisdictions. The need for real time reporting into a database that is not itself a market is questioned. While timely information is necessary, reporting time frames should depend on the level of data required to be reported, the complexity of the transaction and the availability of the required technology systems on a global basis. 

The question of a block trade threshold is also addressed in many of the comment letters. For example, the International Swaps and Derivatives Association (ISDA) recommends that the analysis to determine appropriate minimum block trade threshold levels should be undertaken separately for the Canadian OTC derivatives market, different asset classes within the market and different products within each asset class as the appropriate threshold levels for different asset classes and products within assets classes in the Canadian market will be different. A uniform block trade threshold is too simplistic and would be damaging to liquidity. Also, all block trade thresholds should be reviewed periodically in light of current market conditions and there should be a mechanism for the immediate reassessment of thresholds during periods of market stress.

An appropriate publication delay for block trades should reflect the time it takes to hedge the exposure without unduly impacting the market and in light of liquidity in the particular market.   Liquidity in many Canadian markets may be quite different from liquidity in some foreign markets. Many large Canadian market participants comment that the publication of block trade data should be delayed for at least a quarter as the public reporting of block trade data runs the risk of inadvertent disclosure of confidential information, potentially enables reverse-engineering strategies and runs the risk that the small number of relatively large participants in the Canadian markets would have the ability to figure out the individual positions of one another.

Access to Confidential Trade Repository Information

The consultation paper also raises a number of concerns relating to access to confidential information, including whether it is necessary for provincial regulators to enact legislation that expressly permits the disclosure of confidential information to and by trade repositories, that amendments to legislation should be enacted to ensure that confidential trade repository data is not made publicly available pursuant to public disclosure laws and that Canadian regulators and the central bank should establish cooperation agreements with foreign jurisdictions that have equivalent legal and supervisory frameworks to facilitate cross border access to trade repository data.

Availability of Information to Public

Another controversial proposal is that trade repositories should make available to the public aggregate data, including information on positions, transaction volumes and average prices. Anonymous post-trade transaction level data should also be made public provided that it would not be detrimental to market liquidity or function. The comment letters urge that the release of data to the public be studied thoroughly, because the publication of such data may compromise the positions of counterparties depending upon the size of the market and the level of aggregation of the data.

Inter-Affiliate Transactions and End User Exemptions

The consultation paper does not deal with the question of inter-affiliate trades. Should inter-affiliate trades be excluded from the reporting requirement (and possibly other aspects of OTC derivatives regulatory reform)? It has been argued that transactions between affiliates merely represent transfers of risk within a corporate group and should not be subject to the same reporting requirements as inter-affiliate transaction data will not provide any valuable information to regulators from either a systemic risk or market conduct perspective. Reporting of inter-affiliate trades will also increase the costs and burden for corporate groups that choose to consolidate their hedging activities in a single entity.

Nor does the consultation paper contemplate exemptions from the reporting requirements for hedging end users.   The CSA will have to consider whether such exemptions should be made available for end users that are hedging risks (particularly in the commodities and energy markets) where they do not pose any systemic risk. Perhaps exemptions of this nature will be discussed by the CSA Derivatives Committee more broadly in its anticipated Consultation Paper 91-405 - Exemptions (Derivatives).

According to IIROC, the CSA and IIROC are proposing to publish a joint notice to solicit feedback on whether additional proposals to enhance disclosure of short sales and failed trades in Canada are required. For example, the joint notice may seek comment on whether "disclosure of short positions by institutional investors may be necessary, similar to 'buy-side' reporting requirements that have been or are being widely implemented in other jurisdictions" as well as the type, level and frequency of public disclosure of failed trades in equity securities traded on all Canadian marketplaces and cleared through CDS.

This subsequent notice on enhanced disclosure, however, has yet to be published. In the U.S., meanwhile, the SEC recently issued a request for comment on the feasibility of requring real-time reporting of short sale positions of publicly listed securities, either publicly or only to the SEC and FINRA. In a sign of what may be to come in Canada, the SEC notice asks specific questions of market participants, including with respect to the benefits and costs of real time reporting of investors' short positions.