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CSA Restarts Canadian Derivatives Regulatory Project and Issues a Revised Business Conduct Rule Proposal – Lexology

After a long pandemic break from publishing regulatory proposals and new rules in respect of over-the-counter derivatives (derivatives), the Canadian Securities Administrators (CSA) is again moving forward with their derivatives regulatory project launched in response to the 2008 financial crisis.

On January 20, 2022, the CSA published for comment a further revised version of Proposed National Instrument 93-101 – Derivatives: Business Conduct (Proposed Rule) and a related proposed Companion Policy. The Proposed Rule would impose business conduct requirements on Canadian and foreign persons engaged in the business of trading derivatives (Derivatives Dealers) or advising on derivatives transactions (Derivatives Advisers) in Canadian provinces and territories (jurisdictions), subject to a range of important exemptions.

The Proposed Rule reflects updates to the second version of the rule published in June 2018. The CSA streamlined the Proposed Rule to address adverse impacts on market liquidity, keep compliance costs competitive and better harmonize the Proposed Rule with requirements in larger markets. This bulletin provides a recap of the Proposed Rule and summarizes the following notable revisions:

  • New blanket exemption for “Foreign Liquidity Providers”

  • Expanded foreign Derivatives Dealer and foreign Derivatives Adviser exemptions

  • Updated exemptions for Canadian financial institutions and dealer members of the Investment Industry Regulatory Organization of Canada (IIROC)

  • New obligations concerning spot foreign exchange contracts applicable to Canadian financial institutions

  • Updated “Eligible Derivatives Party” (EDP) definition

  • New exemption from the obligation to designate a “Senior Derivatives Managers” if transacting only with EDPs and certain trading thresholds are satisfied

  • Accommodation of registered advisers’ existing compliance systems

The comment period for the Proposed Rule ends on March 21, 2022.

The Proposed Rule is expected to operate in conjunction with a separate Registration Rule for derivatives as discussed in our April 2018 Blakes Bulletin: Canadian Derivatives: Registration Regime for Dealers and Advisers Gets Momentum, but the CSA has indicated that they will not be publishing an updated proposed Registration Rule at this time.

This bulletin also summarizes a proposal, published for comment by the Ontario Securities Commission (OSC) on January 21, 2022, to introduce new regulatory fees for Derivatives Dealers participating in Ontario’s derivatives markets. The comment period for the proposed new regulatory fees ends on April 21, 2022.

We also summarize changes to the mandatory clearing rule published on January 27, 2022, which will extend mandatory clearing obligations to certain affiliates of members of derivatives central counterparties with effect for transactions entered into on or after September 1, 2022.

SUMMARY OF THE PROPOSED RULE

The Proposed Rule will impose obligations on market participants engaging in the “business of trading derivatives as principal or agent” (i.e., Derivatives Dealers) and the “business of advising others as to transacting in derivatives” (i.e., Derivatives Advisers). This “business trigger” is substantively unchanged from the previous versions of the Proposed Rule and applies if a market participant engages in such business in a jurisdiction and an exemption is not available. The Proposed Rule will subject Derivatives Dealers and Derivatives Advisers (Derivatives Firms) to core business conduct standards intended to protect investors and derivatives counterparties, reduce risk, improve transparency and accountability, and promote responsible business conduct in derivatives markets.

Eligible Derivatives Parties

Under the Proposed Rule, Derivatives Firms will owe a core set of obligations to all Derivatives Parties (defined below) and additional obligations to Derivatives Parties that are not EDPs or are EDPs who are individuals or commercial hedgers that have not waived the protections provided to non-EDPs.

EDPs include:

  • Canadian financial institutions

  • Derivatives/investment dealers and advisers registered in any jurisdiction

  • Companies that have net assets of at least C$25-million or are “commercial hedgers” and that have, in each case, made specified representations concerning their knowledge and experience to evaluate certain derivatives information

  • Individuals who own financial assets with a net realizable value of at least C$5-million and who have made such specified representations concerning their knowledge and experience

  • Investment funds that are managed by a person or company registered as an investment fund manager in any jurisdiction or are advised by an adviser registered or exempted from registration under the securities legislation or commodity futures legislation of any jurisdiction

The CSA made numerous updates to the definition of EDP in the Proposed Rule, including eliminating the requirement that a commercial hedger have net assets of at least C$10-million.

General Obligations Applicable to All Derivatives Business with Both EDPs and Non-EDPs

Subject to applicable exemptions, the following core set of obligations are proposed to apply when transacting or proposing to transact with, or advising or proposing to advise, any person or counterparty (Derivatives Party), including when dealing with EDPs:

  • A requirement to act fairly, honestly and in good faith with the Derivatives Party (Fair Dealing)

  • Conflict of interest management and disclosure obligations

  • “Know your Derivatives Party” requirements (KYC Requirements)

  • Complaints handling requirements

  • Tied selling prohibition

  • Obligations to segregate collateral and other assets received from Derivatives Parties

  • An obligation to deliver written confirmations of transactions

  • Documentation and record-keeping requirements

In the previous versions of the Proposed Rule, the complaints handling and tied selling provisions did not apply when dealing with EDPs. Derivative Firms will be obligated to:

  • Establish, maintain and apply policies, procedures, controls and supervision sufficient to provide reasonable assurances regarding compliance with derivatives laws, risk management requirements and individual competence and integrity requirements.

Derivatives Dealers will also be obligated to:

  • Self-report non-compliance with the Proposed Rule or other laws related to trading in derivatives if the non-compliance creates or created a risk of material harm to any Derivatives Party or to capital markets, or is part of a pattern of material non-compliance.

  • Designate one or more individuals as “Senior Derivatives Managers” who will be responsible for supervising derivatives-related activities for the derivatives business units of the Derivative Firm, addressing material non-compliance and preparing certain compliance reports for the Derivatives Firm’s board.

Additional Obligations When Dealing with or Advising Non-EDPs, Individual EDPs and Eligible Commercial Hedgers

The additional obligations below apply if a Derivatives Firm is dealing with a non-EDP or an EDP who is either an individual or eligible commercial hedger that has not waived the protections provided by the Proposed Rule:

  • Specific KYC Requirements in respect of the Derivatives Party’s needs, objectives, financial circumstances and risk tolerance

  • Product suitability obligations

  • Permitted referral arrangements and related disclosure obligations

  • Disclosure obligations, including in respect of account terms, conflicts of interest, fees and charges, third-party compensation, how performance benchmarks might be used, the Derivative Firm’s method of holding collateral and related risks

  • Pre-trade disclosures regarding the types of derivatives and services offered, transaction risks, material terms of the derivatives and delivery of a standard statement regarding the use of leverage

  • Daily valuation reporting by Derivatives Dealers and monthly valuation reporting by Derivatives Advisers

  • Quarterly account statement delivery obligations

  • Requirements in respect of the holding, use and investment of initial margin

In addition, Derivatives Dealers whose head office or principal place of business is not in Canada must provide Derivatives Parties with additional standard disclosure, including a statement that there may be difficulty enforcing legal rights against the Derivatives Dealer because of the location of its head office or principal place of business.

New Obligations of Canadian Financial Institutions regarding Spot FX Contracts

A new provision of the Proposed Rules will apply to Canadian financial institutions (including Schedule I and II banks) that are Derivatives Dealers that have had over C$500-billion notional amount of derivatives outstanding as of any month-end (Large Financial Institution Dealers).

This newly proposed provision will require Large Financial Institution Dealers to comply with Fair Dealing, conflict of interest, complaints handling, and compliance and record-keeping obligations in respect of their physically-settled spot FX trading activity when transacting in the “institutional foreign exchange market.” The institutional foreign exchange market is defined for this purpose by reference to the “global foreign exchange market comprised of persons or companies that are active in foreign exchange markets as part of their business.” This provision specifically does not apply to transactions with non-EDPs, individuals or counterparties that are EDPs solely by virtue of being commercial hedgers.

This newly proposed provision would apply to FX transactions that are not otherwise subject to the Proposed Rule because they are excluded from the Proposed Rule’s definition of “derivatives”. This marks a considerable expansion of the Proposed Rule to the FX business of Large Financial Institution Dealers Proposed Rule.

EXEMPTIONS FROM THE PROPOSED RULE

New Foreign Liquidity Providers Exemption

The CSA added to the Proposed Rule a new “foreign liquidity provider” exemption for foreign Derivatives Dealers in respect of transactions with other Derivatives Dealers and registered investment dealers that, in each case, are transacting as principal for their own account. This foreign liquidity provider exemption provides an alternative to relying on the Foreign Dealer Exemption described below and applies automatically without giving prior notice or satisfying the other requirements under the Foreign Dealer Exemption.

The foreign liquidity provider exemption is available only if the Derivatives Firm is registered, licensed or authorized (or otherwise operates under an applicable exemption) under the securities, commodity futures or derivatives legislation of its home jurisdiction to carry on the activities in its home jurisdiction that registration as a derivatives dealer would permit it to carry on in Canada.

Expanded Foreign Derivatives Dealer and Foreign Derivatives Adviser Exemptions

The CSA streamlined the foreign derivatives dealer exemption (Foreign Dealer Exemption) and foreign derivatives adviser exemption to more closely conform to the international dealer and international adviser exemptions in National Instrument 31-103 – Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). Significantly, the CSA has amended the wording of these exemptions so that a foreign Derivatives Dealer or Derivatives Adviser that complies with their conditions will receive a complete exemption from the Proposed Rule.

A notable difference between these exemptions and those contained in NI 31-103 is that these exemptions will be limited to foreign dealers and advisers in a “specified foreign jurisdiction”: namely, Australia, Brazil, Hong Kong, Japan, the Republic of Korea, New Zealand, Singapore, Switzerland, the United States of America, the United Kingdom of Great Britain and Northern Ireland and any member country of the European Union.

Under the proposal, a Derivatives Dealer whose head office or principal place of business is in a specified foreign jurisdiction will be exempt from the provisions in the Proposed Rule if the Derivatives Dealer:

  • Transacts only with, for or on behalf of, a person or company in the local jurisdiction that is an EDP

  • Is registered, licensed or authorized under the securities, commodity futures or derivatives legislation of a specified foreign jurisdiction to conduct the derivatives activities in the foreign jurisdiction that it proposes to conduct with the derivatives party

  • Is subject to and complies with the laws of the foreign jurisdiction applicable to the Derivatives Dealer relating to the activities being conducted with a derivatives party whose head office or principal place of business is in Canada

  • Reports to the CSA regulator in a timely manner any circumstance in which the Derivatives Dealer is not or was not in compliance with the laws of the foreign jurisdiction relating to trading in derivatives to which the Derivatives Dealer is subject, if any of the following apply:

    • The non-compliance creates or created, in the opinion of a reasonable person, a risk of material harm to a Derivatives Party whose head office or principal place of business is located in Canada

    • The non-compliance creates or created, in the opinion of a reasonable person, a risk of material harm to capital markets in Canada, or

    • The non-compliance is part of a pattern of material non-compliance relating to the activities being conducted with one or more Derivatives Parties whose head office or principal place of business is in Canada

  • provides the CSA regulator with prompt access to its books and records upon request with respect to any matter relating to the activities conducted with Canadian Derivatives Parties

To benefit from the Foreign Dealer Exemption, the foreign Derivatives Dealer must provide its counterparties a specified disclosure statement and submit a completed Form 93-101F1 – Submission to Jurisdiction and Appointment of Agent for Service of Process.

Similarly, a Derivatives Adviser whose head office or principal place of business is in a specified foreign jurisdiction will be exempt from the provisions in the Proposed Rule if the Derivatives Adviser satisfies conditions that are generally analogous to the Foreign Dealer Exemption except that the foreign Derivatives Advisor has no obligation to self-report non-compliance to the regulator or securities regulatory authority.

Updated Exemptions for Canadian Financial Institutions or IIROC Dealer Members

The Proposed Rule now includes specific exemptions, in completed appendices, available to IIROC dealer members and Canadian financial institutions.

Provided that IIROC dealer members comply with the corresponding IIROC regulatory provisions in connection with their derivatives activities and promptly notify the CSA regulator of each instance of material non-compliance, they will be exempt from certain provisions of the Proposed Rule. These include KYC Requirements and provisions relating to handling complaints, derivatives-party-specific needs and objectives, suitability, relationship disclosure information, pre-transaction disclosure, daily reporting, segregating derivatives party assets, holding initial margin, investment or use of initial margin, content and delivery of transaction information, derivatives party statements, designation and responsibilities of Senior Derivatives Managers, and the responsibility of Derivatives Dealers to report to the regulator or the securities regulatory authority.

With respect to Canadian financial institutions, provided they comply with the corresponding prudential regulatory provisions in connection with their derivatives activities and promptly notify the CSA regulator of each instance of material non-compliance, they will also be exempt from certain provisions of the Proposed Rule. These include KYC Requirements and provisions relating to tied selling, segregating derivatives party assets, holding initial margin, investment or use of initial margin and a Derivatives Party agreement.

Schedule III banks (i.e., Canadian bank branches of non-Canadian banks) are not permitted to rely on the above exemption but may qualify for one of the foreign dealer exemptions described elsewhere in this bulletin.

New Foreign Derivatives Sub-Adviser Exemption

A new provision in the Proposed Rule fully exempts foreign derivatives advisers that act as derivatives advisers in their home jurisdiction and, in Canada, only advise other advisers and registered dealers that are members of IIROC (Qualifying Sub-Advisers). As drafted, the exemption will be available only if the Qualifying Sub-Adviser has agreed in writing with its Canadian clients that it will be responsible for any loss that arises out of its failure to exercise the powers and discharge the duties of its office honestly, in good faith and in the best interests of its clients and such clients’ clients, or its failure to exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances.

The exemption will be available only to a derivatives sub-adviser whose head office or principal place of business is in specified foreign jurisdictions, including the United States, the United Kingdom and the European Union.

Expanded Exemption for Derivatives Traded on a Swap Execution Facility where the Identity of the Derivatives Party is Unknown

The Proposed Rule provides that a Derivatives Dealer will be exempt from its provisions, except for sections relating to Fair Dealing, handling complaints, and compliance and record-keeping, in respect of a transaction on and subject to the rules of a derivatives trading facility (which is the CSA’s term for a Swap Execution Facility) if the Derivatives Dealer does not know the identity of the derivatives party prior to and at the time of execution of the transaction.

New Exemption from the Requirement to Designate a Senior Derivatives Manager

The CSA added a new exemption from the requirement to designate a senior derivatives manager. The exemption is available to certain Derivatives Dealers who only transact with EDPs and whose aggregate month-end outstanding gross notional amount of derivatives transactions (ANA) falls below a de minimis financial threshold in each of the previous 24 calendar months. The ANA threshold is C$250-million or, if the Derivatives Dealer and any affiliated Derivative Dealers qualify as Derivatives Dealers solely as a result of transactions in respect of commodity derivatives, C$3-billion. Transactions entered into by affiliates of the Derivatives Dealer are aggregated for the purpose of determining ANA, but non-Canadian Derivatives Firms may disregard transactions with non-Canadian counterparties when determining ANA.

Accommodation of Registered Advisers’ Existing Compliance Systems

The CSA also added a new exemption providing that a registered Derivatives Adviser will be exempt from specific provisions of the Proposed Rule corresponding to business conduct requirements applicable to the Derivatives Adviser under NI 31-103.

In addition, the previously proposed requirement that Derivatives Advisers designate an individual as a senior derivatives manager has been removed and will now only apply to Derivatives Dealers.

Delayed Implementation and Transition Period

The Proposed Rule will come into force one year after the publication date of the final rule. Furthermore, a grandfathering provision will permit Derivatives Dealers to rely on current counterparty classification and exemption categories in respect of certain transactions (Legacy Transactions) entered into before the effective date of the Proposed Rule. Specifically, the Proposed Rule will not apply to Legacy Transactions with permitted clients (as defined under NI 31-103) and Derivatives Parties for which dealer registration exemptions are currently available under the Derivatives Act (Quebec) or provincial blanket order exemptions. However, the Fair Dealing obligation would apply from the effective date of the Proposed Rule, which could presumably apply, for example, in respect of unwinds of Legacy Transactions. In addition, the CSA has added a five-year transition period to the Proposed Rule that will temporarily expand the definition of EDP. During the transition period, an EDP will include the current counterparty classifications discussed above and eligible contract participants (as defined under section 1(a)(18) of the United States Commodity Exchange Act).

New Regulatory Fees For Dealers Participating in Ontario’s Derivatives Markets

On January 21, 2022, the OSC published for comment proposed amendments to OSC Rule 13-502 Fees (Proposed Fee Amendments). Under the Proposed Fee Amendments, the OSC would impose annual participation fees on derivatives market participants. The proposed new fee is intended to recover the OSC’s costs of monitoring and regulating the derivatives market, which are projected to increase significantly to nearly C$13.5-million by 2023, or 9% of total projected OSC costs.

The new annual fee would be tiered based on the fee payer’s average outstanding notional during the relevant one-year fee period of all derivative transactions that are required to be reported to a designated trade repository under OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting (OSC Rule 91-507). However, no fee is payable (1) by a market participant if its average outstanding notional for the relevant one-year fee period is under C$3-billion, (2) by an entity that is not a reporting counterparty (as defined in OSC Rule 91-507) or (3) by a recognized or exempt clearing agency.

The proposed average notional amount tiers and annual participation fees are set out below:

Average Daily Notional Amount Outstanding During Derivatives Fee Year (in C$)

Participation Fee (in C$)

Under $3-billion

$0

$3-billion to under $7.5-billion

$3,000

$7.5-billion to under $15-billion

$7,500

$15-billion to under $50-billion

$15,000

$50-billion to under $100-billion

$50,000

$100-billion to under $300-billion

$100,000

$300-billion to under $500-billion

$200,000

$500-billion to under $1-trillion

$450,000

$1-trillion to under $4-trillion

$750,000

$4-trillion to under $10-trillion

$1.35-million

$10-trillion and over

$1.9-million

As part of the Proposed Fee Amendments, the OSC would reduce existing capital markets participation fees payable by a total of approximately C$3.1-million. Reporting issuers with a market capitalization under C$1-billion are expected to see participation fee reductions of 5% to 16%, and registered or exempt firms with revenues attributable to Ontario capital markets activities under C$100-million are expected to see participation fee reductions of 2% to 16%.

The OSC has also proposed to reduce certain other fees, including reducing filing fees for reports of exempt distributions on Form 45-106F1 from C$500 to C$350.

AMENDED MANDATORY CLEARING RULE

On January 27, 2022, the CSA announced amendments to National Instrument 94-101 – Mandatory Central Counterparty Clearing of Derivatives (NI 94-101), which will extend mandatory clearing obligations to certain affiliates of members of derivatives central counterparties with effect for transactions entered into on or after September 1, 2022. Currently, only participants of certain regulated derivatives clearing agencies (i.e., central counterparties) (Clearing Members) are subject to mandatory clearing obligations in respect of designated classes of derivatives (namely, certain interest rate swaps and rate forward agreements).

The amendments will result in affiliates of these Clearing Members also being subject to the same mandatory clearing obligations if the affiliate has been a party to derivatives with an aggregate notional amount exceeding the test set out in the amendments (i.e., in excess of C$1-billion average month-end gross notional over a three-month reference period). Imposing clearing obligations on such affiliates was contemplated in previous versions of NI 94-101, but this requirement has not been in force pending the release of these new amendments, which clarify that investment funds, special purpose vehicles, securitization pools and real estate investment vehicles that do not rely on guarantees from affiliates will not be considered to be affiliates of Clearing Members and, accordingly, will not be caught by the mandatory clearing requirements imposed on affiliates of Clearing Members.

Canadian large derivatives parties (i.e., a Canadian party to derivatives having in excess of C$1-billion average month-end gross notional over a three-month reference period which has, together with any Canadian affiliates, an aggregate of C$500-billion average month-end gross notional over the preceding 12-month period) will also be subject to mandatory clearing from September 1, 2023.

The amendments also clarify the scope of the inter-affiliate trade and multilateral portfolio compression exemptions from the mandatory clearing requirement.

CONTINUING DEVELOPMENTS IN CANADIAN DERIVATIVES MARKETS

The next two to three years should be interesting times in the development of derivatives regulations in Canada. In addition to the Proposed Rule, a new consultation draft of the Registration Rule may potentially be issued, and a draft Capital Markets Act published by the Ontario government in October 2021 is currently subject to stakeholder consultation.

Blakes periodically provides materials on our services and developments in the law to interested persons.This article is for informational purposes only and does not constitute legal advice or an opinion on any issue. Blakes would be pleased to provide additional details or advice about specific situations if desired. For permission to reprint articles, please contact the Blakes Marketing Department at 416-863-4345 and [email protected] © 2019 Blake, Cassels & Graydon LLP.

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