The proposed federal Securities Act tabled by the federal government on May 26 establishes a framework for the regulation of exchange-traded and over-the-counter derivatives markets and their participants. Don’t expect to see a new regime too soon though. This legislation has not yet been introduced as a Bill but only laid before Parliament on a Ways and Means motion. The draft legislation has been referred to the Supreme Court of Canada to obtain a ruling as to whether it is within the legislative competence of the federal Parliament and will not be introduced until that question is resolved. Provinces are given the choice to opt into the federal scheme as well. Many provinces (not including Quebec and Alberta) have taken part in the process and would be expected to opt into the national scheme.
Even if not all provinces opt in, a relatively uniform approach across the provinces to the regulation of exchange-traded and OTC derivatives will be welcome, given the patchwork of inconsistent approaches that currently prevails. The substance of the regulatory regime will be in the relevant regulations, policies and exemptions. The proposed Act merely establishes the broad framework for regulation. Further details may be forthcoming when the Canadian Securities Transition Office (the CSTO) releases its detailed commentary in the next few weeks.
The proposed Act suggests that the regulators are sensitive to the differences between traditional securities and securities markets and derivatives and their markets.
The Act establishes categories of derivatives and deals with each category in a different way. The categories are “prescribed derivatives”, “exchange-traded derivatives”, and “designated derivatives”. Prescribed derivatives are treated like traditional securities. Exchange-traded and designated derivatives are subject to Part 7 of the Act, which deals specifically with derivatives. The definition of “derivative” is quite wide, but regulation largely depends on categorization in one of the three categories. Also, the regulators may make a designation under the Act that certain contracts or instruments are not derivatives. This effectively creates a fourth category of excluded derivatives (our term, not the Act’s). The definition is:
“derivative” means an option, swap, futures contract, forward contract or any other financial or commodity contract or instrument whose market price, value, or delivery, payment or settlement obligations are derived from, referenced to or based on an underlying interest including a value, price, rate, variable, index, event, probability or thing. It does not include a contract or instrument that is designated under subsection 237(1) [i.e. by the Chief Regulator] not to be a derivative or that is within a class of contracts or instruments that are designated by the regulations not to be derivatives.
Some features of note are:
The Act contemplates that there will be certain securities that have derivative features that it would be appropriate to classify and regulate as securities. Although the term “derivative” is widely defined in the Act, the definition of “security” includes only “a derivative that is within a prescribed class of derivatives”. We expect that prescribed derivatives would be the types of hybrid products that would under the existing provincial regimes be most like investment contracts. For example, notes with derivative features that are distributed through a dealer network to investors may be the type of derivative to be prescribed – one where the securities-like features predominate. For these types of derivatives, prospectus and registration requirements would apply.
We note also with respect to bank offered principal protected notes, that evidences of deposit of Canadian financial institutions and of authorized foreign banks in respect of their business in Canada are excluded from the definition of “security”, as they are under existing provincial legislation.
No one will be able to trade in an exchange-traded derivative in Canada unless the exchange is (a) a recognized exchange (i.e. those recognized to do business in Canada subject to Canadian regulatory oversight) or (b) an exchange that is accepted by the Chief Regulator (presumably those exchanges that do not do business in Canada and hence would not be subject to regulatory oversight, but where there are customers for those products in Canada). (s.89)
It is clear that prospectus requirements do not apply to exchange-traded derivatives (s.91). Other parts of the Act can be deemed (with necessary modification) to apply to them (s.92).
The category most participants in OTC derivatives markets will be interested in is the designated derivatives category.
Unless exempted, a prescribed form of risk disclosure statement will be required to be both filed and delivered to trade in a designated derivative. What types of derivatives fall within or outside this category will be determined by the regulator. We expect that there will be a large class of exempt transactions, along the lines of the exemptions that currently exist for contracts between qualified parties in various provinces, such as Quebec, Alberta and British Columbia. The types of transactions one might anticipate being subject to the prescribed risk disclosure requirement are FX transactions or CFD’s with retail investors.
It is clear that prospectus requirements do not apply to designated derivatives (s.91).
Further, the regulations can designate which parts of the Act that otherwise apply to securities (other than the prospectus requirements) will apply to designated derivatives or some sub-class of them (i.e. it would deem them to be securities for some purposes) (s.92). The regulations could presumably modify the requirements of the Act to be more appropriate for the type of derivatives in issue or the method of transacting. There is a clear attempt to build in maximum flexibility.
For example, trade reporting to a repository might be applied to derivatives even if they are exempt from disclosure requirements or participants are exempt from registration requirements.
Given the wide definition of “derivative” and the difficulty there will be in defining categories precisely, inevitably certain types of contracts and relationships that do not engage any securities or financial markets concerns will appear to be swept into the regime. In light of that there is a clear power to exclude defined categories from the application of the Act. An example of this might be commercial contracts for the delivery of commodities.
Regulation Making Power
The Authority (i.e. the new federal securities regulator) has wide regulation making powers, many of which relate to “derivatives” (s.227). Clearly the powers include establishing the categories referred to above of prescribed derivatives and designated derivatives as well as the exemptions from those categories. In addition, the Authority can prescribe requirements, conditions and standards of conduct to be met, and practices to be carried out, by, for example, exchanges, clearers and the persons that trade in different classes of derivatives with different classes of persons. It can prescribe requirements with respect to registration and prohibitions and restrictions applicable to persons that trade in different classes of derivatives with different classes of persons.
For example, this regulation-making power could extend to imposing trade reporting requirements or perhaps even mandatory clearing. There is a public comment process built into the legislation and regulations must be approved by the relevant Minister.
If this legislation is eventually enacted, the regulators will have a great deal of flexibility in terms of regulating derivatives or particular aspects of derivatives markets. The Act gives no indication of how derivatives will actually be regulated under this Act. We would anticipate that bi-lateral contracting of OTC derivatives between sophisticated parties will remain free of disclosure and registration requirements. We suspect many of the policy decisions remain to be made on many significant issues (such as clearing and trade reporting) and that they will not be made until more of an international consensus emerges.