Categories of registration and business triggers under CSA's proposed derivatives registration regime
As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently published Consultation Paper 91-407 Derivatives: Registration, which contains regulatory proposals specific to the implementation of a registration regime for derivatives market participants in Canada. Under the Paper’s proposals, the imposition of “derivative-appropriate” registration requirements would be based on the type of activity conducted by derivative market participants regardless of the nature of the underlying asset.
The Committee developed the proposals in light of Canada’s G20 commitments to improve the regulation and oversight of OTC derivatives markets and with consideration of derivatives registration regimes in the U.S. and Europe. While the Committee also considered the existing securities regulatory framework, the proposed business triggers for derivatives registration and the requirements applicable to registrants would be substantially different than those applicable in the securities context, given the differences in the purpose of trading, the existence of risk-amplifying leverage in most categories of derivatives and the complexity of derivatives contracts.
Ultimately, the Paper discusses minimum requirements for each category of registration, namely those of (i) derivatives dealers; (ii) derivatives advisers; and (iii) large derivative participants.
Categories of registration
Persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business would be required to register as a derivatives dealer in each province and territory in which they conducted such business.
While the Ontario Securities Act contains a list of activities that are considered a “trade”, the Paper clarifies that certain activities such as the termination, material amendment, assignment, novation or disposition of a derivatives contract will also be considered a derivatives trade. Therefore, after inception, a derivatives trade will be considered to occur whenever there is a material change to the terms of the derivatives contract.
Further, a number of factors, largely derived from securities case law and regulatory decisions, would be considered when determining if a person is in the business of trading derivatives. The non-exhaustive list of factors that may suggest a business purpose or activity would include (i) the provision of services relating to the intermediation of trades between counterparties to derivative contracts; (ii) acting as a market maker by taking both a long and a short position in a derivative or category of derivatives; (iii) trading with the intention of being remunerated or compensated; (iv) contacting anyone to solicit derivatives trades; (v) providing clearing services to third parties; and (vi) engaging in activities similar to a derivatives dealer.
Under the factors provided, as with the analogous securities dealing registration requirements, dealing in derivatives does not have to be an entity’s primary business to be captured by the triggers proposed by the Committee.
Persons that carry on the business of advising others in relation to derivatives, or who hold themselves out to be in that business in any Canadian jurisdiction, would be required to register as a derivatives adviser. A person would be considered to be "advising" in relation to derivatives whenever they provide another person with any advice or direction relating to trading derivatives, including providing advice in relation to (i) the management of a portfolio of derivatives; (ii) the use of derivatives as an investment strategy or part of an investment strategy; and (iii) hedging strategies.
In determining whether a person was “in the business” of providing derivatives advice, a number of factors would be relevant, including whether the person was (i) directly or indirectly providing advice about derivatives trading activity with repetition, regularity or continuity; (ii) being, or expecting to be, remunerated or compensated; (iii) contacting anyone to solicit business relating to advising in derivatives trades; and (iv) engaging in activities similar to a derivatives adviser, including promoting a trading strategy or offering software that provided a client with guidance relating to the purchase of derivatives.
Large Derivatives Participant (LDPs)
According to the Paper, entities holding a “substantial position” in a derivative or category of derivatives, and whose exposure to derivatives markets results in counterparty exposure that could pose a serious risk to financial markets, should also be subject to registration. Registration under the LDP category would not be based on a business trigger. While the Paper does not provide one, the Committee recommended that consultation proceed to establish a threshold for this category of registrant.
The Committee also recommended that the new regime include the registration of individuals (i) where they are the ultimate designated person (such as the president or CEO), chief compliance officer or chief risk officer of a registrant; (ii) as a representative of a derivatives adviser where they provide clients with advice relating to derivatives, whether or not the client is a qualified party; and (iii) as a representative of a derivatives dealer where they provide services relating to trading to clients, whether or not the client is a qualified party.
Exemptions from requirement to register
The Paper proposes a number of exemptions from the registration requirement.
Dealers Providing Advice
A person registered as a derivatives dealer would be exempt from the obligation to register as a derivatives adviser where (i) the obligation to register as a derivatives adviser resulted solely from the provision of advice in relation to a derivatives trade; (ii) the advice was not in relation to an account over which that the derivatives dealer has discretionary trading authority; (iii) the derivatives dealer did not charge a fee for the provision of the advice; and (iv) the derivatives dealer had complied with all of the registration requirements applicable to a derivatives adviser.
The Paper proposes that government entities not be subject to an obligation to register. Further, crown corporations whose obligations were fully guaranteed by the applicable government would be exempted from registration as an LDP or as a derivatives dealer where their trading activity was restricted to trading as a counterparty with qualified persons. However, a crown corporation would not be exempt from a requirement to register where it (i) triggered registration as a derivatives adviser by advising entities that were not governments or crown corporations; (ii) triggered registration as a derivatives dealer and intermediated trades on behalf of clients that were not governments or crown corporations; or (iii) triggered registration as a derivatives dealer and trades with counterparties that were non-qualified parties.
The Paper recommends that recognized clearing agencies (or those exempt from recognition) not be subject to a requirement to register as a derivatives dealer, derivatives adviser or a LDP where the obligation to register resulted solely from carrying on the ordinary business of a clearing agency. (There is already or will be a separate registration regime for clearers.)
Transactions with Affiliated Entities
The Committee recommends that the registration requirements not apply to persons based on dealing or advising activities solely with affiliates.
Uniform definition of derivative across CSA jurisdictions is needed
The Paper does not define what would constitute a “derivative” for the purposes of registration and, at present, no single, harmonized definition of derivatives products exists across CSA members. Legislation in many Canadian jurisdictions contemplates that an instrument meeting the general definition of derivative may be treated as a derivative, a security, or excluded in whole or in part from regulation. Moreover, some jurisdictions include derivatives in the definition of security, while other jurisdictions maintain a separate definition altogether.
In CSA Consultation Paper 91-301 relating to reporting to trade repositories, the Committee introduced the “Scope Rule” to resolve conflicts that arise when a contract or instrument meets both the definition of "derivative" and "security" under applicable provincial legislation. The Scope Rule purports to classify which contracts or instruments are to be regulated as derivatives, securities or outside the scope of both derivatives and securities legislation altogether. In this respect, Consultation Paper 91-301 can provide some insight as to which types of instruments the Committee may recommend to be considered derivatives for the purposes of triggering registration as a derivatives dealer or adviser. In any event, the Committee will need to induce a high degree of regulatory coordination, both within Canada and between Canadian and global authorities, to ensure that a uniform and consistent definition is applied under the new registration regime. The CSA received a number of comments on certain issues with that definition in the context of the proposed trade reporting rule.
Absence of de minimus exemption
Unlike under Dodd-Frank, there is no proposed exemption for a person that engages in a de minimus level of swap transactions. The amount of business an entity engages in will be factored into the determination of whether the entity is carrying on business as a dealer.
Potential for compliance with two registration regimes
Persons dealing in or advising on derivatives that have securities as their underlying asset will be subject to registration under both the proposed derivatives regime and the existing securities regime. The Committee states that all types of derivatives should be subject to a consistent regime regardless of whether or not such derivatives have securities as their underlying asset. The Paper thus recommends that steps be taken in order to streamline the registration process to ensure that such persons can be registered and regulated in an efficient manner.
Investment funds to be regulated by the securities registration regime
According to the Committee, investment fund managers should continue to be registered under the securities registration regime regardless of the nature of the investment fund or the assets held by the fund. However, an advisor to a fund who triggers the obligations outlined above would be subject to the derivatives advisor registration requirements, in addition to the securities registration regime, if such an adviser provided advice in relation to both derivatives and securities.
Third party regulators to carry out regulatory functions
The Paper proposes that the CSA rely on third-party regulators to carry out some or all of the regulatory functions of the new registration regime. The Committee has stated that these regulators could include foreign regulators and regulators responsible for regulating financial institutions (i.e. OFSI) and self-regulatory organizations (i.e. IIROC).
Specifically, under the Consultation Paper, foreign derivatives dealers and advisers subject to an equivalent registration regime in their home jurisdiction could be exempted from certain registration requirements, such as with respect to financial and solvency obligations, compliance and risk management systems and entity-level record keeping. In such cases, however, registration in the applicable Canadian jurisdictions would still be required.
Although substituted compliance or equivalence may resolve conflicts and duplication, it may not be the most appropriate solution in every case. As the OTC Derivatives Regulator Group recently noted, close consultation by the CSA with the relevant authorities in other jurisdictions will be necessary to ensure the efficacy of substituted compliance. The details regarding how substituted compliance will work in practice is expected to be discussed in future meetings of international regulators.