In February, the Canadian Securities Administrators (CSA) published a revision to National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (proposed clearing rule) for a 90-day comment period.

In February, the Canadian Securities Administrators (CSA) published a revision to National Instrument 94-101 Mandatory Central Counterparty Clearing of Derivatives (proposed clearing rule) for a 90-day comment period.  This proposed clearing rule sets out when certain over-the counter (OTC) derivatives are required to be cleared through a recognized or exempt clearing agency (RCA). Interest Rate Derivatives (IRD) subject to mandatory clearing under this rule will be required to be cleared as soon as practical but no later than end-of-day. 

The revision scales back the clearing obligation

The revision decouples the rule from the derivative registration requirement[1] that is still under consideration by the CSA and narrows the classes of counterparties for which clearing will be required by introducing a clearing threshold. Under the proposed new rules, any entity that subscribes to clearing services of a regulated clearing agency and any affiliate to such a member will be required to clear derivative transactions that are mandated to be cleared. In addition, a local counterparty[2], with a gross notional amount of outstanding derivatives of C$500 billion as of the effective date of the rule must clear their derivative transactions. This is a similar approach to Australia where a clearing threshold of $A100 billion (gross notional outstanding positions) has been introduced and in Singapore where entities with in excess of $S20 billion worth of derivative contracts, on a gross notional outstanding basis must mandatory clear.[3]

A local counterparty determines if it exceeds the clearing threshold by calculating the notional amount of all outstanding derivatives which were entered into by itself and those of its affiliated entities that are also local counterparties. If a local counterparty exceeds the threshold, they must clear all subsequent transactions.

Take note of changes to the clearing exemptions

The revision includes two exemptions: an exemption for intragroup transactions and another exemption for transactions that are part of a multilateral portfolio compression exercise.

For the intragroup exemption to apply, the two affiliated counterparties must prepare their financial statements on a consolidated basis in accordance with specified accounting standards or the two affiliates entering into the derivative transaction must be prudentially supervised on a consolidated basis and entities are able to demonstrate that there is an adequate centralized risk function in place to monitor and manage risks. A written agreement between the counterparties setting out the terms of the transaction must also be in place.

The portfolio compression exemption was not in the initial clearing rule however; Australia has a similar exemption in its clearing rules.[4] This exemption applies when several counterparties enter into a multilateral portfolio compression exercise that changes or terminates or replaces prior un-cleared transactions that were not mandatory clearable derivatives when they were initially entered into. The resulting transaction must meet the following conditions:

• the resulting transaction is entered into as a result of more than two counterparties changing or terminating and replacing prior transactions;
• none of the prior transactions were entered into after the date on which the derivative or class of derivatives became a Mandatory Clearable Derivative;
• the prior transactions were not cleared by a Regulated Clearing Agency;
• the resulting transaction is entered into by the same counterparties as the prior transactions;
• the multilateral portfolio compression exercise is conducted by a third-party provider

To rely on either of these exemptions, the local counterparty must keep adequate records to demonstrate they have met the requirements of the exemption and must file the appropriate exemption form with the regulator(s) within 30 days after the local counterparty relies on the exemption. (in the case of intragroup exemption – Form 94-101FI)

To clear or not to clear – mandatory clearing of Canadian IRD is still uncertain

Within in the rule proposal there is a list of OTC derivatives that qualify and are subject to mandatory clearing (See Appendix A).[5] The list includes a variety of single-currency interest rate swaps (IRS) and forward rate agreements mainly denominated in USD, EUR and GBP.  Although the proposed list includes Canadian (CAD) interest rate swaps, the CSA recognizes in its comments that its mindful that no other jurisdiction requires CAD swaps to be cleared and is currently seeking comments from market participants. Of note, Australia is requiring AUD swaps to be subject to clearing when the rules come into effect (April 2016) and Singapore proposed in its July consolation that SGD swaps are cleared.[6]

A few more steps to go

The proposed rule takes Canada closer to fulfilling the market reforms agreed by the G-20 and demonstrates increased harmonization with international practices. It is more aligned with other market centres of a similar size and it introduces a clearing threshold which scales back the clearing requirement and simplifies the determination process for derivative participants. However, there are a few more steps before mandatory central clearing of derivative transactions will begin. The comment period closes on May 24^th 2016 after which the CSA must consider comments and answers to specific questions posed in the consultation paper. Once an effective date is determined, entities wishing to supply clearing services must complete Form 94-101F2 Derivatives Clearing Services, identifying all derivatives or classes of derivatives for which it will provide clearing services. Once the rule is in effect, regulated clearing agencies will be required to disclose on a public website all derivative products that it clears and identify which products are subject to mandatory clearing.   

How Should a Local Counterparty Prepare

Derivative participants (or local counterparties) should take some time to evaluate whether they might meet the clearing threshold and consider the products that are proposed to be subject to the clearing obligation in Annex A of the rule to determine if the rules will impact their operating model. If it is determined the rules will apply, the local counterparty should engage with a regulatory clearing agency(s) (RCAs).  Factors to consider when selecting a RCA are the credit rating of the firm, their clearing offering and associated costs. Negotiating a clearing agreement will take some time, so start early. In tandem, firms should review their operating model to determine if they have adequate systems in place to capture and confirm transactions, address margin requirements and manage collateral. It is important to review the entire business workflow to ensure the data can flow across front to back office processes and down to accounting and client reporting systems.

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This information is intended for information purposes and does not constitute legal advice. The proposed consultation can be found on the OSC website: http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20150224_94-101_roc-derivatives.htm

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[1] Proposed derivative registration 91-407

[2]  “local counterparty” in a Canadian jurisdiction, meaning that it: i) is organized under the laws of the jurisdiction; ii) has its head office or principal place of business in the jurisdiction; or iii) is an affiliate of a person or company that is organized under the laws of the jurisdiction and such person or company is responsible for all or substantially all of the liabilities of the counterparty;

[3] Rule is still in proposal – Consultation Paper, July 2015. Draft Regulation for Mandatory Clearing of Derivative Contracts

[4] ASIC Derivative Transaction Rules (Clearing) 2015

[5] In Quebec, mandatory clearable derivatives will be determined by the AMF

[6] MAS seeks comments in its July 2015 consultation. Draft Regulation for Mandatory Clearing of Derivative Contracts