The Proposed NI and CP set out a business conduct regime for OTC derivatives, and will apply to derivatives advisers and dealers regardless of registration status. This third publication addresses comments received on the rule, generally with respect to the potential negative impacts that would have resulted on derivatives market liquidity from the prior proposed requirements. The NI and CP are intended to, among other things, reduce systemic risk and improve transparency in the OTC derivatives markets while still meeting IOSCO’s international standards. It includes provisions relating to conflicts, know-your-derivatives-party, senior management duties and suitability. It will apply to a person or company that meets the definition of “derivatives adviser” or “derivatives dealer”, including federally regulated Canadian financial institutions, and a business trigger test (the same as for NI 31-103) will be used to determine which provisions of the NI will apply. Even if an entity is subject to the requirements (because they meet the business trigger and can not utilize one of the exemptions in the NI), certain eligible derivatives parties can waive certain of the requirements.
The changes from the prior iterations of the rule are intended to streamline the operationalization of the requirements (i.e. primarily to allow registered advisers to leverage their existing compliance infrastructure) and ensure that access to OTC products will not be unduly limited to customers in the Canadian OTC derivatives market. For example, a new foreign liquidity provider exemption will be available to foreign dealers when they transact with Canadian derivatives dealers (i.e. the inter-dealer market), and a new exemption will be available to foreign advisers, dealers and sub-advisers which are similar to the existing international exemptions in NI 31-103. In addition, IIROC dealer members will be exempted from certain requirements when they comply with IIROC requirements, and Canadian financial institutions will be exempt from certain provisions when they comply with the Bank Act or OFSI requirements. The proposed requirement to have a senior derivatives manager will now only apply to certain derivatives dealers with a specified notional amount of derivatives outstanding. The complaint handling provisions and tied selling provisions, on the other hand, have been extended to apply to all derivatives parties. A new transition period will allow certain derivatives firms to treat existing permitted clients, etc. as “eligible derivative parties” under the NI for up to five years, and there will be a delayed effective date of one year from the final publication of the NI. The CSA is seeking general comments, and responses to eight specific questions, including some related to the requirements to have a senior derivatives manager, the commercial hedger definition (as part of the eligible derivatives party definition), the treatment of registered securities advisers/commodity trading managers, and whether the new CFRs should be included in the NI.
Overview of the Council’s Comments:
The CAC supports many of the changes that have been made to the Proposed Instrument as we support the principles behind the business conduct proposals which include reducing systemic risk and meeting the International Organization of Securities Commissions’ statement of related principles and objectives.
Many of the provisions of the Proposed Instrument are improvements over the prior proposals and are responsive to comments and concerns raised by market participants. The focus on maintaining liquidity for the Canadian marketplace is quite important given the structure of OTC derivatives markets and the limited number of dealers and active counterparties in certain instrument types.
While the CAC does not have a strong view as to whether the $10 million financial threshold for qualifying as a commercial hedger is the appropriate quantum, the CAC is concerned that removing a financial threshold altogether may lead to potential negative externalities and incentivize problematic behaviour. Financial assets are not necessarily a proxy for financial sophistication, removing the financial threshold in the case of OTC derivatives may lead certain employees of dealers or intermediaries to erroneously help their clients conclude that they indeed have the requisite knowledge and experience to transact in OTC derivatives. Any derivative firm that has clients waiving their rights as commercial hedgers should be required to have rigorous supervision requirements with respect to those transactions and related client documentation, including evidence of client due diligence and any waivers.
Further, the CAC is not currently in support of the exemptions in section 31.1 from the senior derivatives manager requirements and we believe that presentation of additional information on the impetus for this change (including any cost-benefit analysis) and related research is required for the CAC to confirm that either of the proposed de minimis exemptions are appropriate in form and related quantum.
With respect to Registered advisers, they are already subject to a comprehensive registration and business conduct regime. The CAC is highly supportive of the ability for registered advisers to leverage their existing compliance infrastructure by complying with corresponding requirements in National Instrument 31-103 which allows for burden reduction. New requirements should only be imposed on registered advisers where a significant regulatory gap has been identified that is specific to derivatives, new conduct considerations, or new types of clients or counterparties.