Canadian securities regulators advance derivatives “business conduct” rules

The Canadian Securities Administrators (CSA) are one step closer towards modernizing Canada’s regulatory oversight of over-the-counter (OTC) derivatives. On September 28, 2022, the CSA hosted a roundtable with industry participants and securities regulators from Canada, the United Kingdom, and the United States. At the roundtable, the CSA gave new insights about the implementation of its third draft of the proposed National Instrument 93-101 Derivatives: Business Conduct Rule (the Proposed Instrument) and its proposed Companion Policy 93-101 Derivatives: Business Conduct (the Proposed Companion Policy).  

On January 20, 2022, the CSA published its third draft of the Proposed Instrument and the Proposed Companion Policy. The Proposed Instrument was initially introduced in 2017, but has undergone two consultation periods.

OTC derivatives are not subject to the same regulatory oversight as other financial instruments. The CSA has stated that the purpose of the Proposed Instrument is to protect participants of the OTC derivatives market by reducing systemic risk, improving transparency, increasing accountability and promoting responsible business conduct in the OTC derivatives market. The Proposed Instrument will enable Canada to fulfill its G20 commitments to regulate the OTC derivatives market. Additionally, the Proposed Instrument will ensure that Canada’s OTC derivatives market is consistent with the standards established by the International Organization of Securities Commissions (an association of organizations that regulate the world’s securities and futures markets).

Proposed obligations for derivatives firms

The Proposed Instrument introduces obligations on “derivatives advisers” and “derivatives dealers” (collectively referred to as derivatives firms) with respect to their dealings with derivatives parties (clients and or any third party).

A derivatives dealer is defined as any person or entity engaging in the “business of trading derivatives as principal or agent.” A derivatives adviser is any person or entity in the “business of advising others as to transacting in derivatives.” The Proposed Companion Policy establishes a list of non-exhaustive factors that can be used to determine if a person or entity is a derivatives firm, such as:

• routinely standing ready to transact derivatives by responding to requests for quotes on derivatives;
• providing services related to the facilitation of trading or intermediation of transactions between third-party counterparties to derivatives contracts;
• providing derivatives clearing services that allow third parties to clear derivatives through a clearing agency; or
• directly or indirectly soliciting in relation to derivatives transactions.

The obligations imposed by the Proposed Instrument are similar to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). Like NI 31-103, the Proposed Instrument imposes obligations through a two-tiered approach.

At the first tier, certain obligations apply in all cases when a derivatives firm is dealing with or advising a derivatives party, regardless of the level of sophistication or financial resources of the derivatives party. These include:

• an obligation of fair dealing, honesty and good faith when dealing with derivatives parties;
• an obligation to identify and disclose conflicts of interest;
• an obligation to collect from derivatives parties information necessary to comply with federal anti-money laundering and terrorist financing regulations;
• an obligation to provide derivatives parties with on-going reports;
• an obligation to respond to formal and informal complaints;
• an obligation to maintain records of communications and transactions with derivatives parties; and
• an obligation to avoid pressuring clients from purchasing a derivatives product.

At the second tier, additional obligations apply when a derivatives firm is dealing with a “non-eligible derivative party” (NEDP) or an “eligible derivatives party” (EDP). EDP refers to sophisticated derivatives parties that do not require the full set of protections afforded to retail customers and investors. A NEDP is a derivatives party that does not fall under the definition of EDP. According to the most recent draft of the Proposed Instrument, the following are considered to be EDPs:

• Canadian financial institutions;
• regulated pension funds;
• securities dealers and derivatives firms registered in Canada or any foreign jurisdiction;
• corporations with net assets of $25 million or greater;
• individuals with net assets of $5 million or greater; and
• investment funds registered in any jurisdiction.

The additional obligations that apply when the derivatives firm is dealing with a NEDP or EDP include:

• an obligation to obtain specific information related to the derivatives party’s objectives, financial situation and risk tolerance;
• an obligation to take reasonable steps to ensure that the recommended derivatives and transaction are suitable for the derivatives party;
• an obligation not to participate in a referral arrangement in respect to derivatives; and
• an obligation to provide disclosures prior to and after a trade of derivatives is made.

It is important to note that an EDP can waive the additional obligations imposed, if the EDP is an individual or a “commercial hedger”. A commercial hedger is a derivatives firm, which confirms in writing, that it has the requisite knowledge and experience to evaluate the information provided to it about derivatives.

CSA’s September roundtable

The roundtable featured two panels: an industry panel and a regulatory panel. During the industry panel, panelists (representing TD Bank, the National Bank of Canada, the Portfolio Management Association of Canada, and the Ontario Teachers’ Pension Plan) summarized their overall support of the third draft of the Proposed Instrument. The panelists highlighted that the Proposed Instrument appropriately balanced the need for regulatory protection without being too burdensome on market participants. The panelists also noted that the Proposed Instrument avoids duplicative and additional barriers for foreign traders of OTC derivatives. This is an important feature because Canada represents a small portion of the global OTC market (Canada accounts for four percent of the global OTC derivatives market). Consequently, the Proposed Instrument will not discourage foreign traders from engaging with Canada’s OTC derivatives market.

During the question and answer session, the CSA indicated that the target publication date of a final draft of the Proposed Instrument will be in the Winter or Spring of 2023. Furthermore, CSA stated that once the Proposed Instrument is adopted, it will be included in the CSA’s annual report. The annual report offers guidance on how the CSA interpret securities laws and requirements, like the business conduct rule.

The foregoing is a general summary of the obligations that will likely be finalized under the Proposed Instrument. Participants of the OTC derivatives market should review their compliance with these requirements. If you have any specific questions on how to navigate these requirements, we invite you to ‎‎contact a member of our team.

This article provides only general information about legal issues and developments, and is not intended to provide specific legal advice. Please see our disclaimer for more details.