Closer to a national derivatives business conduct regime

The Canadian Securities Administrators (CSA) are one step closer to establishing a national business conduct regime for persons who deal in or advise on over-the-counter (OTC) derivatives. On January 20, 2022, the CSA published proposed National Instrument 93-101 Derivatives: Business Conduct (the Proposed Instrument) and its companion policy (CP). In many Canadian jurisdictions OTC dealers and advisers are currently regulated by assorted blanket rulings. A national conduct regime was initially proposed in 2017 and the Proposed Instrument follows two prior consultations published since 2017. It is anticipated it will come into force with a proposed new registration rule, proposed National Instrument 93-102 Derivatives: Registration (the Registration Instrument). The latest version of the Registration Instrument was published in April 2018 and our legal update is available here. 

This update provides a brief overview of the Proposed Instrument and highlights the principal changes since the prior proposal.

Overview of the regime

The Proposed Instrument, if adopted, will establish a robust national code of conduct that not only meets the International Organization of Securities Commissions (IOSCO) standards, but is also consistent with the regulatory approach taken by most IOSCO jurisdictions with active OTC derivatives markets. The Proposed Instrument and Registration Instrument are designed to:

• reduce risks to market participants and protect investors;
• ensure key staff members of derivatives dealers and derivative advisers have the necessary education, training and experience needed to carry out their obligations and discharge such obligations properly;
• allow derivative firms and individual representatives to register with applicable securities regulators in Canada and allow those regulators to deny registration in appropriate circumstances; and
• improve transparency and accountability.

Conduct Addressed

The Proposed Instrument regulates the following conduct of OTC derivatives market participants:

• fair dealing;
• conflicts;
• know your derivative party (KYDP) and suitability;
• pre-transaction disclosure;
• reporting and compliance;
• senior management duties;
• record keeping; and
• treatment of derivatives party assets.

The obligations of a dealer or adviser imposed by the Proposed Instrument will depend upon the counterparty that the dealer or adviser is engaged with. The requirements are similar to the requirements for securities dealers and advisers but are tailored to the OTC market. Investor protection is based on a two-tiered approach depending upon the other party to the derivative transaction:

• certain obligations will be applicable to dealing with or advising any derivatives party; 
• additional obligations will apply when dealing with or advising:
  • a non-eligible derivatives party (a non-EDP); or
  • an eligible derivatives party (an EDP) that is an individual or commercial hedger where the protections available to non-EDPs have not been waived. These obligations include additional KYDP and suitability requirements, permitted referral arrangements, additional disclosure obligations (including pre-trade disclosure, daily (dealers) and monthly (advisers) valuation reporting and information regarding the holding, use and investments of initial margin accounts.

EDPs include Canadian financial institutions, pension funds, securities and derivatives dealers and advisers registered in any jurisdiction, corporations with net assets of $25 million or more, commercial hedgers and individuals with net assets of $5 million or more. Both specified commercial hedgers and individuals must make certain representations regarding their knowledge and experience.

Application

The Proposed Instrument applies to a “derivatives dealer” or “derivatives adviser,” which is defined as persons in the business of dealing or advising or holding themselves out as being in the business of dealing or advising in OTC derivatives regardless of whether they are required to be registered or exempt from registration under the Registration Instrument. For example, certain Proposed Instrument requirements apply to federally regulated financial institutions regardless of the availability of an exemption from registration. The CP sets out factors to be considered in determining whether there is an obligation to comply with the code. The Proposed Instrument also contains a number of exemptions.

Changes to prior proposal

The changes introduced in the Proposed Instrument focus mainly on preserving access to the derivatives market, market liquidity and the ability of market participants to comply within an existing compliance system. The following are key changes to the previous version of the Proposed Instrument:

• Foreign liquidity provider exemption. An exemption from the Proposed Instrument has been introduced for “foreign liquidity providers” where they transact with derivatives dealers in Canada. The purpose of the exemption is to preserve and facilitate liquidity in the inter-dealer market. There are no filings or other compliance requirements to rely upon the exemption. The new exemption supplements the general foreign dealer exemption for transactions by a foreign dealer with an EDP introduced by the Prior Proposal and contains conditions of reliance;
• Streamlining of foreign dealer and adviser exemptions. These exemptions have been amended to make them similar to the international dealer and adviser exemptions in the general registration regime. The exemptions apply when foreign dealers and advisers are dealing with or advising an EDP. The exemption will be subject to the dealer or adviser being located in a prescribed jurisdiction considered to have a comparable regulatory regime and being in compliance with the requirements of that jurisdiction. The prescribed countries are the US, Brazil, any member of the EU, the UK, Switzerland, the Republic of Korea, Hong Kong, Japan, Australia, New Zealand, and Singapore;
• New exemption for international derivatives sub-advisers. This exemption will allow a foreign derivative sub-adviser to provide advice to registrants without compliance;
• New exemption for IIROC members and Canadian financial institutions. An expanded exemption from certain requirements of the Proposed Instrument for IIROC registered members and Canadian financial institutions who comply with the equivalent requirements contained in IIROC rules, the Bank Act or OSFI, as applicable, has been introduced;
• Revised definition of an EDP. The EDP definition has been amended by removing the $10 million financial threshold for non-individual commercial hedgers that was included in the prior proposal. An EDP is generally considered a derivative party who does not require the protections of a retail investor or customer due to their sophistication or have sufficient resources for professional advice or are capable of protecting themselves by contractual negotiations;
• Transition for existing clients. The Proposed Instrument also provides a transition period that will allow existing permitted clients, accredited counterparties, qualified parties, and eligible contract participants under CFTC rules to be considered as EDPs for up to five years;
• Complaints. The complaints handling and tied selling requirements have been extended to dealings with all derivatives parties as opposed to non-EDPs or individual EDPs and eligible and commercial hedgers as set out in the prior proposal;
• Short-term foreign wholesale FX contracts in the institutional FX market. Some of the regime’s provisions will now apply to derivatives dealers that are Canadian financial institutions with significant activity in short-term wholesale foreign exchange contracts; and
• Limited notional amount of derivatives. The limited notional amount of derivatives for derivatives dealers for the purpose of certain compliance exemptions has been amended to propose an amount of $3 billion for commodity derivatives and $250 million for all other OTC derivatives. This is subject to further analysis and discussion about thresholds and the definition and methodology for determining the dealer’s “notional amount.”

Next steps

The CSA requested comments on the above changes, among others, by March 21, 2022. The CSA has indicated the Proposed Instrument will come into effect one year after the instrument is finalized. We currently anticipate the Proposed Instrument will not be effective until late 2023. A copy of the current proposal is available here.