Canadian Regulators Propose Broad Derivatives Dealer and Adviser Business Conduct Rules
April 24, 2017
On April 4, 2017, the Canadian Securities Administrators (CSA) published for comment Proposed National Instrument 93-101 – Derivatives: Business Conduct (Business Conduct Rule), which would impose a range of business conduct requirements on Canadian and foreign persons engaged in the business of trading in over-the-counter derivatives (derivatives) with Canadian clients (Derivatives Dealers) or advising Canadian clients in connection with transacting in derivatives (Derivatives Advisers) in any Canadian province or territory (jurisdictions).
Subject to exemptions that may be available to certain regulated financial institutions and market participants, the obligations in the Business Conduct Rule are proposed to apply to all Derivatives Dealers and Derivatives Advisers (Derivatives Firms) even if the Derivatives Firm is not required to register as a derivatives dealer or adviser in any jurisdiction. This approach is intended to ensure that all Derivatives Firms will be subject to certain minimum standards in relation to their business conduct towards their counterparties and clients. The CSA have also indicated that a separate proposed rule setting out the obligation to register as a derivatives dealer or adviser, together with related regulatory obligations and applicable exemptions, will be issued by the CSA this summer (Dealer and Adviser Registration Rule).
The Business Conduct Rule is intended to establish a robust investor protection regime that meets the international standards of the International Organization of Securities Commissions, reduces risk, improves transparency and accountability and promotes responsible business conduct in derivatives markets.
Subject to applicable exemptions, the Business Conduct Rule proposes one set of business conduct rules that will apply to Derivatives Firms when transacting with, or on behalf of, or advising any counterparty or client (Derivatives Party) and an additional set of rules that will apply to Derivatives Firms when dealing with Derivatives Parties that do not qualify as “eligible derivatives parties” (EDPs). Both sets of requirements are listed below.
Requirements Applicable to Derivatives Firms When Dealing With Any Derivatives Party
- Fair dealing obligations
- General Know-Your-Client requirements
- Segregation of Derivative Party assets
- Maintenance of compliance and risk management supervision and control systems
- Senior derivatives manager supervision and certification requirements
- Obligations to self-report to regulators material non-compliance with the Business Conduct Rule, securities laws or internal policies
- Conflict of interest management and disclosure obligations
- Documentation and record-keeping requirements
Requirements Applicable to Derivatives Firms When Dealing With Non-EDPs
- Specific Know-Your-Client requirements in respect of the Derivatives Party’s needs, objectives, financial circumstances and risk tolerance
- Product suitability obligations
- Permitted referral arrangements and related disclosure obligations
- Complaint handling requirements
- Obligation to provide fair and reasonable pricing to counterparties
- Obligation to establish procedures to obtain advantageous terms for clients when acting as agent
- Prohibition of coercive tied selling
- Disclosure obligations in respect of account terms, fees and charges, third-party compensation, relationship and conflict of interest matters, transaction risks, performance benchmarks and certain obligations imposed on the Derivatives Firm by the Business Conduct Rule
- Pre-trade disclosures regarding transaction terms, risks, pricing and the most recent valuation of the derivative
- Daily reporting of valuations of outstanding transactions and monthly account statement obligations
- Requirements in respect of the holding, use and investment of a Derivative Party’s assets
- Requirement to provide a standard statement regarding leverage and the use of borrowed money to finance derivatives transactions
- A Derivatives Firm not headquartered in Canada must provide Derivatives Parties with standard disclosure regarding difficulties in enforcing legal rights against the Derivatives Firm due to the location of its head office and must also identify agents for service of process in applicable Canadian jurisdiction
It is not yet clear whether the business conduct requirements under the Business Conduct Rule will only apply when the relevant Derivatives Party is headquartered, organized or registered in a Canadian jurisdiction in which the Derivatives Firm is engaging in derivatives business or if Canadian Derivatives Firms will be subject to these requirements on their worldwide derivatives activities.
Some of the more important business conduct requirements and the scope of applicable exemptions are discussed below. In all cases, reference should be made to the particular text of the Business Conduct Rule and the related companion policy since this bulletin only provides a summary and there are numerous details in the Business Conduct Rule that warrant closer scrutiny and comment.
DERIVATIVES DEALERS AND ADVISERS SUBJECT TO THE BUSINESS CONDUCT RULE
Obligations under the Business Conduct Rule only apply to market participants that are “engaging in the business of trading derivatives as principal or agent” or are “engaging in the business of advising others as to transacting in derivatives” in a jurisdiction. The proposed companion policy published with the Business Conduct Rule provides a non-exhaustive list of factors to be considered under the business trigger test, including whether an entity:
- Routinely quotes prices or acts as a market maker
- Regularly trades or advises in any way that produces, or is intended to produce, profits
- Facilitates or intermediates transactions (e.g., acting as a broker)
- Carries on derivatives transaction activity with the intention of being compensated
- Directly or indirectly contacts others to solicit derivatives transactions including using any means to offer transactions, participation in transactions or services related to transactions
- Engages in activities similar to a derivatives adviser or derivatives dealer
- Provides derivatives clearing services
The companion policy specifies that these factors do not all carry the same weight when considering if the business trigger test has been met, no one factor will be determinative, and an entity’s activities are to be considered holistically.
The test applies on a jurisdiction-by-jurisdiction basis to all derivatives activities carried on in the relevant jurisdiction. A foreign company that carries on dealing or advising as a business with Derivatives Parties in a jurisdiction will be subject to the Business Conduct Rule even if the foreign company does not have any place of business, staff or other presence in Canada.
The Business Conduct Rule also provides that any person required to register as a derivatives dealer or adviser in a jurisdiction will also be subject to the Business Conduct Rule, but it remains to be seen whether registration obligations will apply to any persons other than Derivatives Dealers and Derivatives Advisers as determined pursuant to the business trigger test discussed above.
SUBSTITUTED COMPLIANCE EXEMPTIONS
Canadian financial institutions (including Canadian banks, trust companies, insurance companies and credit unions) and Canadian securities dealers that are registered as investment dealers will be exempted from certain Derivatives Dealer requirements that are to be specified in appendixes to the Business Conduct Rule so long as the organization complies with corresponding requirements applicable to the organization, which are also to be specified in appendixes.
The relevant appendixes remain blank in the current consultation draft of the Business Conduct Rule and so we cannot yet determine how extensive these substituted compliance exemptions will be. The CSA have indicated that they intend to collaborate with the Bank of Canada, the Office of the Superintendent of Financial Institutions and the federal Department of Finance in connection with the development of this Business Conduct Rule. Consequently, substituted compliance for Canadian financial institutions may depend in part upon the introduction of new federal regulatory requirements that are analogous to particular requirements in the final Business Conduct Rule.
INTERNATIONAL DERIVATIVES DEALER AND ADVISER EXEMPTIONS
A Derivatives Dealer whose head office or principal place of business is outside of Canada, and that is authorized to, and engages in, the business of dealing in derivatives in a foreign jurisdiction listed in an appendix to the Business Conduct Rule (and in its home jurisdiction, if different), will be exempt from some of the business conduct requirements provided that it only solicits and transacts with counterparties in the relevant Canadian jurisdiction that are EDPs.
The specific business conduct requirements that will continue to apply to a Derivatives Dealer that benefits from this exemption are to be set out in an appendix to the Business Conduct Rule, which is currently blank.
This exemption is analogous to the international dealer exemption from securities dealer registration requirements that is provided to certain non-Canadian securities dealers and financial institutions. As with the international securities dealer exemption, in order to benefit from the international derivatives dealer exemption, a Derivatives Dealer must provide specified disclosures to its counterparties, file a submission to jurisdiction and appointment of agent for service with Canadian regulators, undertake to make books and records available to the Canadian regulators upon request, and satisfy annual notification and fee payment requirements.
The Business Conduct Rule also provides an international derivatives adviser exemption for Derivatives Advisers whose head office or principal place of business is outside of Canada and that are authorized to conduct the relevant derivatives advisory activities in a foreign jurisdiction listed in an appendix to the Business Conduct Rule if the only clients in the relevant Canadian jurisdiction are EDPs. The limitations and requirements applicable under this exemption are similar to those applicable under the international derivatives dealer exemption, and this international derivatives adviser exemption is analogous to the international securities adviser exemption available to foreign securities advisers.
It is expected that the CSA will also consider providing an international derivatives dealer exemption and international derivatives adviser exemption under the Dealer and Adviser Registration Rule.
The Business Conduct Rule as currently drafted provides that a Derivatives Dealer may not rely on the international derivatives dealer exemption in a Canadian jurisdiction if it is in the business of trading in derivatives on an exchange or a derivatives trading facility designated or recognized in such Canadian jurisdiction. It is unclear if this restriction should apply where the relevant exchange or trading facility is located outside of Canada.
Derivatives “end-users” would typically not be considered to be Derivatives Dealers or Derivatives Advisers and consequently would not be subject to the Business Conduct Rule. However, a specific end-user exemption is provided, which exempts the end-user from all requirements of the Business Conduct Rule. This could provide greater comfort to some end-users, including those that regularly engage in proprietary derivatives trading and are thereby caught by the second business trigger factor set out in the companion policy, as mentioned above.
In order to qualify for the end-user exemption, a person may not:
- Solicit, or otherwise transact in a derivative with, for, or on behalf of, a person that is not an EDP
- Advise non-EDPs in respect of derivatives transactions other than by providing general advice in accordance with certain specified requirements
- Regularly quote prices at which they would be willing to transact in a derivative or otherwise make, or offer to make, a market in a derivative
- Regularly facilitate or otherwise intermediate transactions in derivatives for another person
- Facilitate the clearing of derivative transactions for any non-affiliated person
The end-user exemption will not be available to any person that is registered under securities laws in any Canadian jurisdiction or to any non-Canadian person that is registered in its home jurisdiction to carry on business as a derivatives dealer or adviser.
ELIGIBLE DERIVATIVES PARTIES
As outlined above, the business conduct requirements are divided into two tiers. The first tier of requirements applies to a Derivatives Firm’s activities with all classes of Derivatives Parties. The second tier of requirements applies when transacting with, or on behalf of, or advising, Derivatives Parties that are not EDPs.
The proposed classes of EDPs include Canadian financial institutions, derivatives dealers and advisers registered in any Canadian jurisdiction, securities investment dealers and securities advisers registered in any Canadian jurisdiction, foreign entities analogous to such types of entities and regulated pension funds.
Additionally, companies with net assets of at least C$25-million as shown on their current financial statements qualify as EDPs if they give certain specified representations concerning their sophistication and the suitability of proposed derivatives transactions.
Individuals that own financial assets with a net value of at least C$5-million also qualify as EDPs if they give such sophistication and suitability representations. However, Derivatives Firms are also required each year to obtain waivers of protections from individuals that are EDPs in order to avoid the application of the second tier of business conduct requirements.
KEY REQUIREMENTS WHEN DEALING WITH ALL DERIVATIVES PARTIES (EDPs AND NON-EDPs)
Fair dealing obligations: Derivatives Firms will be required to deal fairly, honestly and in good faith with all Derivatives Parties. The companion policy sets out the view that this obligation is context-specific and will be applied differently based on the level of counterparty sophistication.
General Know-Your-Client requirements: Derivatives Firms will be required to establish a Derivative Party’s identity, including the nature of its business and the identity of any individual that owns more than 25 per cent of its voting shares or, if the Derivatives Party is a partnership or trust, exercises control over the Derivatives Party’s affairs. Furthermore, if there is cause for concern, the Derivatives Firm must make reasonable inquiries as to the reputation of the Derivatives Party. Finally, if a Derivatives Firm will have any credit risk in relation to the Derivatives Party, it must also establish the Derivatives Party’s creditworthiness.
Segregation of Derivative Party assets: Any asset “received or held by a Derivatives Firm, for or on behalf of a Derivatives Party” (Derivatives Party Assets) must be segregated (i.e., separately held or separately accounted for) from the positions and property of the Derivatives Firm and of other persons.
Senior derivatives manager supervision and certification requirements: Each individual responsible for directing the activities of a derivatives business unit within a Derivatives Firm is required to supervise and promote compliance with the Business Conduct Rule, applicable securities laws and the Derivative Firm’s related compliance and risk policies and procedures mandated by the Business Conduct Rule. Each such senior derivatives manager must also certify annually to the Derivative Firm’s board that the business unit is in material compliance with the Business Conduct Rule and such laws and policies, or identify all cases of material non-compliance.
Obligations to self-report to regulators material non-compliance with the Business Conduct Rule, securities laws or internal policies: Where a Derivatives Firm is advised by its senior derivatives manager of material non-compliance with the Business Conduct Rule, applicable securities law or related internal policies and procedures, the Derivatives Firm must address the non-compliance, document its response and make a timely report to the regulator.
KEY REQUIREMENTS WHEN DEALING WITH NON-EDPs
Specific Know-Your-Client requirements in respect of the Derivatives Party’s needs, objectives, financial circumstances and risk tolerance, and product suitability obligations: Before transacting with a non-EDP, a Derivatives Firm must reasonably ensure the suitability of the derivative, including by obtaining information concerning the Derivatives Party’s needs and objectives, financial circumstances and risk tolerance.
Complaint handling requirements: Derivatives Firms will be required to follow an effective complaint handling policy, which allows them to document and respond to complaints in a fair and timely manner.
Obligation to provide fair and reasonable pricing to counterparties: When transacting with a non-EDP, a Derivatives Dealer must make a reasonable effort to provide a price that is fair and reasonable, taking into consideration all factors relevant to the transaction.
Use and investment of a Derivative Party’s assets: Derivatives Party Assets may only be used to secure, settle or guarantee the Derivatives Party’s obligations and to secure the credit of the Derivatives Party, and generally no other liens are permitted in Derivatives Party Assets. Furthermore, a Derivatives Firm may not invest Derivatives Party Assets except in certain permitted investments and overnight repo transactions where the Derivatives Firm bears the risk of loss. Further clarification will be required to determine how these restrictions align with standard market practices in respect of holding and rehypothecation of collateral.
Prohibition of coercive tied selling: A Derivatives Firm cannot pressure or coerce a non-EDP to obtain a product or service from any particular party as a condition of obtaining a product or service from the Derivatives Firm. Written disclosure of this prohibition must also be given to all non-EDP Derivatives Parties.
Pre-trade disclosures regarding transaction terms, risks, pricing and the most recent valuation of the derivative: Before transacting in a type of derivative with a non-EDP for the first time, a Derivatives Dealer must provide written disclosure describing the derivative’s material characteristics and risks. Furthermore, for each individual transaction, a Derivatives Dealer must notify the Derivatives Party of the derivative’s price and most recent valuation.
The CSA have provided an extended 150-day comment period for the Business Conduct Rule in order to allow market participants to consider at the same time the forthcoming proposed Dealer and Adviser Registration Rule. The comment period for the Business Conduct Rule closes on September 1, 2017.
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