Trade local, clear global: Bank of Canada elaborates on Canadian authorities' decision to allow OTC derivatives clearing through global central counterparties 

publication 

February 2013

Derivatives Bulletin

On October 1, 2012, Canadian authorities1 released a notice (the "Notice") permitting the use of any recognized central counterparty ("CCP"), including global CCPs, by Canadian market participants in connection with mandatory CCP clearing of over-the-counter ("OTC") derivatives in Canada.2 According to the Notice, global CCPs could be utilized by Canadian OTC derivatives users if such global CCPs met certain safeguards; however, the Notice provided few details about these safeguards.

In the December 2012 issue of the Financial System Review, the Bank of Canada published an article titled The Canadian Approach to Central Clearing for Over-the-Counter Derivatives (the "Canadian Approach") which provided more insight into the Notice, and included clarification of the required safeguards for global CCPs.3 Both the Notice and the Canadian Approach build on Consultation Paper 91-406 – Derivatives: OTC Central Counterparty Clearing published by the Canadian Securities Administrators Derivatives Committee (the "CSA Committee") in June 2012, which, as part of Canada's G-20 commitment to OTC derivatives reform, proposed requirements for mandatory CCP clearing of OTC derivatives transactions, but did not specifically recommend the use of local or global CCPs.4

While the Notice did not elucidate the reasoning behind Canadian authorities' recommendations regarding global and local CCPs, the Canadian Approach clarifies their decision-making process. In the Canadian Approach, the authors first discuss the challenges of using either local CCPs or global CCPs in Canada's financial market. They describe the framework within which Canadian authorities analyzed the two approaches. Lastly, they discuss the safeguards that are being put in place for global clearing. The authors conclude that while local clearing may be the simplest solution for oversight, the global approach is more efficient and robust.

(1)    global versus local CCPs

The primary difference between global and local CCPs is that while global CCPs provide clearing in multiple jurisdictions and currencies, local CCPs are situated in a single jurisdiction and likely clear trades only in the local currency. OTC derivatives markets are international – they span multiple jurisdictions and currencies. Therefore, the local CCP approach would still require some trades to be cleared by a global CCP.

(2)    proposed framework for choosing between the two approaches

Canadian authorities analyzed the two clearing approaches by looking at their effects on the stability, efficiency, and development of the Canadian markets. First, they examined financial stability by analyzing:

  1. the capacity of Canadian authorities to oversee the CCPs' activities during the normal course of business and to intervene to mitigate shocks during a crisis, if necessary; and

  2. how the structure of both the CCP and the cleared market affect the CCP's ability to mitigate financial shocks.

While Canadian authorities would be better able to oversee and regulate local CCPs than global CCPs, such oversight would be limited to locally cleared trades. The more complex oversight of global CCPs would require a "co-operative oversight framework", wherein the CCP's primary regulator would work directly with regulators in other jurisdictions. Global CCPs are generally considered better able to respond to member default due to their large membership and are likely able to absorb more losses than local CCPs. On the other hand, those participating in global CCPs feel the shock of members from other jurisdictions defaulting. Nevertheless, those participating in local CCPs would not be completely shielded from the effect of member defaults in other jurisdictions, since either they would also be clearing in global CCPs or global participants would be clearing in the local CCP.

Second, Canadian authorities examined efficiency. Clearing in local CCPs would be less efficient than in global CCPs, since those clearing in local CCPs would likely also have to utilize global CCPs, resulting in higher costs because (i) members of local CCPs would have to pay membership fees of both local and global CCPs, (ii) more collateral would be required and members would have to contribute to the default funds of both local and global CCPs, and (iii) regulatory costs would rise.

Third, Canadian authorities examined the development of the Canadian market in the context of both the global and local CCP approaches. This analysis did not favour either approach to clearing with one reason being that while building local CCPs could stimulate local development and expertise, any such benefits would need to be weighed against the aforementioned costs.

(3)    safeguards for global clearing

Canadian authorities have been collaborating with international bodies, including the Financial Stability Board, to establish safeguards for global clearing that would protect the stability of local markets. The safeguards address four concerns: (i) fair and open access; (ii) oversight and regulation; (iii) recovery and resolution; and (iv) access to emergency liquidity.

First, access should be provided on transparent and objective criteria. Second, participating authorities should be allowed to actively take part in the oversight of global CCPs, such as the aforementioned "cooperative oversight arrangement". Third, all jurisdictions in which systemically important CCPs are located should have recovery and resolution regimes and should provide assurance that the regimes will take into account the interests of all relevant jurisdictions. Lastly, CCPs must have access to adequate liquidity to withstand a default by any member. In the event that a private sector liquidity arrangement is insufficient, the central bank of the CCP's home country may want to exchange collateral of a solvent CCP for emergency liquidity. Any technical obstacles to central banks providing such emergency liquidity in all relevant currencies are being removed at the international level.

The safeguards are already being put in place at global CCPs operating in Canada, including SwapClear. SwapClear has revised its access rules to match the Principles for Financial Market Infrastructures5 (the "CPSS-IOSCO Principles") and the access safeguard. SwapClear's primary regulator, the U.K. Financial Services Authority, has established a bilateral and multilateral cooperation and information-sharing network, which includes the Bank of Canada. Further, Canadian regulators participate in an information sharing process which involves bilateral memoranda of understanding. Many jurisdictions, including the U.K., are committed to establishing recovery and resolution regimes for global CCPs. Canadian and U.K. regulators will require SwapClear to meet the liquidity requirements of the CPSS-IOSCO Principles.

The detailed description of these four safeguards in the Canadian Approach is helpful for global CCPs in understanding future industry standards and regulations. Such detailed criteria will also be helpful for Canadian OTC derivatives market participants in deciding which global CCP to join.

next steps

Some Canadian OTC derivatives market participants have been advocating for a local approach to CCPs. The authors of the Canadian Approach, in recommending the global approach to CCPs, conclude that global CCPs promote liquidity and efficiency in the global OTC derivatives market, which helps make them more robust to financial shocks and allows derivatives users to appropriately manage their risk. Canadian authorities, however, have recommended the use of any CCP recognized in Canada, including global CCPs.

Canadian authorities are continuing to work towards implementing Canada's OTC derivatives reform. The Office of the Superintendent of Financial Institutions ("OSFI") published an update on January 24, 2013, with respect to its progress in implementing reforms in the Canadian OTC derivatives market. OSFI states that it will publish an updated Derivatives Best Practices Guideline (B-7) in 2013. Further, the CSA Committee is expected to publish the last two consultation papers on Canada's OTC derivatives reform in early 2013.6 We will continue to monitor all developments and are available to answer any questions or concerns about recent proposals.

by Shahen A. Mirakian and Maria Sagan

1 Canadian authorities include the Bank of Canada, the Canadian Securities Administrators, the Office of the Superintendent of Financial Institutions, and the Alberta, British Columbia, Ontario, and Quebec securities commissions.

2 The Bank of Canada, "Statement by Canadian Authorities on Clearing of Standardized OTC Derivatives Contracts", (October 1, 2012).

3 Nikil Chande, et al., "The Canadian Approach to Central Clearing for Over-the-Counter Derivatives," Financial System Review (December 2012).

4 For more information about CSA Consultation Paper 91-406 – Derivatives: OTC Central Counterparty Clearing, please refer to McMillan LLP Derivatives Law Bulletin "Welcome to (counter)party central: Canadian regulators publish consultation paper on OTC derivatives central counterparty clearing" (June 2012).

5 The Principles for Financial Market Infrastructures were developed by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions.

6 For a review of CSA Consultation Paper 91-401 – Over-the Counter Derivatives Regulation in Canada, please see McMillan LLP Derivatives Law Bulletin "Change Is Near but Unclear: Canadian Regulators Publish Initial Proposals on OTC Derivatives" (November, 2010); for a review of CSA Consultation Paper 91-402 – Derivatives: Trade Repositories, please see McMillan LLP Derivatives Law Bulletin "Reporting for Duty: Canadian Regulators Publish Framework for OTC Derivatives Trade Reporting and Repositories" (June, 2011); For a review of CSA Consultation Paper 91-403 – Derivatives: Surveillance and Enforcement please see McMillan Derivatives Law Bulletin "Conduct and Consequence: Canadian Regulators Publish Consultation Paper on OTC Derivatives Market Conduct Rules, Surveillance, and Enforcement" (November 2011); For a review of CSA Consultation Paper 91-404 – Derivatives: Segregation and Portability in OTC Derivatives Clearing please see McMillan Derivatives Law Bulletin "Collateral (Un)Damaged: Canadian Regulators Publish Consultation Paper on Segregation and Portability in OTC Derivatives Clearing" (February 2012); For a review of CSA Consultation Paper 91-405 – Derivatives: End-User Exemptions please see McMillan Derivatives Law Bulletin "Can I Be Excused? Canadian Regulators Publish Consultation Paper on End-User Exemptions in the OTC Derivatives Market" (April 2012).

a cautionary note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2013