On February 10, 2012, the Canadian Securities Administrators Derivatives Committee (the "Committee") released its Consultation Paper 91-404 ("Consultation Paper 91-404") on Segregation and Portability in OTC Derivatives Clearing. Consultation Paper 91-404 is part of a series of eight papers that expand on the proposals for the regulation of over-the-counter ("OTC") derivatives set out in Consultation Paper 91-401. Please see our earlier client alert, entitled Over-The-Counter (OTC) Derivatives Market in Canada: On the Road to Reform and Regulation, regarding Consultation Paper 91-401. The other papers in this series that have been published to date are Consultation Paper 91-402 on Trade Repositories (published June 23, 2011) and Consultation Paper 91-403 on Surveillance and Enforcement (published November 25, 2011). The remaining five papers are expected to be published over the next few months.
The Committee acknowledges that rules developed for the Canadian derivatives market must be consistent with international practice in order to ensure that Canadian market participants and financial market infrastructures have full access to the international market. One of the fundamental premises of OTC derivatives regulation is the introduction of mandatory clearing of all OTC derivatives that are determined to be appropriate for clearing and capable of being cleared. It is expected that all central counterparties ("CCPs") will have very rigorous eligibility requirements for direct participation as a clearing member. As a result, it is likely that most buy-side participants and smaller financial intermediaries may not qualify as a direct clearing member and will need to clear their trades indirectly through a third party. All proposed rules regarding the segregation and portability of customer collateral need to address both the direct and indirect clearing of OTC derivatives trades.
Under derivative transactions, there are typically two types of collateral requirements – initial margin and variation margin. Initial margin is the collateral that is posted at the beginning of the trade to protect against replacement cost losses due to potential future movements in contract value, counterparty default and counterparty credit risk. Variation margin is collateral that is posted from time to time during the trade based on changes in the market value of the derivatives contract. Consultation Paper 91-404 focuses on two important issues in connection with the posting of collateral: segregation and portability.
SEGREGATION
Segregation refers to the separation of the collateral posted by a customer from the other assets of the clearing member or CCP. Some of the existing legislation in Canada, including the Québec Derivatives Act and the Commodity Futures Act of both Ontario and Manitoba, already contain segregation requirements. Under the Dodd-Frank Act in the United States, any person holding collateral in connection with cleared swaps is required to be registered and must segregate customer collateral from their own assets and separately account for such collateral. In addition, customer collateral that is posted by a defaulting clearing member cannot be applied to the clearing member's proprietary positions and customer collateral cannot be used to margin or guarantee derivative trades of other customers. Similar to the Dodd-Frank requirements, the Committee recommends that clearing members must segregate customer collateral from their own proprietary assets and that all CCPs have in place an account structure that enables the efficient identification and segregation of positions and collateral belonging to the customers of a clearing member from the positions and collateral of the clearing member's other customers as well as those that belong to the clearing member itself.
PORTABILITY
Portability refers to the ability to facilitate a timely and efficient transfer of customer accounts from one clearing member to one or more other clearing members. The concept of portability is particularly important in the context of the insolvency or default of a clearing member. When examining any collateral and segregation model, the portability of customer positions and related collateral is a key mechanism to ensure that if a clearing member defaults or becomes insolvent, its customer positions are not terminated and customer positions and collateral can be transferred to one or more non-defaulting clearing members without having to liquidate and re-establish the positions. This portability feature is important to allow customers to maintain continuous clearing access and to promote efficient financial markets.
COMPLETE LEGAL SEGREGATION MODEL
The Committee considers various international approaches and segregation models to address the segregation by clearing members of individual customer accounts. In the view of the Committee, any acceptable segregation model must include record keeping requirements that would be sufficient to allow the CCP to more readily allocate positions and collateral relating to a customer of the clearing member from the clearing member's own assets and those of other customers. In addition, the Committee clearly states that any acceptable segregation model cannot allow non-defaulting customer collateral to be used to support defaulting customer positions. Balancing these concerns with the additional costs of requiring full physical segregation, the Committee concludes that the most appropriate segregation model for CCPs operating in Canada is the "Complete Legal Segregation Model". Under this model, clearing members will be permitted to hold all customer collateral in an omnibus account, but all collateral must be recorded and attributed by both the CCP and the clearing member to each customer based on its collateral advanced. Initial margin would be paid and collected on a gross per customer basis. The clearing member would be able to post to the CCP the total required customer margin from the omnibus account, without regard to the customer to whom the collateral belongs. However, each clearing member would be required to report daily to the CCP the rights and obligations attributed to each customer. In the event of a clearing member default, each non-defaulting customer would be protected from losses on the positions of other customers, although all customers would bear some risk of loss resulting from the investment of the collateral in the customer pool. To minimize this risk, the Committee recommends that CCPs and clearing members only be able to invest customer collateral in instruments with minimal credit, market and liquidity risk. In addition, under the "Complete Legal Segregation Model", the CCP would be permitted to access the collateral of defaulting customers up to the value equal to the margin required to be posted by such customers, but would not have access to the collateral posted by non-defaulting customers.
To create further safeguards for posted collateral, the Committee suggests that CCPs should hold the collateral posted in their favour at one or more supervised and regulated entities that have robust accounting practices, safekeeping procedures and internal controls. The Committee further recommends that all CCPs that operate in Canada should be required to publicly disclose their segregation and portability arrangements so that customers can evaluate the level of customer protection provided. The Committee is also considering whether Canadian customer collateral accounts should be required to be governed by Canadian laws. With respect to uncleared OTC derivative trades, the Committee suggests that the parties should be free to negotiate the level of segregation required for collateral. It is considering whether OTC derivatives dealers should be required to offer arrangements for collateral to be held with a third-party custodian for uncleared transactions.
PERFECTION BY CONTROL OVER CASH COLLATERAL
The Committee recognizes that any arrangement regarding the segregation and portability of collateral is affected by personal property security, securities transfer and bankruptcy and insolvency laws. In particular, the Committee focuses on the issue of perfecting a security interest in cash collateral under Canadian law and suggests that provincial laws may need to be amended to create a perfection by control regime for cash collateral. We would applaud these amendments, as the current state of the law makes it difficult to properly perfect a security interest in cash. For this reason, together with the end-user derivative rules that apply to all mutual funds, we have strongly recommended that our mutual fund clients do not post cash as collateral. The Committee's recommendation in this regard should help to address this issue. Please see our earlier client alert, entitled ISDA Releases Key Provisions to the Standard Credit Support Annex Proposal, for some additional commentary in this connection.
APPLICATION OF CANADIAN BANKRUPTCY AND INSOLVENCY LAWS
The application of bankruptcy and insolvency laws, whether as a result of a stay of proceedings or a temporary prohibition on dealing with the assets of an insolvent clearing member, would interfere with portability of customer collateral. The Committee suggests that any CCP operating in Canada would need to provide an analysis of all laws applicable to customer collateral in each jurisdiction of operation, including bankruptcy and insolvency laws, with a view to ensuring that the CCP's ability to expeditiously facilitate the termination of customer clearing member relationships, port positions or enforce collateral relationships are not compromised by applicable bankruptcy and insolvency laws. We would suggest that this will require a comprehensive review of the bankruptcy regime that applies to securities dealers in Canada, as we do not believe that our current regime is consistent with the Committee's desire for portability. The Committee has asked a number of specific questions and is soliciting public comments by April 10, 2012 on Consultation Paper 91-404. Following this consultation period, the Committee will finalize rule making guidelines and each province will begin the rule making process.
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