A financial derivative can generally be described as an instrument or contract whose value depends on, or is derived from, something else, such as a commodity or a reference rate or index. Derivatives can be broadly classified into two categories: exchange-traded derivatives and over-the-counter (OTC) derivatives.
Exchange-traded derivatives are traded through intermediaries, such as exchanges, based on standardized exchange contracts with the intermediary as the counterparty to the contract.
OTC derivatives are privately negotiated bilateral contracts entered into between the contracting parties directly (typically based on standardized agreements and contractual terms, such as those developed by the International Swaps and Derivatives Association, Inc.). OTC derivatives are largely entered into between sophisticated parties (such as financial institutions or similar entities) for the purposes of hedging financial or portfolio risks or for diversifying portfolios of assets.
Historically, the treatment of exchange-traded derivatives under securities legislation has been inconsistent, in part, because of a difference of views as to whether or not they are “securities” or should be treated as such. Derivatives are regulated in Canada through securities regulatory authorities only in the provinces of Alberta, British Columbia, Manitoba, Ontario, and Quebec. Alberta and British Columbia can be grouped together as they take a similar approach. The approach taken by Ontario and Manitoba is also similar, but differs from that taken in British Columbia and Alberta. Lastly, Quebec has recently passed a new Derivatives Act that has introduced yet a third approach to derivatives regulation in Canada. These approaches are summarized below along with other developments that have been undertaken in the past with respect to the regulation of derivatives.
Alberta and British Columbia regulate derivatives directly through their securities legislation. The legislation regulates exchange-traded derivatives based on the concept of “exchange contracts”. Exchange contracts are not included in the definition of “security”, but are regulated through securities legislation by the imposition of registration requirements for dealers and advisors and the regulation of those exchanges on which exchange contracts are traded (pursuant to recognition requirements for such exchanges). Unlike exchange-traded derivatives, while OTC derivatives are generally included in the definition of “security”, the application of most aspects of securities legislation to OTC derivatives is clawed back through broadly applicable blanket exemptions. This approach is often described critically as one which attempts to blanket the entire field of OTC derivatives and then carves it back through exemptions to leave only those areas that are intended to be regulated (namely, the retail market as such). Shortcomings commonly cited with this approach include the difficulty in determining whether a particular type of derivative is or is not regulated as a security, particularly on account of the evolving nature of the derivatives industry versus the comparatively static approach to how they are attempted to be captured under securities regulation.
In Ontario and Manitoba the approach is quite different. Exchange-traded derivatives are not regulated under securities legislation and are governed by separate commodity futures legislation that applies to commodity futures contracts and options. Commodity futures legislation in these provinces generally governs commodity futures by imposing registration or recognition requirements on exchanges operating in the province and by imposing dealer and advisor registration requirements with respect to trading or advising on commodity futures contracts traded on recognized exchanges. A commodity futures contract that is not traded on a recognized exchange constitutes a “security” for the purposes of securities legislation. With respect to OTC derivatives, the application of securities regulation is not clear. While the definition of “security” is not as broad as it is in Alberta and British Columbia, so as to clearly capture OTC derivatives, there is a lack of consensus as to whether particular types of OTC derivatives, such as those that involve the physical settlement of equities or debt securities, are “securities” for securities law purposes. Despite such uncertainty in the law, however, the better view is that cash-settled OTC derivatives would not likely be characterized as securities, whereas OTC derivative transactions that will or may require the physical delivery of an underlying security could be regulated as an act in furtherance of a trade. With respect to a physically-settled OTC derivative, however, it is unlikely it would be characterized as a security separate from the underlying interest to which it relates. To the extent that an exchange-traded derivative (that is not traded on a recognized exchange) or an OTC derivative do fall within the scope of “securities”, they are generally exempt from prospectus and registration requirements as they typically will qualify for available private placement exemptions. Other than the extent to which they may fall under the definition of “securities” in this manner, OTC derivatives are not otherwise directly regulated in Ontario although the Ontario Securities Commission does have rule-making power to regulate them to the extent they involve securities markets.
Quebec has recently passed a new Derivatives Act that applies to both exchange-traded and OTC derivatives. This Act imposes recognition and registration requirements on intermediaries as well as registration requirements on dealers and advisors. Notably, however, OTC derivatives and transactions involving “accredited counterparties” are carved-out from the application of most of the substantive provisions of the legislation. The legislation has been passed but is not yet in force and the specific rules required to implement it (and that will determine the breadth of its scope) have yet to be published.
In addition to the work undertaken in Quebec in developing the Derivatives Act, the regulation of derivatives was studied in Ontario most recently by an advisory committee charged with reviewing the Commodity Futures Act. In its final report, dated January 2007, the Advisory Committee concluded that the Commodity FuturesAct was outdated and in immediate need of reform. With respect to exchange-traded derivatives, the Advisory Committee also made a number of other recommendations, including the repeal and replacement of the existing commodity futures legislation with new legislation that would include clearer and more precise definitions of commodity futures contracts and would regulate exchanges, clearing corporations, and self-regulatory organizations through a core principles approach. Specifically, the Advisory Committee recommended imposing a recognition requirement on exchanges and clearing organizations (or allowing for appropriate recognition exemptions) and allowing for self-certification of rules by these entities. Mandatory recognition of self-regulatory organizations was also recommended with self-certification being left open to further study. Notably, as well, the Advisory Committee also recommended that while this regulation should be achieved through separate legislation applying to commodity futures contracts, the next best alternative would be to include such regulation in a self-contained part of the Securities Act (Ontario). With respect to OTC derivatives, the Advisory Committee came to the conclusion that, while there was a role for securities regulatory oversight in the retail OTC market, such regulation should define the regulated activity precisely and not be overbroad. In this respect, further study and consultation was recommended.
The work of the Advisory Committee followed from earlier efforts made by the Ontario Securities Commission to impose regulation on OTC derivatives through proposed Rule 91-504. The proposed rule was returned to the Ontario Securities Commission by the then Provincial Minister of Finance in December 2000 for reconsideration. In particular, the Minister had asked the Ontario Securities Commission to reconsider whether the approach taken was appropriate in that it attempted to regulate OTC derivatives in a broad fashion under the Securities Act and then provide significant carve-outs through exemptions (as is currently the case in Alberta and British Columbia). Given the uncertainty with respect to the extension of the concept of a “security” to OTC derivatives under the Securities Act (Ontario) (as discussed above), under proposed Rule 91-504 the Ontario Securities Commission was endeavouring to include OTC derivatives as “securities” by way of interpretation guidance, and then would have provided broad-based exemptions similar to the approach taken in Alberta and British Columbia.
Under the Uniform Securities Act proposal, the CSA had originally proposed to adopt the approach taken by Alberta and British Columbia and to regulate exchange contracts. However, under the original proposal the uniform legislation was also to include carve-outs in Manitoba and Ontario to allow their separate regulation under commodity futures legislation to continue. The original proposal with respect to OTC derivatives was to include them in the concept of “security”, but to allow for broad exemptions from prospectus and registration requirements for trades between qualified parties.45 The proposal to regulate OTC derivatives was met with significant opposition by a range of industry participants. They discouraged such regulation noting that the approach was similar to that previously rejected by the Ontario Minister of Finance and raised concerns that it would impede derivatives markets.46 In the end, it appears the compromise reached was to maintain the status quo in Ontario by allowing for Ontario specific carve-outs. In this respect, it was proposed that the definition of derivative would not be included in the Uniform Securities Act, but that the Act would instead allow for rule-making authority to enable the Ontario Securities Commission to define the term. As well, it was proposed that derivatives would not be included under the definition of “security” and that in Ontario the definition of “trade” would not include entering into a derivative.47
What is clear from a review of past attempts to change the manner in which OTC derivatives are regulated is that it is an area that requires significant further study and industry consultation. Any extension in the application of securities regulation to OTC derivatives would arguably represent a significant substantive departure to how they are currently regulated in most provinces. The concern from an investor protection point-of-view with respect to OTC derivatives lies mainly in the retail OTC market, which is an area that has yet to be clearly defined or identified. If such identification is possible, it is still questionable whether the protection sought to be provided to retail OTC participants is properly achieved by regulating them in the same manner as securities. On this account, while further consideration and discussion is clearly warranted, the approach currently suggested for the draft Securities Act is to preserve the status quo in each province to the extent possible. This can be achieved by including the concept of “exchange contract” and imposing regulation with respect to exchange contracts that would replicate the approach taken in British Columbia and Alberta under securities legislation and in Ontario and Manitoba through commodity futures legislation. The draft Securities Act would arguably result in duplication of commodity futures legislation. The provincial legislatures in Manitoba and Ontario would then have the option of repealing such legislation (which, as discussed above, has already been cited as being outdated and in need of reform). With respect to provinces that do not currently regulate either OTC or exchange-traded derivatives, this approach represents little change in that regulation of exchange contracts would extend primarily to exchanges, clearers, and other intermediaries operating in a particular jurisdiction in the derivatives area. Thus, the regulation would only be relevant to the extent that such operations exist in a particular jurisdiction. Further consideration of the Quebec approach is needed recognizing that Quebec has proceeded in a somewhat different direction.
45 The reasons why Ontario does not wish to participate in the passport system are explained in Ontario Securities Commission Notice 11–904, “Request for Comment regarding the Proposed Passport System.”
46 Other concerns about Canada’s securities regulatory structure have been described by previous expert bodies and commentators. See, for example, the Crawford Panel on a Single Canadian Securities Regulator (2006), the Wise Persons’ Committee to Review the Structure of Securities Regulation in Canada (2003), or Harris, Douglas A. “White Paper: A Symposium on Canadian Securities Regulation: Harmonization or Nationalization?” Capital Markets Institute (October 2002).
47 For information on the non-bank ABCP crisis in Canada, see Chant, John. “The ABCP Crisis in Canada: The Implications for the Regulation of Financial Markets.” Expert Panel on Securities Regulation (2009).