The securities regulatory authorities in all Canadian jurisdictions other than British Columbia recently published in final form Multilateral Instrument 93-101 Derivatives: Business Conduct ("MI 93-101") and its companion policy (together with MI 93-101, the "Business Conduct Rule"), which establish business conduct standards applicable to the over-the-counter ("OTC") derivatives markets. MI 93-101 will take effect on September 28, 2024, with a five-year transition period to help derivatives market participants operationalize the new requirements. The British Columbia Securities Commission ("BCSC") intends to adopt substantially similar rules on a later date, at which time the Canadian Securities Administrators plan to convert MI 93-101 into a national instrument.

Background

The participating regulators note that Canada is the only G20 country that has not yet implemented business conduct standards for OTC derivatives markets, and the Business Conduct Rule was first proposed in April 2017 to close this regulatory gap. The Business Conduct Rule was developed through an extensive consultation process and is intended to establish a robust market conduct regime that is consistent with the international standards for OTC derivatives adopted by the International Organization of Securities Commissions ("IOSCO") and the approach taken by most IOSCO jurisdictions with active derivatives markets.

Application

The Business Conduct Rule will apply to any person or company that is in the business of trading or advising in OTC derivatives in the Canadian market (each a "derivatives firm"), regardless of whether the derivatives firm is registered or exempt from registration, subject to certain exemptions, described below. As with National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103"), which applies to securities-related activities, MI 93-101 regulates OTC derivatives-related business conduct on the basis of a two-tiered regulatory framework. Generally, certain core obligations will apply in all cases when a derivatives firm is dealing with or advising a derivatives party, regardless of the level of sophistication or financial resources of the derivatives party. Additional obligations will: (i) apply if the firm is dealing with or advising a derivatives party that is not an "eligible derivatives party" ("EDP"); and (ii) apply but may be waived if the firm is dealing with or advising a derivatives party that is an EDP that is an individual or a specified commercial hedger.

EDPs

The definition of "EDP" has been adjusted for greater alignment with the definition of "permitted client" under NI 31-103, as well as with the bright-line tests used under Canadian and foreign securities and exchange-traded derivatives legislation, and is expected to reduce the re-papering burden on derivatives firms. The definition of an "EDP" includes, among others:

  • financial institutions;
  • registered derivatives dealers, derivatives advisers, advisers and investment dealers;
  • regulated pension funds;
  • governments and certain government entities;
  • certain registered or authorized persons and companies acting on behalf of a managed account;
  • investment funds whose investment fund manager is registered or whose adviser is registered or exempt from registration;
  • persons and companies, other than individuals, that have net assets of at least C$25 million as shown on their most recently prepared financial statements;
  • commercial hedgers;
  • individuals who beneficially own financial assets that have a net aggregate value of at least C$5 million; and
  • qualifying clearing agencies.

Core obligations

Unless an exemption is available, the following obligations will apply in all cases when a derivatives firm is dealing with or advising a derivatives party:

  • Fair dealing: the firm must act fairly, honestly and in good faith with a derivatives party;
  • Conflicts of interest: the firm must establish, maintain and apply reasonable policies and procedures to identify all material conflicts of interest between the firm and the derivatives party and respond to and disclose such conflicts;
  • Know your derivatives party: the firm must establish, maintain and apply reasonable policies and procedures to establish and verify the identity of the derivatives party and keep collected information current;
  • Handling complaints: the firm must document and respond promptly to complaints about any product or service offered by the firm or an individual acting on its behalf;
  • Tied selling: the firm must not impose undue pressure on or coerce a person or company to obtain a derivatives-related product or service from a particular person or company as a condition of obtaining another product or service from the firm;
  • Compliance: the firm must establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient to provide reasonable assurance of compliance with securities legislation, risk management and individual competency;
  • Senior manager duties: a derivatives dealer must designate a senior derivatives manager for each derivatives business unit to supervise derivatives-related activities in the business unit to ensure compliance, address any incidents of material non-compliance and report to the firm's board of directors;
  • Reporting of non-compliance: a derivatives dealer must report certain instances of non-compliance to the regulator in a timely manner;
  • Recordkeeping: the firm must enter into agreements that establish all of the material terms governing the relationship between the firm and the derivatives party and keep and retain records of all derivatives transactions and advising activities; and
  • Segregation of derivatives party assets: the firm must segregate derivatives party assets and derivatives positions from the property and positions of the firm and other persons and companies.

Additional obligations

The following obligations will also apply when a derivatives firm is dealing with or advising a derivatives party that is not an EDP or, alternatively, is an EDP that is an individual or an eligible commercial hedger and has not waived these protections:

  • Suitability: the derivatives firm must take reasonable steps to ensure that the derivative and transaction are suitable for the derivatives party;
  • Referral arrangements: the derivatives firm and persons acting on its behalf must not participate in a referral arrangement unless the terms of the arrangement are set out in a written agreement, all referral fees are recorded, certain prescribed written disclosures are provided to the derivatives party and reasonable steps are taken to verify that the person or company has the appropriate qualifications and/or is registered to provide the services; and
  • Relationship and pre-transaction disclosure: the derivatives firm must deliver to the derivatives party all of the information that a reasonable person would consider important about the derivatives party's relationship with the firm, the derivatives and services offered and the related risks before transacting with the derivatives party for the first time.

Short-term foreign exchange ("FX") contracts and instruments

Although short-term FX contracts are not considered to be "derivatives" as defined in existing provincial derivatives product determination rules, a subset of provisions in the Business Conduct Rule will apply to certain transactions involving short-term FX contracts and instruments in the institutional FX market, which are typically settled within two business days or less. The "institutional FX market" is defined in MI 93-101 as the global FX market comprised of persons or companies that are active in FX markets as part of their business and transact in FX contracts or instruments, including short-term FX contracts or instruments. A derivatives dealer that transacts with a derivatives party in a short-term FX contract or instrument in the institutional FX market, is a Canadian financial institution and has had a month-end gross notional amount under all outstanding derivatives that exceeds C$500 billion will be subject to the fair dealing, conflicts of interest, complaints handling and compliance requirements in the Business Conduct Rule, as is generally consistent with existing expectations under the voluntary FX Global Code of Conduct.

Exemptions

The Business Conduct Rule also provides a number of exemptions from requirements of MI 93-101 to certain derivatives market participants (subject to prescribed conditions), including for:

  • Foreign liquidity providers, in respect of transactions with derivatives dealers in Canada, to facilitate access and liquidity in the inter-dealer market;
  • Derivatives end-users, since these counterparties would typically transact with a derivatives dealer that may itself be subject to requirements in MI 93-101;
  • Foreign derivatives dealers and advisers that are regulated under the laws of certain designated foreign jurisdictions to conduct the activities that they propose to conduct with an EDP in Canada, subject to conditions and filings that are similar to those applicable to the filings-based international dealer and international adviser exemptions available under NI 31-103 in respect of cross-border securities-related activities;
  • Canadian investment dealers, which are already subject to corresponding rules of the Canadian Investment Regulatory Organization ("CIRO") applicable to transactions with a derivatives party;
  • Canadian financial institutions, which are already prudentially regulated by the Office of the Superintendent of Financial Institutions ("OSFI") and required to comply with the corresponding OSFI requirements or Bank Act (Canada) provisions applicable to transactions with a derivatives party;
  • Derivatives dealers, in respect of derivatives transacted on a derivatives trading facility where the identity of the derivatives party is unknown;
  • Derivatives dealers whose aggregate notional amount of derivatives activity falls below certain financial thresholds;
  • Derivatives advisers, in respect of general advice that does not purport to be tailored to the needs of the recipient;
  • Foreign derivatives sub-advisers, in respect of advice to qualified derivatives advisers and derivatives dealers that have agreed to be liable for losses that arise from certain failures of the derivatives sub-adviser;
  • Registered advisers that comply with the corresponding requirements in NI 31-103, to allow such advisers to extend their existing compliance systems to cover their derivatives activities; and
  • Qualifying clearing agencies, governments, central banks and similar international organizations as well as persons and companies in respect of transactions with affiliated entities that are not an investment fund.

What's Next?

The Business Conduct Rule will come into force on September 28, 2024, with a five-year transition period that is set to expire on September 28, 2029. While BCSC Staff anticipate that MI 93-101 will also take effect on September 28, 2024, in British Columbia, they will provide more information once a final version of the Business Conduct Rule is published in their jurisdiction.

Lastly, the regulators note that they continue to monitor the implementation of the Client Focused Reforms for securities market participants and will consider whether comparable provisions are appropriate for the OTC derivatives market in the future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.