Canadian regulators respond to energy firms’ concerns on derivatives

Updated OTC derivatives rules satisfy concerns of energy traders, but inconsistencies with Dodd-Frank remain

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Canadian energy traders have welcomed revised rules on over-the-counter derivatives, which seek to address the issue of extraterritoriality, but warn that inconsistencies with the US Dodd-Frank Act will continue to be a challenge.

“We’ve made some progress, but certainly there’s still significantly more progress required,” says a Calgary-based lawyer at a large Canadian energy producer. “Absolutely, the new [rules] have more clarity, [but] we’re looking for more alignment with the Dodd-Frank requirements to avoid unintentional inconsistencies and conflicts.”

As a member of the Group of 20, Canada is working towards implementing mandatory clearing, execution and reporting requirements for OTC derivatives. However, Canadian market participants face an added complication, as derivatives rules are not determined by the federal government – and are instead set separately by the country's 10 provinces and three territories.

The Canadian Securities Administrators (CSA) – a body comprising local securities regulators – is attempting to co-ordinate efforts aimed at regulating OTC derivatives. In December 2012, it published the country’s first two ‘model rules’ aimed at reforming the market, which focus on product determination and reporting to trade repositories. Those model rules are eventually expected to be written into the law of each individual province or territory, incorporating a few local variations. However, market participants expressed unease with the original model rules – and on June 6, the CSA released an updated version.

“After the model rules were released, there was a 90-day consultation period and the changes that were made are absolutely a response to the comments we received. We feel we addressed the majority of the comments and made appropriate changes to the framework,” says Kevin Fine, Toronto-based director of the derivatives branch at the Ontario Securities Commission.

[The proposals] create duplicative regulatory oversight and... provide no regulatory or public interest benefit

As the model rules were updated on June 6, supervisors in Quebec, Manitoba and Ontario proposed final rules based on them, while other provincial supervisors are expected to follow suit.

Among energy trading firms, one of the biggest worries in the original model rules was extraterritoriality. Due to the definition of a 'local counterparty' within the model rules, foreign subsidiaries of Canadian firms would have been required to register and report their trades to a CSA-designated trade repository.

“Canadian companies operate globally and in many cases utilise foreign subsidiaries to achieve these operations. The proposed definition would make each of these subsidiaries subject to oversight by Canadian regulators, irrespective of the circumstances of the company, the country in which they operate, or the regulatory regime in place in that country,” complains a February 4 comment letter from oil major Shell’s Canadian unit. “This extraterritorial reach will create duplicative regulatory oversight and risk, along with obligations and burden on market participants that are costly and provide no regulatory or public interest benefit.”

Other large energy companies, including oil major BP’s Canadian unit and Houston-based gas producer and utility Direct Energy, also expressed concern about the clause.

The newly updated rules narrow the definition of a local counterparty and do not catch foreign subsidiaries, notes Derek West, senior director for derivatives oversight at Quebec's Autorité des marchés financiers and chair of the CSA’s derivatives committee. He adds that the feedback and criticism received from market participants has been helpful in finalising the rules. “We had quite a few comments on that issue and we take the comments on board, because obviously this is a market-place that up until five years ago was very opaque. We don’t want to be making rules and suddenly find out from the industry that we’ve hamstrung them.”

The model rules on product determination are particularly significant, as they define which products will become subject to oversight as OTC derivatives. Initially, regulators had opted to exclude physical commodity contracts that do not give the option of cash settlement and are not expected to be cash-settled. However, firms were left confused by ambiguities in the original proposals, including whether the definition of a commodity would cover emissions, for example, or whether derivatives regulation would be extended to book-outs, which involve fees being exchanged between counterparties where physical settlement is not possible.

By contrast, the revised rules make clear that book-outs will not be considered OTC derivatives, and the definition of commodities includes “certain intangible commodities, such as carbon credits and emission allowances”.

Nonetheless, firms remain concerned about inconsistencies between the embryonic Canadian regime and Dodd-Frank. Due to the close ties Canadian firms share with US counterparts, many of the country’s commodity market players have already brought themselves in line with Dodd-Frank, say lawyers.

“A lot of Canadian energy companies have already put in systems in place to be subject to Dodd-Frank because they are caught by it on the cross-border applicability provisions,” says Priscilla Bunke, a Calgary-based associate at law firm Dentons. “They have already spent a lot of money to put systems in place and are hoping that whatever the Canadian regulators come up with matches Dodd-Frank, so they don’t have to create new systems just to be able to meet the obligations here.”

Responding to these concerns, West says regulators are not just looking at US rules, but are also studying the European Market Infrastructure Regulation (Emir) and equivalent rules in other parts of the globe. Where it makes sense to bring rules into line with Dodd-Frank, they will seek to achieve that, he says. “But we’re not just photocopying Dodd-Frank… We speak with all our colleagues around the world and meet regularly, so it’s not just looking at Dodd-Frank and Emir, but also looking at what Australia, Japan and Singapore are doing as well.”