Derivative Instruments

NEW MARGIN REQUIREMENTS FOR NON-CENTRALLY CLEARED DERIVATIVES

In July 2016, the Canadian Securities Administrators (CSA) proposed a new framework for minimum margin requirements for non-centrally cleared derivatives. The proposals are part of an ongoing effort to make the over-the-counter (OTC) derivatives market more secure and transparent.

According to a McCarthy Tétrault LLP client bulletin, the proposed framework is “largely consistent” with standards developed by the Basel Committee on Banking Supervision, the International Organization for Securities Commissions and the Office of the Superintendent of Financial Institutions.

The margin requirements apply to all OTC derivatives not cleared through a central counterparty where the counterparty to the derivatives are “covered entities.” Such entities are financial institutions whose outstanding derivatives exceed $12 billion calculated on an aggregate month-end average.

Covered entities whose initial margin on outstanding derivatives exceeds $75 billion must exchange initial margin and variation margins. The proposal provides a formula for calculating these values.  Initial margin may not be re-pledged or re-used, except on a one-off basis to fund back-to-back hedges.

Assets exchanged as margin should be highly liquid and non-volatile in times of financial stress. They should not be dependent on the creditworthiness of the counterparty providing the collateral or on the value of the derivatives that are the consideration for the exchange. Their quoted prices should be reasonably accessible to the public.

The CSA has proposed the following (non-exhaustive) list of eligible collateral: cash; gold; debt securities issued by or guaranteed by the Government of Canada or the Bank of Canada or the government of a province or territory of Canada; debt securities issued and fully guaranteed by the Bank for International Settlements, the International Monetary Fund or a multilateral development bank with a rating of at least BB-; debt securities issued by foreign governments with a rating of at least BB-; debt securities issued by corporate entities with a rating of at least BBB-; equities included in major Canadian stock indices; and some types of mutual funds.

AMENDMENTS TO OTC DERIVATIVES TRADE REPORTING RULES

Amendments to OTC trade reporting rules came into force throughout Canada on July 29, 2016.

The amendments require local counterparties to obtain legal entity identifiers (LEI), which are part of a global system used to identify counterparties to financial transactions.

“This amendment addresses an anomaly in the existing rules which require a reporting party to report the LEI of its counterparty, but the reporting party has no ability to obtain this LEI on behalf of its counterparty,” says a McCarthy  client bulletin. “Now that there will be an obligation placed on all local counterparties to obtain an LEI, this should assist reporting parties in satisfying their obligation to report the LEI of counterparties.”

The rules also reduce the scope of public disclosure. The existing rules require that certain information be public disseminate for other than inter-affiliate transaction. The amendments now limit the disclosure requirements  to the following transactions: interest rate swaps based on CDOR, USD LIBOR, EURIBOR and GBP LIBOR; credit derivatives on all indices, and equity derivatives on all indices. Transactions involving the exchange of more than one currency or resulting from a bilateral or multilateral compression exercise are also excluded.

“By limiting the asset classes of transactions to be disclosed, along with the imposition of rounding and capping conventions, the amendments attempt to balance the benefits of post trade transparency with the potential harm that may be caused from inadvertently disclosing a counterparty’s identity,” McCarthy states.

Parties required to disseminate must do so within 48 hours after the transaction’s timestamp.

VALUATION OF DERIVATIVES

The Federal Court of Appeal has ruled that a corporation that was not a financial institution could resort to the mark-to-market method in calculating its federal income tax.

The decision, Kruger Inc. v. Canada, was released in June 2016. It allowed Kruger to recognize an accrued year-end loss on its foreign exchange account.

The Court found that Kruger’s valuations were reliable, and on “the broad recognition of mark-to-market accounting for purposes of computing income from dealing in foreign exchange options, and the uncontested evidence that banks, financial institutions and mutual funds which engage in this activity report their income on this basis with the CRA’s approval.”

According to a Davies Ward Phillips & Vineberg LLP client bulletin, Kruger “may indicate that a taxpayer, which has derivatives or other property or obligations acquired or incurred on income (rather than capital) account, has the option to report its gains or losses on those holdings on a mark-to-market rather than realization basis for tax purposes if, under generally-accepted accounting principles, it also prepares its financial statements on a mark-to-market basis.”

But Davies cautions that CRA may not accept this as Kruger’s import.

“It likely will be concerned that taxpayers would consider selectively adopting mark-to-market tax accounting whenever they sustained significant accrued losses on their derivatives book, or other trading positions that they have marked to market for accounting purposes,” the firm states. “The CRA is also cautious about changing long-standing assessing practices except when these have been clearly found to be incorrect.”