1. Purpose

This Guidance Note is published for the following purposes:

• to present a revised custodial agreement decision tree (Chart 1) which provides clarification on early warning charge,
• to remind  Dealers that when there is no acceptable custodial agreement in place at an otherwise acceptable securities location, the early warning charge applies regardless of whether or not the member engages in any other business with the custodian, and
• provide guidance on when reduction in capital requirements regarding custody arrangements are available to a  Dealer and how the reduced requirements are to be calculated.

1. When are the reduced requirements available?

The reduced capital requirements are only available for Dealer external custodial arrangement situations where the Dealer has failed to execute with the custodian a written custodial agreement (in a form acceptable to IIROC) and the custodial location is otherwise considered to be an “acceptable securities location” (as defined in the general notes and definitions to Form 1). The reduced capital requirements are not available for Dealer outside custodial arrangement situations where the custodial location is not considered to be an “acceptable securities location”.

1. How the reduced requirements are to be calculated?

The reduced capital requirements more precisely address outside custodial arrangement risks by setting out specific requirements to address setoff risk,1  fraud risk and agreement risk as follows:

• Setoff risk - Setoff risk must be provided for on Statement B of Form 1 on a dollar for dollar basis in determining a Dealer’s risk adjusted capital, where a Dealer has been unable to execute a custodial agreement.
• Fraud risk - The reduced requirements do not mandate that capital be provided to address fraud risk. This is consistent with the current general regulatory approach with respect to fraud risk. That is, rather than requiring Dealers to provide capital for the possibility of the occurrence of fraud, IIROC’s focus is on ensuring that Dealers have adequate preventative and detective fraud risk controls in place.
• Agreement risk - In order to continue to provide a general incentive for Dealers to obtain written custodial agreements, 10% of the market value of the securities held in custody at a location without an executed custody agreement must be provided on Statement C of Form 1 in the determination of a Dealer’s early warning reserve.

1. Examples

To illustrate how the calculations would work for specific situations the following examples have been prepared:

1. Example #1

Dealer enters into custodial arrangement with ABC Custody Services, but does not sign a custodial agreement to document the arrangement. The market value of the securities held in custody is $10.0 million. The Dealer has no other business with ABC Custody Services.

Capital requirements

• Setoff risk requirement - Nil. The Dealer has no other business with ABC Custody Services so the  Dealer has no other obligations to the custodian and the custodian has no right to seize assets held in custody.
• Agreement risk requirement - $1.0 million. The requirement is 10% of the market value of the securities at ABC Custody Services which is $1.0 million. This amount is deducted on Line 4 of Statement C as part of the early warning reserve calculation.

1. Example #2

The Dealer enters into custodial arrangement with DEF Custody Services, but does not sign a custodial agreement to document the arrangement. The value of the securities held in custody is $10.0 million. The Dealer also enters into a significant number of securities borrowing and lending transactions with DEF Custody Services on an ongoing basis, and as at the date of calculation has received a call from DEF Custody Services to provide additional collateral in the amount of $5.0 million. Aside from the custodial arrangement and the securities borrowing and lending transactions activity, the Dealer has no other business with DEF Custody Services.

Capital requirements

• Setoff risk - $5.0 million. The amount of the setoff risk requirement is the lesser of the setoff risk exposure ($5.0 million) and the value of the securities held in custody ($10.0 million). This amount is deducted on Line 20 of Statement B as part of the risk adjusted capital calculation.
• Agreement risk requirement - $1.0 million. The requirement is 10% of the market value of the securities at DEF Custody Services, which is $1.0 million. This amount is deducted on Line 4 of Statement C as part of the early warning reserve calculation.

1. Example #3

Dealer enters into custodial arrangement with GHI Custody Services, but does not sign a custodial agreement to document the arrangement. The value of the securities held in custody is $10.0 million. The Dealer also enters into a significant number of securities borrowing and lending transactions with GHI Custody Services on an ongoing basis, and as at the date of calculation has received a call from GHI Custody Services to provide additional collateral in the amount of $9.5 million. Aside from the custodial arrangement and the securities borrowing and lending transactions activity, the Dealer has no other business with GHI Custody Services.

Capital requirements

• Setoff risk - $9.5 million. The amount of the setoff risk requirement is the lesser of the setoff risk exposure ($9.5 million) and the value of the securities held in custody ($10.0 million). This amount is deducted on Line 20 of Statement B as part of the risk adjusted capital calculation.
• Agreement risk requirement - $0.5 million. The requirement is normally 10% of the market value of the securities at GHI Custody Services which is $1.0 million. However because $9.5 million is already being provided above for setoff risk and the total losses are limited to the value of the securities held in custody ($10.0 million), the requirement in this case in reduced to $0.5 million. This amount is deducted on Line 4 of Statement C as part of the early warning reserve calculation.

1. Summary of examples

Example #1 illustrates that where a Dealer has no other business with an outside custodian that otherwise qualifies as an acceptable securities location, the capital requirement associated with the Dealer not executing a written custodial agreement (in a form acceptable to IIROC) is limited to a 10% charge as part of the early warning reserve calculation.

Example #2 illustrates that where a Dealer has other business with an outside custodian that otherwise qualifies as an acceptable securities location, the capital requirement associated with the Dealer not executing  a written custodial agreement (in a form acceptable to IIROC) has two parts:

1. a charge for any setoff risk exposure to the custodian as part of the risk adjusted capital calculation; and
2. a 10% charge as part of the early warning reserve calculation.

Example #3 illustrates that in total, the charges provided for in the risk adjusted capital and early warning reserve calculations shall not exceed 100% of the market value of the securities held in custody.

1. Summary Custodial agreement decision tree chart

Attached as Appendix 1 is a chart summarizing the considerations in determining whether a capital charge applies to security positions held under a particular custodial arrangement.

1. Applicable Rules and statements

Guidance Note relates to:

• Statement B of Form 1, and
• Statement C of Form 1.

1. Previous Guidance Note

This Guidance Note replaces Member Regulation Notice MR0529 - Amendments to Statement B and C of Form 1 – Custodial Agreements.

1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.

1. Attached documents

Appendix 1 – Custodial agreement decision tree chart

• 1A definition for “setoff risk” was developed as part of this proposal. Pursuant to the Notes and Instructions to Statement B of Form 1 “’setoff risk’, shall mean the risk exposure that results from the situation where the Dealer Member has other transactions, balances or positions with the entity, where the resultant obligations of the Dealer Member might be setoff against the value of the securities held in custody with the entity.”