Investor Alert:
CIRO is issuing a warning to Canadian investors regarding Canada Token Trade.
While there are many back office sharing arrangements that may be entered into between two Dealer Members (Dealers), including “jitney” or omnibus arrangements, clearing arrangements, introducing broker / carrying broker arrangements and any other arrangement where one Dealer provides certain back office services to another Dealer, the previous IIROC Dealer Member Rules focused mainly on those arrangements where individual client assets were held:
As such is the case, there were specific rule requirements to be met when securities were held by the Dealer at an external custodial location or held by a carrying broker on a fully-disclosed basis for an introducing broker. There were, however, no specific rule requirements to be met when securities were held pursuant to a “jitney” or omnibus account arrangement or other similar account arrangement at another Dealer. Also, it was unclear whether specific IIROC Dealer Member Rules applied to “clearing arrangements”.
In the past IIROC had taken the position that clearing arrangements were a form of introducing broker / carrying broker arrangement. In accordance with this IIROC position, entering into a clearing arrangement could only be done by complying with the requirements set out in IIROC Dealer Member Rule 35 (current Rule 2400). As part of a review of various back office sharing arrangements, IIROC has reconsidered this previous position and has determined that a clearing arrangement, as defined within IIROC Rule subsection 2402(1) and described in this Guidance Note, is not a type of introducing carrying / broker arrangement and, as a result, entering into a clearing arrangement does not require compliance with the requirements set out in IIROC Dealer Member Rule 35 (current Rule 2400).
The elements of Guidance Note that describe which back office sharing arrangements are acceptable to IIROC and which activities performed collectively comprise an introducing broker/carrying broker arrangement and a clearing arrangement, are codified in Rule 2400.
A clearing arrangement is an agreement between two Dealers, in which back-office services are outsourced from one Dealer to the other Dealer and, more specifically, where the primary purpose is the clearing and settlement of trades by one Dealer for the other Dealer. Such arrangements are common where a Dealer doesn’t have access to the capital markets in a particular jurisdiction but wishes to transact in the securities of that particular jurisdiction for its clients and/or for its own account.
To facilitate this arrangement, the clearing Dealer opens up separate delivery against payment / receipt against payment (DAP/RAP) accounts for the outsourcing Dealer and each of the outsourcing Dealer’s clients that wish to participate in the arrangement. In the case of client accounts, these accounts are opened up in the name of each client and represent separate accounts on the books of the clearing broker. The clearing Dealer opens up individual accounts for each client, since, by necessity in order to ensure that client trades are properly settled and delivered to the correct custodian, each client must inform the clearing Dealer of its identity and the identity of its settlement agent custodian. Executed trades are then settled by the clearing Dealer by:
In summary, the services provided by the clearing Dealer under a clearing arrangement are:
The following services are not provided by the clearing Dealer under a clearing arrangement:
In the case of trade/account financing, this service is not provided by the clearing Dealer given that in a DAP/RAP account:
There is therefore, no need for the clearing Dealer to finance purchases or to borrow securities on the client’s behalf to cover short sale obligations and no general need to finance client trades or client account balances.
Custodial services are not provided by the clearing Dealer under a clearing arrangement, given that in a DAP/RAP account, the clearing Dealer is never responsible for holding cash and/or security positions in custody for the other Dealer or the other Dealer’s clients. To illustrate this point, consider the example of a purchase transaction that takes place in a DAP/RAP account. In this example the trade either:
In both scenarios, there is no regulatory or contractual obligation for the clearing Dealer to provide custodial services relating to the trade.
Certain combinations of functions provided by one Dealer to another constitute an Introducing Broker/Carrying Broker Arrangement, whereas other combinations of functions do not. The following are six main trading related functions that are performed:
Function |
Function |
Function |
Function |
Function |
Function |
Trade execution |
Trade settlement |
Custody of cash |
Custody of securities |
Book-keeping |
Financing of client positions |
Combinations of functions that do not constitute an introducing broker/carrying broker arrangement include:
Function |
Description |
Functions #1 and #2 |
This combination of functions is a “jitney” or “omnibus” arrangement and is not subject to Rule 2400. |
Functions #2, #3 and #4 |
This combination of functions is a custodial arrangement and is not subject to current Rule 2400. Of course this arrangement is subject to other requirements set out in the IIROC Rules relating to custody of client cash and securities |
Functions #1, #2, and #5 |
This combination of functions is not subject to current Rule 2400. The introducing broker/carrying broker requirements do not apply where cash and security custody is performed at a separate [entity] and assets are not commingled in any way with the service provider’s assets. This requires distinct segregation of securities by means of individual account FINS numbers at the Canadian Depository for Securities Ltd. or other depository for securities of the service. |
Function #5 |
The preparation of books and records is not subject to Canadian Depository for Securities Ltd. This function is typically performed by a service bureau with the firm retaining the responsibility to comply the IIROC Rules for bookkeeping. |
Functions #1 through #6 |
This combination of functions is subject to the introducing and carrying broker rules and is classified as either a Type 1, 2 or 3 Arrangement pursuant to Rule 2400. |
Functions #1 through #5 |
This combination of functions is subject to the introducing and carrying broker rules where financing of client positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to Rule 2400. |
Functions #2 through #6 |
This combination of functions is subject to the introducing and carrying broker rules where trade execution is performed by the introducer and is classified as either a Type 2 or 3 Arrangement pursuant to Rule 2400. |
Functions #2 through #5 |
This combination of functions is subject to the introducing and carrying broker rules where trade execution and financing of client positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to Rule 2400. |
A clearing arrangement is a combination of functions #1, #2 and #5 from the above table. A clearing arrangement is not considered to be an introducing broker/carrying broker arrangement under Rule 2400. This is because clearing arrangement services do not obligate the clearing broker to provide custodial services for client cash, security and investment product positions.
There are other relevant general rule requirements, practical considerations, outsourcing due diligence obligations and IIROC notification requirements that apply to clearing arrangements.
As a clearing arrangement involves the execution, clearing and settlement of trades by the clearing broker on behalf of another Dealer, the clearing broker will be exposed on a daily basis to the credit risk associated with each DAP/RAP account opened under the arrangement. As such, to the extent a trade settlement failure occurs and/or an unsecured debit balance exists in one or more accounts, the clearing broker would be required to provide for this credit risk in accordance with the account margining requirements set out in IIROC Form 1 and Series 5000.
The following are practical issues to be addressed when a clearing arrangement is being considered:
It is for these reasons that IIROC would expect that for any clearing arrangement involving an IIROC Dealer, either domestic, cross-border inbound or cross-border out-bound:
As a clearing arrangement is an outsourcing arrangement, Dealers are reminded of their due diligence obligations as summarized in Guidance Note GN-2300-20-003 – Outsourcing arrangements.
Pursuant to subsection 2246(2) a Dealer Member must notify IIROC in writing before any material change to its business activities. IIROC expects to be informed of any material clearing arrangements that are being entered into by a Dealer.
IIROC Rules this Guidance Note relates to:
This Guidance Note replaces Rules Notice 14-0010.
This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.