IFLR Webcast Dodd-Frank Act Title VII Update

Transcription

1 NY IFLR Webcast Dodd-Frank Act Title VII Update May 21, 2013 Presented By Robert Dilworth David Kaufman Anna Pinedo 2013 Morrison & Foerster LLP All Rights Reserved mofo.com

2 Overview of Presentation Will review status of: Swap Dealer and MSP registration Swap data recordkeeping Swap data reporting External and internal business conduct standards Mandatory swap clearing Will review major unfinished rulemaking areas: OTC margin requirements Swap execution facilities Extraterritoriality Additional mandatory clearing designations SEC Title VII implementation Related areas: Volcker Rule, Lincoln Amendment Proposed legislation/future prospects 2

3 Swap Dealer/MSP Registration First wave of registrations occurred on December 31, 2012 Close to 70 swap dealers provisionally registered, no MSPs Under regulatory structure, registrations tend to occur at month end Over last four months, total swap dealers provisionally registered has climbed to 77, with two MSPs having provisionally registered Noteworthy developments and issues: Limited Purpose Designation for Swap Dealers: appears at least one of these has been granted for a swap dealer that has limited its dealing activities to physical commodities swaps understand that other entities have pursued limited purpose designation that focuses only on certain FX transactions (NDFs) or a combination of FX and IRS Middle market US banks: many are attempting to structure their IRS and FX businesses to stay within de minimis threshold Foreign banks: though many of largest foreign banks have registered as swap dealers, many others are structuring business to stay within de minimis threshold or are struggling with whether to register or curtail activities 3

4 Swap Dealer/MSP Registration (cont d) For potential swap dealers, application of de minimis threshold remains a critical issue For entities engaged in FX business, focus has been on limiting scope of activities to FX swaps and FX forwards covered by the Treasury exemption At least as of end of April 2013, major energy companies have not registered so presumably they are closely monitoring the nature and extent of their swap dealing activities Note that only dealing activity needs to be counted against the de minimis threshold for SD purposes Interim final rule exempts certain hedging transactions from threshold calculation Scope of this exemption has been of concern Commenters have called on CFTC to expand and clarify this exemption when rule is fully finalized 4

5 Recordkeeping Recordkeeping requirements are in effect for all market participants Important that even non-registered end-users appreciate that they are subject to recordkeeping requirements For registered entities, recordkeeping requirements are more extensive and various forms of temporary no-action relief have been provided by the CFTC In particular, CFTC in late 2012 provided relief for Daily Trading Record requirements in Rule This rule imposes some of the most challenging technological recording and search function requirements that swap dealers and MSPs face, including Recording pre-execution trade information, including records of all oral and written communications provided or received concerning quotes, solicitations, bids, instructions, trading and prices, that lead to the execution of a swap (or lead to the conclusion of a related cash or forward transaction), whether communicated by telephone, voic , facsimile, instant messaging, chat rooms, electronic mail, mobile device or other digital or electronic media Industry is not yet capable of complying and on March 30, 2013 the CFTC extended its no-action relief until June 30,

6 Swap Data Reporting Full reporting obligations are now in effect for swap dealers and MSPs, subject only to various forms of no-action relief All other market participants faced a starting date of April 10, 2013 for their reporting obligations. CFTC received numerous requests to defer this April 10 th start date and provide other forms of no-action relief On April 5, the CFTC provided no-action relief for reporting obligations arising from certain inter-affiliate transactions This relief applies to reporting under Parts 45 and 46, not Part 43 which already has a limited exception for reporting non-arm s-length affiliate swaps The relief is broader for swaps between wholly-owned affiliates than for swaps between majority-owned affiliates However, many market participants had been hoping that the CFTC would issue broader temporary relief deferring the general April 10 th start date for at least several months to give non-registered entities additional time to implement the arrangements and systems required for swap data reporting 6

7 Swap Data Reporting (cont d) On April 9, 2013, the CFTC responded to market concerns with broader reporting relief for non-registered (i.e., non-sd/non-msp) entities, as follows: For a Financial Entity, for swaps for which it has reporting responsibility: under each of Part 43 and Part 45, no relief for new IRS or CDS executed from and after April 10th under each of Part 43 and Part 45, new commodity, FX and equity swaps need not be reported until 12:01 a.m. on May 29, 2013, but must backload and report all data for such swaps executed between April 10 and May 29 by no later than 12:01 a.m. on June 29, 2013 (to same extent as required under Part 45 as if no relief granted) all historical swaps (any pre-april 10, 2013 swap for which it has reporting responsibility under Part 46) can be reported by September 30, 2013 For a non-financial Entity, for swaps for which it has reporting responsibility: under each of Part 43 and Part 45, new IRS and CDS need not be reported until 12:01 a.m. on July 1, 2013, but must backload and report all data for such swaps executed between April 10 and July 1 by no later than 12:01 a.m. on August 1, 2013 (to same extent as required under Part 45 as if no relief granted) under each of Part 43 and Part 45, new commodity, FX and equity swaps need not be reported until 12:01 a.m. on August 19, 2013, but must backload and report all data for such swaps executed between April 10 and August 19 by no later than 12:01 a.m. on September 19, 2013 (to same extent as required under Part 45 as if no relief granted) all historical swaps (any pre-april 10, 2013 swap for which it has reporting responsibility under Part 46) can be reported by 12:01 a.m. on October 31,

8 Swap Data Reporting (cont d) A number of troublesome issues have arisen relating to swap data reporting Under Part 45 and 46 of CFTC regulations, if neither party to an off-exchange swap is a swap dealer or MSP and only one party is U.S. Person, the U.S. Person generally has the reporting obligation This has been a particular issue for non-registered foreign banks with U.S. clients IIB submitted no-action request to CFTC No direct relief granted, though April 9 th no-action letter affords some indirect relief For smaller entities, systems burdens can be excessively costly Has spawned a market for third-party service providers to offer reporting services Engaging a service provider, however, does not relieve reporting party of compliance responsibility No action relief has been need to address many problem areas, such as Failure of parties to obtain LEI/CICIs Technological issues Prime brokerage problems 8

9 Swap Data Reporting (cont d) Value and use of data are also being called into question Commissioner O Malia has been very vocal recently in expressing his displeasure with the reporting requirements as well as many other aspects of the CFTC s regulatory rollout. In March, O Malia complained about an impending data nightmare Immediately after the April 9 th no-action relief was granted, he issued a statement listing various complaints, including his concern that the CFTC is facing immense challenges in using data that the three SDRs are reporting due to inconsistent and incomplete reporting, technology shortfalls and integration issues 9

10 Business Conduct Standards External and Internal Business Conduct Standards are coming into effect this spring and summer These are applicable to, and create compliance burdens for, swap dealers and MSPs Other market participants are indirectly affected in several ways: End-users may need to take certain actions in order to continue to be able to trade with swap dealers and MSPs and to elect the end-user clearing exception Non-registered financial entities may need to consider whether the market practices observed by swap dealers and MSPs compel them to adopt some or all practices on a voluntary basis Serious questions remain as to whether the market will be generally ready to implement these standards by the current CFTC deadlines 10

11 Business Conduct Standards (cont d) For External Business Conduct Standards, effective date was May 1, 2013 after being delayed through no-action relief External Business Conduct Standards General standards covering verification of counterparty status, KYC and institutional suitability requirements, disclosure obligations relating to material risks, characteristics and conflicts of interest, daily mark-to-market values, clearing disclosures Additional standards apply to interactions with Special Entities End-user documentation is also to be addressed by this date Swap dealers are attempting to address this area in several ways ISDA Protocol Bi-lateral documentation based on or incorporating portions of the ISDA Protocol (IECA form is prime example) Standalone bi-lateral onboarding documentation ISDA has warned that many market participants would not be on-boarded in time and may be cut off by dealers 11

12 Business Conduct Standards (cont d) The ISDA DFA Protocols consist of August DF Protocol and DF Protocol 2.0 August DF Protocol consists of: ISDA August 2012 DF Protocol Agreement (including form of Adherence Letter) ISDA August 2012 DF Supplement (including Schedules) ISDA August 2012 DF Protocol Questionnaire (and Questionnaire Answer Sheet, which also addresses the additional questions in the Addenda) ISDA August 2012 DF Terms Agreement (to be used where parties do not have a master agreement in place but wish in any event to comply for swaps they execute) Amended and Restated Addendum I to Questionnaire (contains supplement representations regarding active fund and commodity pool operator eligible contract participant categories that became effective on December 31, 2012) Addendum II to Questionnaire (contains supplement representations regarding U.S. person and clearing determination phase-in category, as well as an election not to receive pre-trade mid-market marks for certain FX and other transactions). 12

13 Business Conduct Standards (cont d) What does the ISDA August 2012 DF Protocol address? Entity status Verify identity Confirm ECP status Special Entity status Identify and verify advisory relationships Confirm essential details Presence of advisor/agent Suitability issues Disclosure requirements Confirm availability of regulatory safe harbors 13

14 Business Conduct Standards (cont d) How does the ISDA August 2012 DF Protocol function? The protocol, in effect, establishes a set of standard amendments to ISDA Master Agreements or other agreements governing swap transactions Submit adherence letter via ISDA website $500 fee An agent may adhere on behalf of multiple entities In addition, an adhering entity must complete the Questionnaire using the Answer Sheet and effect delivery of the Questionnaire to those trading parties for which it wishes the Protocol to be effective ISDA and Markit have established ISDA Amend, an online system, to facilitate the delivery of Questionnaires by pairs of counterparties It is also possible to deliver Questionnaires outside of the online system. By adhering to the Protocol and exchanging completed Questionnaires with a counterparty, a party will have amended its covered agreements with such counterparty to include various representations that address many external business conduct requirements and, in particular, are geared to satisfying certain regulatory safe harbors available to SDs and MSPs. 14

15 Business Conduct Standards (cont d) What is the substantive effect of the Protocol? Each adhering party will make the representations in Schedules 1 and 2 (and almost all counterparties will also elect to make the representations in Schedule 3) to the DF Supplement, which cover certain generally applicable matters (e.g., ECP status) Certain adhering parties will make the representations in Schedules 4 through 6 to the DF Supplement, which cover cases where a party has a Designated Evaluation Agent or is an ERISA or non-erisa Special Entity The Protocol is not intended and does not purport to address all external business conduct compliance requirements In addition, ISDA notes that further protocols may be needed to address regulatory requirements that have not yet been adopted. ISDA DF Protocol 2.0 is discussed below. Verification of Commercial End-User Status is addressed in ISDA Protocol

16 Business Conduct Standards (cont d) ISDA Dodd-Frank Protocol 2.0 This second ISDA protocol, which was finalized in late March 2013, goes beyond the external business conduct rules. Addresses rules relating to (1) the end-user exception to clearing; (2) portfolio compression and reconciliation; and (3) swap trading relationship documentation rules, as well as certain related matters. These rules were not addressed in the ISDA August 2012 DF Protocol, because they were finalized by the CFTC after its publication. What does the ISDA Protocol 2.0 consist of? ISDA March 2013 DF Protocol Agreement (including form of Adherence Letter) ISDA March 2013 DF Protocol Supplement (including Schedules with representations) ISDA March 2013 DF Protocol Questionnaire (and Questionnaire Answer Sheet) ISDA March 2013 DF Protocol Master Agreement (used to establish a deemed 2002 ISDA Master Exchange of March Protocol Questionnaire via ISDA Amend started May 20,

17 Business Conduct Standards (cont d) ISDA Dodd-Frank Protocol 2.0 (cont.) What are the substantive provisions of Protocol 2.0? Schedule 1 definitions. Schedule 2 general terms for agreements between the parties and specific inputs applicable to the trade documentation, swap portfolio reconciliation, and confirmation rules as well as an optional termination provision (in case the applicable SD or MSP determines that the related rules do not apply to it) and provisions relating to the end-user exception to clearing. Schedule 3 parties agreements on daily valuations of swaps for the purposes of internal risk management for SDs and MSPs as well as the dispute resolution process for any such risk valuations. Schedule 4 parties agreements on exchange of portfolio data for the purposes of portfolio reconciliation. 17

18 Business Conduct Standards (cont d) ISDA Dodd-Frank Protocol 2.0 (cont.) How does the ISDA Protocol 2.0 function? Adherence by submission of an adherence letter. Exchange of questionnaires with designated counterparties. Completion of the process will amend a party s covered agreements. A separate $500 fee is required to adhere to ISDA Protocol 2.0. ISDA has been pursuing other initiative to help address the compliance challenges presented by business conduct and reporting requirements, including 2013 Reporting Protocol (with alternative side letters), which is designed to assist market participants (not just registered entities) in compliance with trade reporting requirements by facilitating the procurement of written consents to disclosure by counterparties, and Exclusionary Terms and Keepwell, which is designed to help recipients of guarantees deal with the risk of a non-ecp swap guarantor 18

19 Business Conduct Standards (cont d) IECA Approach The International Energy Credit Association ( IECA ) has prepared an amendment agreement designed to simplify the EBC amendment process for energy swap market participants. Applies the basic terms of the August 2012 Protocol (Schedules 1 and 2), with an opt-in for the remaining Schedules. Requires completion and exchange of either the ISDA or IECA questionnaires. Not limited to energy swaps there is nothing stopping any swaps market participant from using it, if it can get its counterparties to agree. 19

20 Business Conduct Standards (cont d) IECA Approach (cont.) Pros: No need to sign up for Protocol ($500 fee). Simple bilateral approach to amending small number of agreements. Uses ISDA Protocol architecture, which is an industry solution, with input from both sell- and buy-side. Cons: For market participants with a large number of counterparties, the Protocol provides a streamlined process for amendment of large volumes of relationship documentation. 20

21 Business Conduct Standards (cont d) Customization of Industry Approaches Some energy derivative users have taken the IECA/ISDA architecture of the IECA approach and tailored it further to cover specific situations (e.g., one counterparty may contemplate registering as an SD/MSP in the future, and so builds in a bifurcated approach to reporting/ebc rules). We have seen some SDs strongly encourage their counterparties to use their own proprietary EBC-oriented amendment documentation (including questionnaires). It appears that these have gained some traction in the marketplace. 21

22 Business Conduct Standards (cont d) As May 1, 2013 commencement date approached, market participants became increasingly concerned over potential for market disruptions CFTC responded with three no-action letters in an attempt to alleviate some of these concerns Letter (April 30, 2013) provided relief for certain prime brokerage activities Subject to conditions, allows prime broker and executing dealer, if both are SDs, to allocate certain external business conduct duties between them Also, provided limited relief for non-sd executing dealers only for exempt FX transactions and only relating to mid-market mark disclosure and scenario analysis requirements Letter (May 1, 2013) expanded prior relief (under Letter 12-46) for failure to disclose pre-trade mid-market marks in deliverable FX transactions to the BIS 31 Currencies (up from 13 currencies) and otherwise same conditions as prior relief Letter (May 2, 2013) provided relief until Sept. 1, 2013 for failure to comply with external business conduct standards for FX transactions that settle no more than seven local business days after trade date 22

23 Business Conduct Standards (cont d) Net effect of these letters is open to debate For example, some have noted that the relief regarding non-disclosure of pretrade mid-market marks in reality may have little effect on what SD needs to do SD need to have system in place anyway for non-fx transactions or trades involving a non-bis 31 currency Moreover, some customers have come to expect these marks Conditions to relief (such as customer agreement) hamper implementation In practice, little may change from the SD s perspective 23

24 Business Conduct Standards (cont d) For Internal Business Conduct Standards and Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements various deadlines apply: Regarding duties of swap dealers/msps and CCO requirements, deadline depends on whether registrant is a U.S. firm or a non-u.s. firm For U.S. firm, requirements are generally now in effect For non-u.s. firm, under CFTC Exemptive Order, deadline is July 12, 2013 Regarding Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements current deadline set by no action relief is July 1, 2013 ISDA Protocols are designed to address various of these requirements 24

25 Mandatory Clearing In general: Section 2(h)(1)(A) of the CEA makes it unlawful to engage in any swap that the CFTC requires to be cleared, unless it is submitted to a registered clearing organization for clearing or an exception is available. The CFTC subjects classes or types of swaps to mandatory clearing by describing them in a clearing determination. To date, there has been only one final clearing determination. Once a final clearing determination has been issued, the related swap types are subject to mandatory clearing on a phased-in timeline based on type of entity (T+90, T+180, T+270) Section 2(h)(7)(A) of the CEA provides an exception to the clearing requirement (the end-user exception ). In the adopting release of the CFTC s final rules addressing the end-user exception, the CFTC announced that it intended to look into a possible additional exception for inter-affiliate swaps. A final rule excepting inter-affiliate trades under specified conditions was adopted in early April

26 Mandatory Clearing (cont d) Mandatory clearing of standard IRS and CDS products commenced on March 11, 2013 for Category 1 entities, with Category 2 entities facing a start date of June 10, End-users will be required to clear these swaps (subject to applicable exceptions) starting September 9, End-user clearing deadline for CDS of itraxx CDS Indices has been extended to October 23, To Clear, or Not to Clear? Possible that some end-users may prefer to clear Some factors end-users may consider when deciding whether to clear: Desire to replace dealer credit risk with CCP credit risk Depending on final OTC margin requirements and the margin levels dealers impose, it may not be much more expensive to clear than not (though until these rules are finalized, hard to make any firm assessment of this). Clearing will require new infrastructure and relationships (SEFs, FCMs). Clearing will require new documentation Some products are not amenable to clearing (i.e., too bespoke and/or illiquid). 26

27 Mandatory Clearing (cont d) Futurization of Swaps Futurization of swaps refers to an effort by some in the industry to restructure swaps as futures in order to avoid certain Dodd-Frank regulatory requirements, including: possibly higher initial margin requirement (swaps have a longer value-at-risk (or, VaR ) charge than futures) for potential SDs and MSPs, futurizing swaps may facilitate avoiding registration (futures do not count toward de minimis or net outward exposure) No EBC rules Reporting (at least no worse than swaps) LSOC (legally separate but with operationally commingled) requirement for initial margin posting relating to cleared swaps In reality, many swaps are the functional equivalent of a series and/or combination of individual futures contracts or options on futures contracts 27

28 Mandatory Clearing (cont d) Futurization of Swaps (cont.) Some exchanges have begun to produce new exchange traded futures products that mimic the behavior of swaps. In 2012, ICE announced it was converting all of its energy swaps into energy futures. CME has also announced it intends to do the same. How far beyond energy swaps will futurization extend? Potential SEF operators are frustrated that delay of finalization of SEF rules is further pushing the cleared swap markets towards futurization. An unintended consequences of Title VII to OTC swaps market. Early in May 2013, ICE announced its intention to launch US credit futures contracts, which could function as alternatives to CDS. Contracts are to be based on Markit CDX and itraxx credit indices Further indication of the potential for futures markets supplanting significant portions of the OTC swaps market 28

29 Mandatory Clearing (cont d) As mandatory clearing progresses, the debate over its utility has become more intense Many argue it will impose an unwarranted liquidity drain on the derivatives market ISDA has made this point on multiple occasions Some market participants have complained that excessive clearing will result in the demise of the customized/bespoke derivatives market which many end-users valued End users have been among the groups raising this concern Others contend that expanding swaps clearing will, as an unintended consequence, result in the shifting to and concentration of risk at CCPs, rather than the elimination of systemic risk as many presume A clearinghouse that clears inappropriate instruments (i.e., swaps that are too illiquid with abrupt price movements) or that are exposed to wrong-way risk could create an unintended risk to the entire clearinghouse with vast systemic consequences Such clearinghouses would likely be the new too big to fail entities 29

30 Mandatory Clearing (cont d) Establishing a clearing relationship As swap clearing becomes a reality, additional or modified documentation will be required by some non-registered entity types (although true corporate end-users may never need to use them) The ISDA Master Agreement may serve a lesser or different role for cleared swaps CFTC regulations place certain constraints on clearing-related documentation Clearing firms currently are proposing the following three types of documents: Futures Account Agreement ( FAA ) Customer agreement for setting up a futures account between an FCM and a customer Cleared OTC Derivatives Addendum to FAA Necessary because FAAs do not address swaps or close-out rights in relation to cleared swaps Execution Agreement New documentation must address consequences if a transaction that is expected to clear is not accepted for clearing 30

31 Mandatory Clearing (cont d) FAA Sets out the bilateral relationship between the clearing member and its customer Not standardized, differs among dealers Historically used for trading futures or options on futures Sell-side friendly and, in relation to futures, not highly negotiated Unilateral hair trigger defaults, with little or no cure period Discretion of FCM to charge whatever margin it believes is required to protect its interests, including over and above what is required by the clearinghouse Aggressive cross-collateralization (including other relationships with the FCM and, frequently, their affiliates) Limited FCM liability provisions (e.g., only gross negligence and willful misconduct) Broad indemnification obligations on customer 31

32 Mandatory Clearing (cont d) FAA (cont.) In negotiations to clear derivatives under the FAA, customer typically attempts to make FAA more like an ISDA Master Agreement by: limiting defaults against customer; including cure periods for defaults; and limiting the amount of margin that FCM may require its customer to post (for example, by requiring FCM to rely on DCO margin calculations). In addition, customers frequently attempt to negotiate for a commitment to clear (with mixed results). 32

33 Mandatory Clearing (cont d) Cleared OTC Derivatives Addendum to FAA Addendum makes FAA applicable to cleared swaps After an initial draft was released by ISDA and the Futures Industry Association ( FIA ) in 2011, some dealers determined that they would need legal opinions in relation to netting for regulatory cap purposes The final standardized document was published in August 2012 As discussed below, the final document resolved the dealers netting opinion concerns by elaborating on close-out of swaps upon termination: Some market participants had wanted to follow futures model (menu of broad rights upon termination, not especially transparent) Others wanted to follow an ISDA-like model (market quotation or similar, more transparent approach) 33

34 Mandatory Clearing (cont d) Cleared OTC Derivatives Addendum to FAA In addition to addressing close out rights, Addendum (or other forms that may be used) will typically: Contain representations as to authority, non-reliance language and tax provisions. Require a clearing member to transfer ( port ) the customer s trades to another clearing member upon client s request in accordance with National Futures Association rules. Many market participants will need to negotiate the Cleared OTC Swaps Addendum Some have already negotiated and agreed to the prior version and will likely need to renegotiate based on the final version 34

35 Mandatory Clearing (cont d) Cleared OTC Derivatives Addendum to FAA (cont.) As compared to its earlier version, the newly published Cleared OTC Swaps Addendum has the following significant features: Covers all derivatives transactions amenable to clearing (including forwards and options), not just swaps Liquidation provision (Section 7): Provides detailed liquidation and close out methodology for clearing members Following a Close-out Event a clearing member may execute Close-out Transactions, but also may execute Risk-reducing Transactions and Mitigation Transactions All such close out activity is to occur in accordance with a defined Liquidation Standard that is based on good faith and commercially reasonable procedures, though it is also recognized that a clearing member may have to effect a close out in circumstances where no prevailing market prices or bona fide quotations are available However, if despite its commercially reasonable efforts, a clearing member determines it cannot satisfy the Liquidation Standard based on quotations, prices and other market data, then it may base its valuation on internal sources 35

36 Mandatory Clearing (cont d) Cleared OTC Derivatives Addendum to FAA (cont.) Another significant feature of the Addendum is an expanded set of tax provisions (Section 8), including: references to FATCA; gross up and indemnity provisions; tax liquidation event provisions; and tax documentation requirements. 36

37 Mandatory Clearing (cont d) Cleared Swaps Execution Agreement This agreement sets out the procedure for trade affirmation or rejection and states what happens if a transaction that is expected to clear is not accepted for clearing Each of the parties to the original transaction (dealer and client) represents that it has a clearing agreement with a clearing member Once a transaction is accepted for clearing, neither dealer nor client has any obligation to the other (DCO becomes a party to both sides of transaction) 37

38 Mandatory Clearing (cont d) Cleared Swaps Execution Agreement If a trade does not clear, then unless otherwise agreed, at the option of the dealer: The dealer (if it is a clearing member) may elect to accept the transaction in its capacity as clearing member, or have a clearing member affiliate do so; If the transaction is not legally required to be cleared, the dealer may enter into the transaction on a bilateral (uncleared) basis; or The transaction may be terminated at the dealer s side of the market if the transaction s failure to clear is caused by the customer or its clearing member (including the customer s clearing member breaching a position limit imposed by the relevant DCO) at the customer s side of the market if the transaction s failure to clear is caused by the dealer or its clearing member (including the dealer s clearing member breaching a position limit imposed by the relevant DCO) at mid-market in certain no-fault scenarios 38

39 Mandatory Clearing (cont d) Cleared Swaps Execution Agreement In accordance with recent CFTC rules, each Execution Agreement can only be bilateral, between dealer and customer As previously proposed by FIA and ISDA, the Execution Agreement would have been trilateral, with optional annexes under which either party s clearing member could become a party to the agreement Trilateral arrangement was a major point of contention with the buy-side, which was concerned that clearing members would steer trades to their own affiliates and restrict the dealers with which the buy-side could transact Market consensus that CFTC final rules effectively prohibit a trilateral agreement 39

40 Mandatory Clearing (cont d) Cleared Swaps Execution Agreement (cont.) Under those rules, among many other restrictions, clearing members may not enter into any arrangement that: discloses to the clearing member the identity of the member s customer s original executing counterparty or restricts the size of the position a member s customer may take with any individual counterparty, apart from an overall limit for all positions held by the customer at the clearing member Manner in which Execution Agreement will be used in evolving cleared swaps market remains unclear If a swap is executed on a DCM, it is likely to trade and clear like a futures contract basic fallbacks as are found in the standard FIA futures give-up agreement should be sufficient in such case If a swap is executed bilaterally, then in general it is a swap that the parties have the right not to clear, so Execution Agreement is only relevant for in case of voluntary clearing In theory could have mandatorily cleared swap that is not available to trade on a SEF, but that is itself a dangerous risk scenario for a CCP So Execution Agreement appears most relevant to the SEF world, which remains unsettled as CFTC has only just finalized its SEF regulations 40

41 Mandatory Clearing/End-User Exception Clearing exception for end-users An end-user may be eligible for an exception from the clearing and trade execution requirements under CEA Section 2(h)(7) and CFTC Rule (formerly Rule 39.6) In order to qualify for the end-user exception, an end-user: Cannot be a financial entity (with limited exceptions); Must use swap to hedge or mitigate commercial risk ; and Must notify the CFTC of how the entity meets its financial obligations associated with entering into non-cleared swaps 41

42 Mandatory Clearing/End-User Exception (cont d) A financial entity includes: SDs, MSPs; Commodity pool operators; Private funds; ERISA plans; or Persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature (defined under Section 4(k) of the Bank Holding Company Act), including securities underwriting and dealing, investment advisory activities, insurance agency or brokerage, and extending credit. On May 16, 2013, the American Securitization Forum (ASF) submitted a noaction request to the CFTC seeking an explicit exemption for securitization swaps from mandatory clearing requirements ASF states that the relief it is seeking is confirmation that swaps used in securitizations that include special provisions to support their legal structures and/or credit ratings are NOT subject to the clearing mandate if no derivatives clearing organization clears swaps with such provisions. Once OTC Margin rules are finalized, would expect follow on no-action request to exempt securitization vehicles from such rules Viability of securitization market will be affected by how CFTC responds to such requests 42

43 Mandatory Clearing/End-User Exception (cont d) Financial entity exceptions: Captive finance affiliate and the 90% rule Primary business is providing financing; Uses derivatives for the purpose of hedging commercial risks related to interest rate or FX exposure; 90 percent or more of which arise from financing that facilitates the purchase or lease of products; and 90 percent or more of such products are manufactured by the parent company or another subsidiary of the parent company Acting as an agent for its non-financial affiliates swaps used to hedge or mitigate commercial risk Small financial institution banks, savings associations, farm credit system institutions, and credit unions with total assets of $10 billion or less 43

44 Mandatory Clearing/End-User Exception (cont d) To qualify for the end-user exception, a swap must be used to hedge or mitigate commercial risk, which requires that a swap: qualifies as a bona fide hedging under the CEA position limit rules, or qualifies for hedging treatment under FASB, or be economically appropriate to reduce, in the ordinary course of business, risks arising from a change in: the value of assets that the entity owns, produces, manufactures, processes or merchandises; the value of liabilities due to fluctuations in interest, currency or foreign exchange rates, or the interest, currency or foreign exchange rate exposures arising from a person s assets, services or liabilities; and not be used for a purpose that is in the nature of speculation, investing or trading and not be used to hedge or mitigate the risk of another swap, unless that other swap itself is used to hedge or mitigate commercial risk. 44

45 Mandatory Clearing/End-User Exception (cont d) Actions to be taken by end-users in connection with the end-user exception: Board/Committee approval (public companies only) Reporting Enter into the ISDA DF Protocol (or similar arrangement) Obtain an LEI/CICI Evaluate margining arrangements Corporate actions to be taken by end-users that are reporting companies Board or an authorized committee must approve decision to rely on end user exception A committee may be authorized by the Board to review the company s swaps policies and evaluate the company s reliance on the end user exception Also covers a reporting company s controlled subs 45

46 Mandatory Clearing/End-User Exception (cont d) Reporting for End-Users Reporting counterparty reports the following data points to an SDR (or the CFTC): whether the swap is subject to the end-user exception; the identity of the exempt end-user; and whether the end-user has filed an annual filing with the SDR (or the CFTC). End-user is required to report annually (or, if it chooses, on a trade-by-trade basis) to an SDR (or the CFTC) containing the following information: whether it is a financial entity or a finance affiliate; whether the swap hedges or mitigates commercial risk; whether it is an SEC reporting company, and, if so, whether the appropriate committee of its board of directors has reviewed and approved the decision to enter into swaps that are exempt from clearing; and how it generally expects to meet its financial obligations: a credit support agreement; pledged assets; a third-party guarantee; its own available financial resources; or other means. 46

47 Mandatory Clearing/End-User Exception (cont d) As discussed above, ISDA Protocol 2.0 is partially responsive to the election of the end-user exception: end-user to notify SD/MSP counterparty if it intends not to clear a swap based on the end-user exception (may be a standing notice for multiple swaps); end-user represents that it is eligible for the exception; and either end-user is deemed to represent that it has filed an annual end-user report with an SDR (or the CFTC) in a filing that is still effective; or it has notified its counterparty that it has not filed an annual report; it is not a financial entity; it is using the swap to hedge or mitigate commercial risk; and it generally meets its financial obligations associated with entering into swaps. And what about non-financial entity inter-affiliate trades? Inter-affiliate trades would appear to be able to take advantage of the end-user exception, subject to complying with SDR reporting and other requirements However, new rule exempting interaffiliate trades should simplify this area 47

48 Mandatory Clearing/Affiliate Exception The CFTC released final Rule on April 1, 2013 CFTC has made clear it anticipates that the exemption will be used primarily for trades between affiliated financial entities that are less likely to be able to use the end-user exception The rule allows the eligible affiliate counterparties to a swap to elect not to clear a swap that would otherwise be subject to mandatory clearing, subject to the following limitations: Only majority-owned affiliates eligible for exemption Both counterparties would have to elect not to clear the swap Swap trading relationship documentation required between the parties Swap must be subject to a centralized risk management program within the group of affiliated entities that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps 48

49 Mandatory Clearing/Affiliate Exception (cont d) Eligible Affiliate Counterparties one counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties; and the financial statements of both counterparties are consolidated under GAAP or International Financial Reporting Standards. Swap Trading Relationship Documentation For SDs/MSPs, an agreement that contains all terms governing the trading relationship between the affiliates, incl. payment obligations, netting of payments, events of default or other termination events, calculation and netting upon termination, transfer of rights and obligations, governing law, valuation and dispute resolution procedures (compliance with business conduct rule satisfies the rule). For non-sds/msps, the terms of the swap must be documented in a written swap trading relationship document that includes all terms governing the trading relationship between the counterparties. 49

50 Mandatory Clearing/Affiliate Exception (cont d) Cross-Border Issues If one of the affiliates is located outside the U.S., and such affiliate enters into any swaps with unaffiliated third parties, one of the following conditions must be satisfied with respect to such third party swaps: Cleared under CEA Section 2(h); Cleared under a comparable and comprehensive but not necessarily identical foreign clearing regime; They are subject to an exception or exemption from clearing pursuant to CEA Section 2(h)(7) or Part 50 of the CFTC s regulations; They are subject to a comparable and comprehensive but not necessarily identical exception or exemption from clearing pursuant to a comparable and comprehensive but not necessarily identical foreign clearing mandate; or Cleared on a DCO or a clearing organization assessed as being in compliance with the Principles for Financial Market Infrastructures. 50

51 Mandatory Clearing/Affiliate Exception (cont d) Cross-Border Issues (cont.) 1-year phase-in for cross-border requirement (EU/Japan/Singapore) Until March 11, 2014, collection of full VM required on all swaps between the EU/Japanese/Singaporean counterparty and unaffiliated third parties. During the phase-in period, the entire cross-border restriction (incl. VM) does not apply where (i) neither counterparty is affiliated with an SD or MSP and (ii) the affiliate that majority owns the other (or the third party affiliate that majority owns both counterparties) is not a financial entity. 1-year phase-in for cross-border requirement (Other Foreign Jurisdictions) Until March 11, 2014, collection of full VM required on all swaps between the non-u.s. counterparty and unaffiliated third parties. Phase-in relief only available if the aggregate notional of swaps of a class subject to mandatory clearing under CEA Section 2(h) entered into by a U.S. entity with its affiliates in such jurisdictions does not exceed 5% of the aggregate notional amount of swaps of such class executed by such U.S. affiliate (calculated on a quarterly basis). 51

52 Mandatory Clearing/Affiliate Exception (cont d) Centralized Risk Management Program The adopting release suggests that if a corporate group already has a centralized risk management program in place that performs this function, that it is likely that the program would fulfill the requirements of the final rule. If at least one of the eligible affiliate counterparties is an SD or MSP, this requirement can be satisfied by complying with the requirements of CFTC Regulation Margin The final rule does not require marking-to-market or payment of IM or VM (the proposed rule had required daily marking-to-market and posting of VM for most trades between affiliated financial entities, except in the case of 100% commonly owned and commonly guaranteed affiliates where the common guarantor is also 100% commonly owned). 52

53 Mandatory Clearing/Affiliate Exception (cont d) Reporting Requirements Reporting counterparty (selected pursuant to Part 45) must provide the following information to an SDR or, if no SDR exists, to the CFTC: Confirmation that both counterparties to the swap are electing not to clear the swap and that each of the counterparties satisfies the requirements to claim the exemption (may not be reported annually); For each counterparty, how it generally meets its financial obligations associated with entering into uncleared swaps (may be reported annually); and If a counterparty is a public company, (i) the SEC Central Index Key number for that counterparty and (ii) acknowledgment that an appropriate committee of the board of directors of that counterparty has reviewed and approved the decision not to clear the swap (may be reported annually). 53

54 Margin Requirements There will be margining requirements for uncleared (OTC) swaps. The margin requirements have not been finalized, although it is anticipated that levels could be comparable to or higher than those for cleared swaps (keeping in mind, however, that clearing houses and FCMs can increase the level of margin on a cleared swap). Once margin requirements are finalized, end-users will need to evaluate their credit support arrangements with their swap dealer counterparties and determine whether any modifications are necessary. Title VII gives end-users the right to require that any initial margin they post be segregated and, if it chooses, held by a third-party custodian. If the end-user opts to have collateral held by a custodian, it will need to negotiate and enter into custodial arrangements. 54

55 Margin Requirements (cont d) Cleared Swaps Margin posted in respect of cleared swaps is required to be legally separate but operationally commingled ( LSOC ) to limit fellow customer risk. For cleared swaps, clearinghouses will drive how much margin will be required for swaps. 55

56 Margin Requirements (cont d) Basel Committee on Banking Supervision ( BCBS ) and the International Organization of Securities Commissions ( IOSCO ) recently came out with a second position paper on margin. While not law, it is influencing the discussion on margin First BCBS/IOSCO position paper s high margin recommendations caused widespread liquidity and pricing concerns Second paper still causing heartburn Mandatory two-way exchange of IM on a gross basis Mandatory full segregation No re-hypothecation/re-use of IM Limits on portfolio margining Mandatory IM and VM exchanges for inter-affiliate trades Continued market concerns regarding liquidity and systemic risk Mandatory margin for non-cleared trades would profoundly affect end-users Increased cost of hedging 56

57 Margin Requirements (cont d) ISDA submitted a 27-page comment letter to BCBS/IOSCO detailing its concerns, including Liquidity drains and cyclicality concerns with proposed IM levels Inappropriateness of imposing margin requirements on highly liquid FX transactions The need for cross-product and portfolio margining Concerns over proposed collateral eligibility and haircuts The need for international coordination and appropriate phase in periods OTC margin is proving to be one of the most contentious areas of swap regulation. Market participants and regulators continue to debate Will excess levels of IM for OTC swaps in effect lead to the end of the highly customized swaps market? Will the failure to harmonize margin regimes internationally lead to regulatory arbitrage across the global swaps market? Will the margin regimes in the global market have a collective adverse liquidity effect that result in less hedging and greater risk retention by entities that otherwise would hedge their risks? 57

58 SEF Structure and Requirements Swap Execution Facilities (SEFs) To promote pre-trade price transparency, Dodd-Frank requires that all swaps that are required to be cleared be executed on a designated contract market ( DCM ) or a SEF, unless the swap type is not available for trading on any DCM or SEF, or another clearing exception applies. SEFs are a brand new type of regulated marketplace created by Dodd-Frank. In September 2011, The CFTC proposed rules governing SEFs (amendments to the CFTC s Part 37 Rules) establishing specific transparency requirements relating to making bids, offers and trades available to all market participants. The proposed rules set a minimum requirement of five requests for quotes (RFQ) as well cross-trading rules on the timing of trades. 58

59 SEF Structure and Requirements (cont d) Since the issuance of these proposed rules, trading requirements for SEFs has been one of the most contentious issues debated among regulators and market participants, with the following issues being at the center of the debate: Permitted execution parameters, such as RQF minimums versus voice brokering or direct single inquiries ISDA recently published the results of a buy-side survey showing the must of the buy-side community is concerned that establishing a high minimum quotation requirement may harm execution and liquidity and even conflict with investment policies Available to trade standards, which affect whether a swap must be executed on a SEF or DCM and in reality could influence which swaps are designated for mandatory clearing Block trade levels which will likely affect the extent to which wholesale business can be effectively conducted via a SEF, but outside of the ordinary multi-lateral execution regime The failure to finalize SEF rules promptly has arguably contributed to the futurization trend noted earlier. 59

60 SEF Structure and Requirements (cont d) On May 16 th, the CFTC approved final rules for SEFs and related matters, in particular addressing the following key points For required transactions (except block trades), must use Order Book or RFQ system, and for RFQ system, initially two and eventually after phase in period three quotes will be required Block sizes for each asset category will at first generally be calculated either based on levels set by DCMs or at 50% of notional amount calculation, with levels generally increasing after phase in period to 67% of notional amount calculation Available to trade status of a swap will be determined and certified by SEFs/DCMs, and then subject to public comment during CFTC review process Voice execution permissible but must still comply with other minimum execution requirements, so likely to be useful only for block trades or permitted transactions (i.e., those not subject to mandatory DCM or SEF trade execution) 15-second delay applies to cross-trades or dealer executing opposite customer via Order Book, but not RFQ system Some immediate criticisms of new rules include: Basic requirement for RFQs not mandated by statute and initial RFQ and block requirements are based on inadequate data Increases in RFQs and block sizes occur automatically, without regard to data that accumulate during interim period Available to trade determination effectively left to SEFs and DCMs Overly restrictive and prescriptive regime may drive more trading offshore 60