Derivatives Regulation Update: Latest Developments and What to Expect in 2016

Transcription

1 Derivatives Regulation Update: Latest Developments and What to Expect in 2016 Thursday, January 14, 2016, 12:00PM 1:30PM EST Presenters: Julian Hammar, Of Counsel, Morrison & Foerster LLP James Schwartz, Of Counsel, Morrison & Foerster LLP 1. Presentation 2. Morrison & Foerster LLP Client Alert: CFTC Proposes Regulation of Automated Trading January 13, Morrison & Foerster LLP Client Alert: CFTC Adopts Uncleared Swaps Margin Rules December 23, Morrison & Foerster LLP Client Alert: The SEC s Registration Rules for Security-Based Swap Dealers August 28, 2015 Morrison & Foerster LLP

2 mofo.com Derivatives Regulation Update: Latest Developments and What to Expect in 2016 January 14, 2016 Presented By Julian Hammar James Schwartz

3 Overview Today s topics will include the following: Final margin rules for uncleared swaps of the CFTC and the prudential regulators; SEC s proposed rules for investment companies use of derivatives; ISDA 2015 Universal Resolution Stay Protocol and related matters; CFTC s proposed rules for automated trading on U.S. designated contract markets; CFTC s preliminary report relating to potential changes in the current de minimis swap dealing threshold for the swap dealer registration requirement; and Expectations for

4 Background Regarding Margin Margin is a significant economic issue that the swap market will need to address in accordance with regulations that have just now been finalized. One of the criticisms of the swap market in the wake of the financial crisis of 2008 was that it did not require parties to provide margin (that is, collateral) to secure their obligations to each other. In practice, in many cases before and (even more so) after the crisis, parties have provided collateral ( variation margin ) reflecting the current ( mark-to-market ) value of their obligations to each other. Dodd-Frank requires regulators to draft rules requiring margin for bilateral swaps that will not be cleared at a clearinghouse (cleared swaps, in contrast, are subject to margin requirements imposed by clearinghouses and their members). 3

5 Background Regarding Margin The regulators have drafted rules for swaps that draw heavily on traditional margin practices in the futures market. Most significantly, the regulations will require many parties (other than commercial end-users) to provide initial margin, which is intended to account for potential changes in value during the time when a swap is in the process of being terminated. Initial margin, when required, will be segregated and not subject to rehypothecation or other use and, as such, a significant new cost for swap dealers and certain other financial entities. It remains to be seen how the market will respond to the margin requirements, and the extent to which, at the margin (so to speak), products other than OTC swaps (for example, futures) may increasingly be used in place of OTC swaps. 4

6 CFTC and Prudential Regulator Final Rules On December 16, 2015, the Commodity Futures Trading Commission ( CFTC ) adopted final rules to impose margin requirements on uncleared swaps entered into by swap dealers and major swap participants subject to CFTC regulation, referred to as Covered Swap Entities or CSEs, that were re-proposed last fall (originally proposed in 2011) in order to take into account the framework published by the Basel Committee on Banking supervision ( BCBS ) and IOSCO published in September The CFTC also adopted an interim final rule to exclude from the requirements most uncleared swaps that swap entities enter into with commercial end users, financial institutions with $10 billion or less in total assets, and certain other entities consistent with the requirements of the Business Risk Mitigation and Price Stabilization Act of

7 CFTC and Prudential Regulator Final Rules The CFTC s final rules are largely the same as the final rules and interim final rule adopted in October 2015 by the Prudential Regulators (the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency) for swap entities subject to their supervision (essentially swap dealers, major swap participants, security-based swap dealers and major security-based swap participants that are banks), with a few important differences. Both sets of rules become effective on April 1, 2016, with a phased-in compliance schedule beginning in September

8 Overview of the Final Rules In general, the CFTC s and Prudential Regulators Rules will: Require swap entities, subject to a $50 million threshold below which initial margin need not be posted or collected, to bilaterally exchange initial margin with other swap entities and with a broad range of financial end users whose use of uncleared swaps meet a notional amount-based threshold ( material swaps exposure ), all such initial margin to be segregated generally with a third-party custodian (not affiliated with either counterparty) and not subject to rehypothecation or other use by the custodian*; Permit the calculation of initial margin by means of either a model-based method or a table-based method; * The final rules clarify that cash collateral may be held in a general deposit account with the custodian if the funds are used to purchase other forms of eligible collateral, is segregated, and the purchase occurs within a reasonable period. 7

9 Overview of the Final Rules Impose a significantly higher initial margin requirement on uncleared swaps as compared to cleared swaps by requiring that initial margin models use a 10 business day closeout horizon for most uncleared swaps as opposed to a 5 business day horizon for most cleared swaps in order to incentivize clearing -- this is not a requirement of Dodd-Frank, which only requires regulators to issue rules to provide for margin for uncleared swaps; and Require swap entities to exchange variation margin with swap entities and with a broad array of financial end users (without regard to the existence of material swaps exposure) without any threshold. 8

10 Scope of the Final Rules Under both sets of rules, a CSE will not be required to collect or post specified amounts of initial or variation margin on swaps with counterparties that are not Swap Entities or financial end users such counterparties are described in the Prudential Regulators rules as Other Counterparties, and as Non-Financial End Users in the CFTC s rules. The final rules retains the financial end user definition used in the Re-Proposal (a list of list of enumerated financial market status types under various U.S. statutes and regulations including banks, brokerdealers, investment companies, insurance companies, commodity pools and ERISA plans) which was intended to provide greater clarity than the financial entity definition used in the statutory exemption from mandatory clearing in the Commodity Exchange Act (CEA). Expressly excluded from the financial end user definition are sovereign entities (central governments or an agency or department thereof) and multilateral development banks. 9

11 Interim Final Rule Exemption In addition, in order to implement the requirements of the Business Risk Mitigation and Price Stabilization Act of 2015, the CFTC s and Prudential Regulators separate Interim Final Rules provide that the requirements of the margin rules will not apply where the counterparty would be eligible for: An exemption from mandatory clearing under Section 2(h)(7)(A) of the CEA or Section 3C(g)(1) of the Securities Exchange Act of 1934 ( Exchange Act ) (i.e., a non-financial entity using the swap to hedge or mitigate commercial risk, certain small financial institutions and captive finance companies); An exemption under CEA Section 4(c)(1) for cooperative entities that would otherwise be subject to the requirement to clear; or The exemption for affiliates under CEA Section 2(h)(7)(D) or Exchange Act Section 3C(g)(4) (i.e., affiliates that act as an agent). 10

12 Other Counterparties/Non-Financial End Users Under the Prudential Regulators rules, if an other counterparty does not qualify for the interim final rule exemption (e.g., a commercial end user that is not hedging or mitigating commercial risk), is exempt from the definition of financial end user (e.g. an MDB), or is a financial end user without material swaps exposure for purposes of initial margin (who are not subject to the rule s initial margin requirements), a Covered Swap Entity must collect margin, if any, from such entities as the CSE determines is appropriate in its overall credit risk management of its exposure to the customer. The CFTC s release does not require this determination, and also removes the requirement contained in the CFTC s re-proposal that CSEs calculate hypothetical margin requirements for swaps with nonfinancial end users, citing the administrative burden and that other CFTC rules should address monitoring of risk exposures for these entities. 11

13 Key Changes to the Re-Proposals The CFTC s and Prudential Regulators final rules also make a number of key changes to the rules as they were re-proposed in the fall of These changes include: Modification to the Material Swaps Exposure amount and Initial Margin Threshold; Revision of the Definition of Affiliate; Expansion of eligible collateral for Initial and Variation Margin; Modification for Eligible Master Netting Agreements; Adoption of an Inter-Affiliate Exemption from Initial Margin; and Changes to the phased-in compliance schedule. 12

14 Notable Differences between the CFTC s and Prudential Regulators Rules The CFTC s final rules have a few notable differences from the Prudential Regulators final rules, including: Providing for a broader exemption from swaps between Covered Swap Entities and their affiliates than the more limited exemption provided by the Prudential Regulators; Delegating authority to the National Futures Association ( NFA ), the self-regulatory organization in the futures and swaps industry, to approve initial margin models, which could also be approved by the CFTC (the Prudential Regulators would undertake their own approvals); Excluding from the financial end user definition treasury affiliates that qualify for an exemption from mandatory clearing that the CFTC has exempted by rule; Providing for greater specificity regarding variation margin calculations; and Not addressing cross-border application of the rules, which are being considered by the CFTC in a separate proposal. 13

15 Financial End Users with Material Swaps Exposure The threshold for determining whether a financial end user has material swaps exposure has been increased under the CFTC s and Prudential Regulators final rules from $3 billion to $8 billion of average daily aggregate notional amount of swaps activity over a 3- month period (determined by reference to the swaps activity of the financial end user and its affiliate(s)), which is more closely aligned with the BCBS-IOSCO Framework. This change will reduce the number of entities from which swap entities must post and collect initial margin, which is required under the rules for swaps between swap entities and financial end users with material swaps exposure. It will also level the playing field between swap entities subject to U.S. rules and those subject to rules of foreign jurisdictions, such as the European Union and Japan, which have more closely followed the BCBS-IOSCO Framework. 14

16 Financial End Users with Material Swaps Exposure Final rules also clarify that swaps that are eligible for the exemption under the interim final rule do not count toward the threshold. In a new provision, the Final Rules clarify the consequences of a change in a counterparty s status: If a change would make the rules stricter, such as when a financial end user becomes a financial end user with material swaps exposure, the stricter rules would apply for new swaps entered into after the change. Where a change would make the rules less strict (such as when the exposure of a financial end user with material swaps exposure falls below the $8 billion threshold), the swap entity may comply with less strict requirements for all outstanding swaps. Accordingly, initial margin, which is not required for swaps with financial end users that do not have material swaps exposure, would no longer apply with respect to all swaps. 15

17 Threshold and Minimum Transfer Amount Certain other amounts in addition to the material swaps exposure threshold have been modified from the re-proposals to take into account changed exchange rates that have occurred since the reproposals were issued: The initial margin threshold amount (i.e., the amount under which initial margin need not be collected) has been reduced from $65 million in the re-proposals to $50 million in the final rules. In addition, the minimum transfer amount across initial and variation margin has been reduced from $650,000 to $500,000. Regulators intend to make adjustments to the rules to take into account changes in exchange rates on a periodic basis as warranted. 16

18 Definition of Affiliate The CFTC s and Prudential Regulators final rules provide for a definition of affiliate that is aligned with established accounting standards rather than relying on the control test contained in the Re-Proposal. The Re-Proposals contained a low level of control for affiliation to exist: Only 25 percent (not 50 percent or more) of the ownership or control, directly or indirectly, of a class of voting securities or total equity. Final rules provide that affiliation exits if a company consolidates the other (or both companies are consolidated with a third company) on financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles, the International Financial Reporting Standards, or other similar standards. 17

19 Definition of Affiliate For a company not subject to such principles or standards, affiliation exists if it would have been consolidated under such principles or standards. The change may make it easier for companies to determine whether, for example, a financial end user has material swaps exposure (which must be calculated to include the exposures of its affiliates). Prudential Regulator Rules include a provision that the relevant regulator has the authority to designate any entity that provides significant support to, or is materially subject to the risks or losses of, another company as an affiliate of that company (even if the entity is not otherwise an affiliate under the rule). The CFTC s rules do not contain a similar provision. 18

20 Eligible Collateral The CFTC s and Prudential Regulators final rules also expand the types of eligible collateral for initial and variation margin. Initial margin is intended to secure potential future exposure -- that is, adverse changes in value that may arise during the period of time when a swap or group of swaps is being closed out -- and is in addition to variation margin, which corresponds to changes in markto-market value of a swap. Under the final rules, eligible collateral types for Initial Margin include U.S. Treasuries, GSE securities, securities issued by BIS, ECB, IMF and MDBs, publicly traded debt (other than asset-backed securities), publicly-traded equities in certain indices and gold, but not securities issued by the pledgor or its affiliate or banks and similar entities. In addition, the final rules permit redeemable securities in certain money market mutual funds that meet specific requirements. 19

21 Eligible Collateral Variation Margin may include major currencies (defined in the final rules) in addition to U.S. dollars and the currency of settlement, while the re-proposal would not have permitted major currencies. In addition, the final rules permit non-cash collateral eligible to be used for initial margin to serve as variation margin for swaps between a covered swap entity and a financial end user (but not for swaps between swap entities), while the re-proposals only permitted cash collateral for variation margin. This change may be welcomed by certain financial entities, such as insurance companies, that hold significant reserves of bonds and other securities and commented that the restriction to cash-only variation margin would reduce their investment returns. The CFTC s rules include a provision, not included in the Prudential Regulators rules, that requires that variation margin calculations use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, or other objective criteria. 20

22 Approval of Initial Margin Models CFTC s and Prudential Regulators final rules differ in terms of the approval of initial margin models. Both sets of final rules, like the re-proposals, impose stringent regulatory requirements on initial margin models, including: Written approval of the relevant regulator for use of initial margin models, Demonstration on an ongoing basis that the model satisfies all of the requirements under the rules, and Prior notice to the relevant regulator before making changes to the model or its assumptions. 21

23 Approval of Initial Margin Models However, the CFTC s final rules would provide a registered futures association (the NFA is the only registered futures association) with authority to approve initial margin models in addition to the CFTC. The Prudential Regulators final rules do not contain a similar provision. All approvals of initial margin models for Covered Swap Entities subject to their supervision will have to be approved by the relevant Prudential Regulator. The CFTC notes that it or the NFA will coordinate with the Prudential Regulators in order to avoid duplicative efforts and to provide expedited approval of Prudential Regulator-approved models. 22

24 Eligible Master Netting Agreements (EMNAs) Relief also was provided from the re-proposals with respect to precompliance date and post-compliance date swaps subject to a single eligible master netting agreement ( EMNA ). For swaps subject to an EMNA, variation margin can be calculated on a net basis and risk offsets can be recognized within asset classes for calculating initial margin. Under the re-proposals, although the rules applied only to swaps entered into after the relevant compliance date, transactions subject to an EMNA applicable to pre-compliance date transactions would be subject to margin requirements for all swaps under the EMNA. Accordingly, counterparties would have to enter into a separate EMNA for new swaps, which received criticism from commenters who argued that this would reduce netting sets and thus increase systemic risk. 23

25 EMNAs The CFTC s and Prudential Regulators final rules permit counterparties to document pre- and post-compliance date swaps as separate portfolios for netting purposes under the same EMNA covered by separate credit support annexes. Accordingly, netting portfolios that contain only uncleared swaps entered before the applicable compliance date are not subject to the final rules. Also with regard to EMNAs, the definition of EMNA is amended to provide that impermissible walk away clauses do not include clauses that only suspend payment obligations when a counterparty defaults. 24

26 EMNAs EMNAs, as under the re-proposals, are subject to a requirement that a swap entity conduct sufficient legal review to conclude with a wellfounded basis that among other things, the contract would be found legal, binding, and enforceable under the law of the relevant jurisdiction. Although unqualified legal opinions are not required, the legal review must be in writing. Prudential Regulator Rules provide that, if a netting agreement does not qualify as an EMNA, the CSE must collect VM on a gross basis but may post on a net basis; no similar provision in CFTC Rules. 25

27 Inter-Affiliate Swaps Exemption Neither the CFTC s nor the Prudential Regulators re-proposals contained an exemption from the margin requirements for swaps between a Covered Swap Entity and its affiliates. Commenters urged the regulators to provide relief in this area, because such inter-affiliate swaps do not create new risk, but rather shift risk within a corporate entity and because requiring initial margin for such trades would unnecessarily tie up capital and would be inconsistent with the CFTC s exemption from mandatory clearing for inter-affiliate swaps, which did not impose such a requirement. The Prudential Regulators and CFTC s final rules provide for an inter-affiliate swaps exemption from the margin requirements, but differ on the treatment of such swaps. 26

28 Inter-Affiliate Swaps Exemption Under the Prudential Regulators final rules, the margin requirements generally apply to swaps between a Covered Swap Entity and its affiliates (unless otherwise exempt), except that: A swap entity is not required to post initial margin to an affiliated counterparty. The swap entity must calculate the amount of initial margin that would be required to be posted to an affiliate (that is a financial end user with material swaps exposure) and provide documentation of such amount on a daily basis. Initial margin must be collected from an affiliate that is a financial entity with material swaps exposure, but the threshold is $20 million (rather than the generally applicable $50 million threshold). 27

29 Inter-Affiliate Swaps Exemption No relief for variation margin: Variation margin must be posted to and collected from financial end user affiliates by swap entities. Initial margin in the form of non-cash collateral for swaps between a swap entity and its affiliates may be held by a custodian that is an affiliate of the CSE or by the CSE itself (rather than an unaffiliated third party as required for uncleared swaps with non-affiliates). The Final Rule allows a covered swap entity to use a 5-day time horizon for modelling the initial margin requirement, rather than the generally applicable10-day horizon, for swaps that are required to be cleared but which are exempt because of a clearing exemption for inter-affiliate swaps. Note that if an affiliate of a swap entity is itself a swap entity, then both swap entities must collect margin, and thus there is no relief from the posting requirement. 28

30 Inter-Affiliate Swaps Exemption The CFTC s final rules provide for a broader exemption from initial margin requirements than the Prudential Regulators rules. Under the CFTC s final rules, a CSE is generally not required to collect initial margin from a margin affiliate (including another swap entity), provided that the CSE meets the following conditions: The swaps are subject to a centralized risk management program that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps; and The CSE exchanges variation margin with the margin affiliate. The CFTC s final rules provide, however, that a CSE must collect initial margin from non-u.s. affiliates that are financial end users that are not subject to comparable initial margin collection requirements on their own outward-facing swaps with financial end users. 29

31 Inter-Affiliate Swaps Exemption In addition, to facilitate compliance with the Prudential Regulators rules, the CFTC s rules would require a CSE to post initial margin with a swap entity that is subject to the Prudential Regulators rules (and required to collect initial margin from its affiliates). As is the case under the Prudential Regulators rules, the CFTC s rules would require that variation margin be exchanged with respect to swaps between a Covered Swap Entity and its affiliates. 30

32 Phased-in Compliance Final Rules adopts the delayed phase-in schedule announced by BCBS/IOSCO in March 2015, which delays implementation of initial margin and variation margin requirements by nine months starting September 1, Phased-in implementation for initial margin depending upon swaps average daily aggregate notional amounts over a 3-month period of the covered swap entity and its affiliates and its counterparties and their affiliates starting from September 2016 (for entities with the largest exposure) through September Delayed-implementation schedule with regard to variation margin for swap entities belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives is less that $3 trillion for March, April and May 2016, until March 1, For purposes of calculating the notional amounts, the final rules clarify that a swap between an entity and its affiliate counts only once and that swaps exempt under the interim final rule do not count. 31

33 Phased-in Compliance Initial Margin Compliance Date September 1, 2016 September 1, 2017 September 1, 2018 September 1, 2019 September 1, 2020 Initial Margin (IM) Requirements IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2016 that exceeds $3 trillion. IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2017 that exceeds $2.25 trillion. IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2018 that exceeds $1.5 trillion. IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2019 that that exceeds $0.75 trillion. IM for any other covered swap entity with respect to covered swaps with any other counterparty. 32

34 Phased-in Compliance for Variation Margin Compliance Date September 1, 2016 Variation Margin (VM) Requirements VM where both the covered swap entity combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2016 that exceeds $3 trillion. March 1, 2017 VM for any other covered swap entity with respect to covered swaps with any other counterparty. 33

35 Cross-Border Application All this would be complex enough if all regulators and market participants had to think about was how the margin rules applied to U.S. market participants. As with other swaps regulations under Dodd-Frank, however, U.S. regulators also need to think about the cross-border application of their rules that is, how the rules will apply to transactions involving parties organized or located outside of the United States. While there are still unanswered questions, and many complexities and nuances, the basic rule is that the U.S. regulators are taking the position that their rules will apply whenever a U.S. market participant is a party to a swap transaction. This sounds simple and commonsensical, but it leaves answered the question of whether, in the cross-border context, U.S. rules will trump non- U.S. rules and, if so, why? Example: swap between U.S. dealer s New York office and German swap dealer s Frankfurt office 34

36 Cross-Border Application Prudential Regulators final rules contain provisions governing the cross-border application of the margin rules, while the CFTC has proposed a separate rulemaking to address cross-border application, which has not yet been finalized. Prudential Regulators final rules, as under their Re-Proposal, exempt foreign swap entities (but not their U.S. branches or agencies) with respect to the foreign non-cleared swaps from the margin requirements. Exemption is not available where the foreign counterparty is, or is guaranteed by, a U.S. entity, a U.S. branch or subsidiary of a foreign bank, or a foreign swap entity that is a subsidiary of a U.S. entity. Substituted compliance (i.e., compliance with non-u.s. rules rather than U.S. rules) may be available for a foreign bank, U.S. branch or a agency of a foreign bank, or an entity that is a foreign subsidiary of a depository institution, Edge Corporation or Agreement Corporation. 35

37 Cross-Border Application However, substituted compliance would be available only if the Prudential Regulators have made a comparability determination for the jurisdiction the rules of which would apply to the uncleared swap. Moreover, substituted compliance would not be available if the swap is guaranteed by a U.S. entity. For all swap entities (including U.S.), a swap entity will be deemed to satisfy the initial margin posting requirement if its posts the amount of initial margin that its counterparty is required to collect under non- U.S. rules, provided that the Prudential Regulators have made a substituted compliance determination with respect to those rules and the swap is not subject to a guarantee from a U.S. entity. Final Rules also provide relief in certain circumstances from the segregation requirements to foreign branches and subsidiaries of U.S. banks and Edge Corporations where inherent limitations in the legal or operational infrastructure in a foreign jurisdiction make it impracticable to segregate collateral. 36

38 Summary of Key Differences between the CFTC s and Prudential Regulators Rules Requirement CFTC Rules Prudential Regulator Rules Inter-affiliate Swaps Approval of Initial Margin (IM) Models Definition of Financial End User/Treasury Affiliates CSE generally is not required to collect or post initial margin for a swap with an affiliate (except a CSE under Prudential Regulator supervision) subject to conditions, unless affiliate s outward-facing counterparty not subject to comparable IM requirements. IM Models may be approved by the NFA as well as CFTC. Excludes treasury affiliates that qualify for a n exemption from mandatory clearing that the CFTC has exempted by Rule. CSE is required to collect (but not post) IM for a swap with a non-cse affiliate that is a financial end user with material swaps exposure; IM requirements differ from generally applicable requirements (shorter closeout period, lower threshold). IM Models must be approved by the relevant Prudential Regulator. No similar provision to CFTC Rule. Definition of Affiliate No similar provision to Prudential Regulator Rule. Relevant Prudential Regulator may determine that a company is an affiliate of another (that is not otherwise an affiliate under the rule) based on the regulator s conclusion that either company provides significant support to, or is materially subject to the risk of losses of, the other company. Netting Agreements No similar provision to Prudential Regulator Rule. If a netting agreement does not qualify as an EMNA, the CSE must collect VM on a gross basis but may post on a net basis. Variation Margin (VM) Calculation VM calculations must use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, or other objective criteria. Cross Border Application Addressed in separate proposal. Addressed. No similar provision to CFTC rule. 37

39 Proposed SEC Rules for Investment Companies Last December the SEC proposed rules regarding the use of derivatives by investment companies and business development companies The Proposed Rules, if adopted without substantial modification, would: limit the notional amounts of derivatives that funds may enter into, require many funds to adopt comprehensive written derivatives risk management programs, actively overseen by their boards of directors, impose substantial recordkeeping requirements and would modify and clarify current SEC requirements that funds segregate assets in connection with their derivatives. Comment period is to end on March

40 Proposed SEC Rules for Investment Companies The SEC s regulation of funds use of derivatives is based on its longstanding view, reaffirmed in the release accompanying the Proposed Rules, that derivatives may constitute senior securities for purposes of the Investment Company Act of Section 18 of the 1940 Act generally prohibits an open-end fund from issuing or selling any senior security (although it permits a mutual fund to borrow from a bank) provided that the fund maintains 300% asset coverage (generally, the ratio of a fund s total assets less liabilities and indebtedness not represented by senior securities, to the aggregate amount of the fund s senior securities). Section 18 also permits a closed-end fund to issue or sell a senior security, subject to asset coverage requirements (200% for equities or 300% for debt). 39

41 Proposed SEC Rules for Investment Companies The restrictions on senior securities contained in Section 18 are intended to prevent funds from exposing themselves and their shareholders to excessive borrowing and unduly increasing the speculative character of the fund s junior securities operating without adequate assets or reserves and potential abuse of the purchasers of senior securities. Since 1979, when the SEC issued a general statement of policy known as Release 10666, it has been clear that the term senior security may include an instrument that does not constitute a security for most purposes under U.S. law 40

42 Proposed SEC Rules for Investment Companies Release applied not to derivatives but to agreements for the purchase or repurchase of securities, including reverse repurchase agreements, firm commitment agreements and standby commitment agreements The SEC stated that it would not raise issues under Section 18 with respect to the types of transactions addressed in the release so long as funds segregated an amount of highly liquid assets with a value equal to the full amount of their potential obligations under the relevant transactions The segregated account holding such assets would function as a practical limit on the amount of leverage which the investment company may undertake 41

43 Proposed SEC Rules for Investment Companies Parts of the new Proposed Rules relate to the most immediate concern of Release 1066, the assets that should be segregated in connection with transactions involving senior securities However, other parts of the Proposed Rules relate more broadly to the regulation of derivatives as senior securities Intended to prevent excessive borrowing and unduly speculative nature of funds by restricting use of derivatives Proposed rules would also require that many funds adopt formalized derivatives risk management program, including policies and procedures designed to assess and manage the particular risks presented by a fund s use of derivatives 42

44 Proposed SEC Rules for Investment Companies Release applied not to derivatives but to agreements for the purchase or repurchase of securities For such transactions, the amount of assets requiring segregation was reasonably clear, and based on the purchase price of the relevant security. Derivatives raise additional issues, however: Value of assets to be segregated? Based on notional amount, mark-to-market value, or something else? Should amount to be segregated depend on purpose for which particular derivative is used? Uses of derivatives include seeking higher returns through increased investment exposures, hedging interest rate, credit, and other risks in investment portfolios and greater transaction efficiency 43

45 Proposed SEC Rules for Investment Companies SEC guidance on segregation of assets in relation to derivatives is currently contained in more than 30 no-action letters, which address questions on an instrument-by-instrument basis Market practice has evolved under which, in relation to certain derivatives, funds segregate the entire notional amount, and in relation to others, they segregate only the mark-to-market value In August, 2011, the SEC, seeking to systematize its approach to regulating funds practices in relation to derivatives, published a concept release, which requested comment on a wide range of issues concerning investment companies uses of derivatives. Proposed Rules follow up on that concept release 44

46 Proposed SEC Rules Segregation Requirements The Proposed Rules would clarify the amounts and nature of the assets that funds are required to segregate in connection with derivatives transactions. Offer a middle ground between requiring the segregation of, one the one hand, the entirety of a transaction s notional amount and, on the other, only its current mark-to-market value. Would require a fund to identify on its books and records qualifying coverage assets, determined daily, with a value equal to the sum of the fund s aggregate mark-to-market coverage amounts and risk-based coverage amounts. 45

47 Proposed SEC Rules Segregation Requirements Mark-to-market coverage amount would mean, for each derivatives transaction, the amount that would be payable by the fund if the fund were to exit the derivatives transaction at the relevant time Risk-based coverage amount would mean, for each derivatives transaction, an amount representing a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions In calculating both mark-to-market coverage amounts and riskbased coverage amounts, a fund could net transactions under the same netting agreement, thus reducing the amount of assets required to be segregated. 46

48 Proposed SEC Rules Segregation Requirements In addition, both mark-to-market coverage amounts and risk-based coverage amounts could be reduced by the amount of margin pledged by the fund to its counterparty in accordance with Section 17 of the Act The mark-to-market coverage amount would be reduced by the value of any variation margin pledged by the fund The risk-based coverage amount would be reduced by the value of any initial margin pledged by the fund 47

49 Proposed SEC Rules Segregation Requirements The Proposed Rules would require that the assets identified on a fund s books and records consist of qualifying coverage assets For derivatives, such assets would consist of cash and cash equivalents, or the particular asset that may be deliverable under a derivatives transaction. The other aspects of the SEC s Proposed Rules, regarding portfolio limitations and risk management programs, are more unexpected than the proposed asset segregation requirements 48

50 Proposed SEC Rules Portfolio Limitations Proposed Rules would limit the notional amounts of derivatives that funds could transact. Portfolio Limitations are a relatively blunt measurement, because derivatives can be put to many uses, and their risk profiles can vary dramatically SEC is interested in finding a reasonably practicable test, even if it may not be the most refined possible test In order to transact derivatives, a fund would be required to conform to one of two portfolio limitations, each intended to prevent a fund from becoming excessively leveraged or speculative. Board approval required for the portfolio limitation under which the fund would operate. 49

51 Proposed SEC Rules Portfolio Limitations The first portfolio limitation would be based on a fund s exposure, a term defined to include, but not be limited to, the notional amounts of a fund s derivatives. The first portfolio limitation would require that a fund s aggregate exposure not exceed 150% of the value of the fund s net assets. Exposure for these purposes would equal the sum of the notional amounts of a fund s derivatives (subject to netting for directly offsetting derivatives) the fund s aggregate obligations, whether conditional or unconditional, under financial commitment transactions (such as reverse repurchase agreements, firm commitment agreements and standby commitment agreements) and aggregate indebtedness under other senior securities transactions 50

52 Proposed SEC Rules Portfolio Limitations The limitation at 150% is based on the SEC s view that exposure levels higher than that level could be used to take on additional speculative investment exposures that go beyond what would be expected to allow for hedging arrangements. Further, limiting exposure to 150% of net assets would allow a fund to obtain a level of indirect market exposure solely through derivatives transactions that could approximate the level of market exposure that would be possible through securities investments augmented by borrowings as permitted under section

53 Proposed SEC Rules Portfolio Limitations The second, risk-based, portfolio limitation would permit greater exposure, up to 300% of a fund s net asset value, but would also require that a fund s derivatives transactions decrease the fund s overall market risk, as measured by Value-at risk or VaR Proposed Rules VaR as an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence interval. For a fund to comply with this second limitation, its full portfolio VaR that, is, the VaR of the fund s entire portfolio, including derivatives would need to be less than the fund s securities VaR, the VaR of the fund s portfolio excluding any derivatives transactions. Requirements for VaR models: must take into account all relevant risk factors, must have minimum 99% confidence interval, must have a time horizon of not less than 10 and not more than 20 trading days and, if using historical simulation, a minimum of three years of historical data 52

54 Proposed SEC Rules Risk Management Programs Under the Proposed Rules, many funds using derivatives would be required to adopt and implement a written derivatives risk management program. The requirement to adopt such a program would apply to any fund that either entered into a complex derivatives transaction or did not implement and comply with a portfolio limitation under which the notional amount of its derivatives could not exceed 50% of its net asset value. For these purposes, a complex derivatives transaction is defined as one under which an amount payable by either party upon settlement, maturity or exercise is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction (e.g., an Asian option or barrier option) or is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price (e.g., a variance swap). 53

55 Proposed SEC Rules for Investment Companies Such programs must be reasonably designed to: assess the risks associated with the fund s derivatives transactions, including an evaluation of potential leverage, market, counterparty, liquidity, and operational risks and any other relevant risks considered relevant; manage the risks associated with the fund s derivatives transactions including by: monitoring whether the fund s use of derivatives transactions is consistent with any investment guidelines established by the fund or its investment adviser, the portfolio limitation applicable to the fund, and disclosure to investors; and informing persons responsible for portfolio management of the fund or the fund s board of directors, as appropriate, regarding material risks arising from the fund s derivatives transactions; and Requirement to segregate the functions associated with the program from the fund s portfolio management Requirement that program be reviewed and updated at least annually 54

56 Proposed SEC Rules Risk Management Programs Under the Proposed Rules, a fund s board of directors, including a majority of directors who are not interested persons of the fund, must: approve the program and any material changes to it; approve the designation of an employee or officer of the fund or the fund s investment adviser (who may not be a portfolio manager of the fund) responsible to administer the program; and review, at least quarterly, a written report prepared by person designated to administer the program that describes the adequacy of the fund s program and the effectiveness of its implementation 55

57 Proposed SEC Rules Record Retention Under the Proposed Rule, a fund would be required to maintain, generally for a period of at least five years, written records relating to, among other things: the policies and procedures adopted by the fund. each determination made by the fund s board of directors with respect to the portfolio limitation applicable to the fund; the mark-to-market coverage amount and the risk-based coverage amount for each derivatives transaction entered into by the fund, and the related qualifying coverage assets maintained by the fund, as determined on each business day; the fund s compliance, after entering into any derivatives transaction, with the portfolio limitation applicable to the fund, reflecting the fund s aggregate exposure, the value of the fund s net assets and, if applicable, the fund s full portfolio VaR and securities VaR. 56

58 Proposed SEC Rules Record Retention In addition, funds that are required to adopt a derivatives risk management program must also maintain, generally for a period of at least five years, copies of: the policies and procedures adopted by the fund as part of its derivatives risk management program; any materials provided to the board of directors in connection with its approval of the derivatives risk management program, including any material changes to the program, and any written reports provided to the board of directors relating to the program; and records documenting the periodic reviews and updates of the derivatives risk management program required by the Proposed Rule 57

59 ISDA Resolution Stay Protocols As of late last year, there are two such protocols: ISDA 2014 Resolution Stay Protocol; and ISDA 2015 Universal Resolution Stay Protocol Primary difference is scope of product coverage the new universal protocol covers not only transactions under ISDA Master Agreements, but also securities financing transactions Securities financing transactions include repurchase transactions and securities lending transactions New protocol supersedes previous one for parties who adhered to previous protocol 58

60 ISDA Resolution Stay Protocols Protocols are contractual solutions to questions relating to the crossborder application of special resolution regimes Protocols are intended to address issue of banks being too big to fail and to give regulators time to facilitate an orderly resolution of a troubled bank The terms of the protocols are especially topical now because proposed regulations will be proposed in the near future that will apply to a broader range of market participants requirements similar to those contained in the protocols Proposed regulations are expected to require regulated institutions to include in their contracts with unregulated counterparties provisions similar to those contained in the protocols New regulations (like 2015 protocol) are expected to apply to derivatives, repurchase transactions and securities lending transactions 59

61 ISDA Resolution Stay Protocols Both protocols were developed by a group of ISDA member institutions in coordination with the Financial Stability Board Address the fundamental concern is that a close-out of derivatives/repo/sec lending transactions by a large institution could destabilize markets and make resolution of the institution difficult Apart from the broader product coverage of the 2015 protocol, the substance of the two protocols is largely similar 60

62 ISDA Resolution Stay Protocols In the U.S., concerns are addressed by Title II of Dodd-Frank ( Orderly Liquidation Authority ), which imposes a limited stay on termination rights against U.S. banks. There are similar provisions in other countries to likewise restrict termination rights against banks However, the cross-border application of such special resolution regimes is not wholly clear What if U.S. bank in resolution faces counterparty in another jurisdiction? Is counterparty bound by Dodd-Frank s special resolution provisions? Similarly, what if non-u.s. bank faces a counterparty in the U.S? Is U.S. counterparty bound by the bank s home country resolution procedures? 61

63 ISDA 2015 Universal Resolution Stay Protocol Under both protocols, adhering parties opt into accepting the special resolution regimes that may apply to their counterparties Such resolution regimes typically stay or override certain default rights that would otherwise arise when a bank enters into insolvency, resolution or similar proceedings In addition, adhering parties opt into contractual stays on certain cross-default rights that would otherwise apply in the context of insolvency proceedings and that are similar to some of the types of stays contained in certain statutory resolution regimes 62

64 ISDA 2015 Universal Resolution Stay Protocol The Protocol was intended to apply only to the 21 largest institutions and their affiliates At latest count there were 203 adhering parties, mainly large banks and their affiliates Many market participants (e.g., fiduciaries such as asset managers) would have potential legal issues if they voluntarily gave up or agreed to delays in exercising their termination rights Accordingly, regulators will likely impose the contents of the protocol on many market participants by regulation in the near future, by means of requiring banks to add similar provisions to their trading agreements 63

65 ISDA 2015 Universal Resolution Stay Protocol When and how will provisions of the protocol be rolled out to the market beyond the largest banks? Regulations are expected soon to be proposed that will, when finalized, require regulated entities to include in their contracts with non-regulated entities provisions similar to those contained in the protocol Such regulations have already been proposed in Germany and the UK ISDA has stated that it expects to release a protocol to facilitate compliance with the expected regulations There will likely be two different forms of the protocol, one for regulated entities and one for buy-side firms 64

66 ISDA 2015 Universal Resolution Stay Protocol Section 1 Opt-in to Special Resolution Regimes Provides generally that if one adhering party is subject to a special resolution regime, then the other adhering party may exercise default rights under a Covered Agreement or related credit support arrangement only to the extent it would be able to do so under such special resolution regime Covered Agreements include both ISDA Master Agreements and numerous forms of repurchase and securities lending agreements Also provides that transfers of Covered Agreements and related credit support arrangements will be effective to the same extent as such a transfer would be effective under the relevant special resolution regime 65

67 ISDA 2015 Universal Resolution Stay Protocol Section 1 Opt-in to Special Resolution Regimes Contains similar provisions that may apply if an affiliate of an adhering party (not the adhering party itself) becomes subject to a special resolution regime or a credit support arrangement runs to the benefit of an affiliate of a party to a Covered Agreement 66

68 ISDA 2015 Universal Resolution Stay Protocol Definition of Special Resolution Regime includes identified resolution regimes of France, Germany, Japan, Switzerland, the UK and the U.S. and Protocol-eligible Regimes, which are defined to include: the resolution regimes of states that are members of the FSB (examples: Argentina, Russia and Saudi Arabia), but only if such resolution regimes incorporate certain protections for creditors no discrimination based on nationality, location or domicile of creditors or jurisdiction where they may be paid limitations on length and nature of stay that may restrict creditors rights; and any other jurisdiction that is the jurisdiction of organization of the ultimate parent entity within a banking group that has been designated by the Financial Stability Board as a global systemically important bank 67

69 ISDA 2015 Universal Resolution Stay Protocol Section 2 Limitation on Exercise of Default Rights in U.S. Insolvency Proceedings Restricts default rights that would otherwise arise if an affiliate of an adhering party, not the party itself, becomes subject to insolvency proceedings Intended to support a single point of entry -style resolution of a parent entity of a financial group, a resolution with only the top-tier parent company entering proceedings 68

70 ISDA 2015 Universal Resolution Stay Protocol Protocol distinguishes between affiliates that are credit enhancement providers and affiliates that are not (but are presumably Specified Entities for purposes of a related ISDA Master Agreement) The protocol overrides contractual rights somewhat more narrowly with respect to a default of a credit enhancement provider of a party to an ISDA Master Agreement than with respect to a default of a Specified Entity of a party to an ISDA Master Agreement 69

71 CFTC s Proposed Reg. AT On November 24, 2015, the CFTC issued proposed rules related to automated trading on derivatives exchanges, referred to as Regulation AT. The proposed rules, if adopted, would create new requirements for proprietary trading firms, designated contract markets ( DCMs ) futures commission merchants ( FCMs ), and other CFTC registrants using algorithmic trading systems. The proposed rules would also require that certain persons register with the CFTC under a new definition of floor trader due to their algorithmic trading through Direct Electronic Access (as defined in the proposed rules) to a DCM. Proposal includes 164 questions for comment. Comment period on the proposed rules closes March 16,

72 Algorithmic Trading CFTC defines Algorithmic Trading broadly under the proposal as trading in any commodity interest on or subject to the rules of a DCM, where: One or more computer algorithms or systems determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order, including but not limited to: the product to be traded; the venue where the order will be placed; the type of order to be placed; the timing of the order; whether to place the order; the sequencing of the order in relation to other orders; the price of the order; the quantity of the order; the partition of the order into smaller components for submission; the number of orders to be placed; or how to manage the order after submission; and Such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM, except for orders modifications, or cancellations that are manually entered into a front-end system by a natural person with no further discretion by any computer system or algorithm, prior to its electronic submission to a DCM. 71

73 Purpose of Proposed Rules The CFTC believes that rules are needed to prevent persons from using Algorithmic Trading to violate the CEA or CFTC regulations, including by disrupting the market. The proposed rules would require risk controls and other requirements in order to address the risks of Algorithmic Trading, including the potential for market disruptions arising from system malfunctions, other errors, or intentional disruptive conduct. Risk controls and other requirements must be adopted at 3 levels: Market participants using algorithmic trading systems (AT persons in the rule); Clearing member FCMs with respect to their AT Person customers; and DCMs executing AT person orders. Proposal applies to algorithmic trading irrespective of whether it is high frequency trading; it does not apply to trading on SEFs. 72

74 Registration Requirement Under current CFTC regulations, persons that engage in proprietary trading (i.e., not on behalf of customers) are not required to register unless they trade for their own account in or around a trading pit, ring, post, or other place provided by a DCM, and, in that case, they must register as a floor trader. Proposed Rules would amend the definition of floor trader to include persons who trade commodity interests at a DCM for their own account through Direct Electronic Access. Direct Electronic Access is defined as an arrangement where a person transmits an order electronically to a DCM, without the order first being routed through a clearing FCM. CFTC requests comment as to whether the floor trader definition should be expanded to all firms operating algorithmic trading systems in CFTC-regulated markets that are not otherwise required to register (not just through direct electronic access). 73

75 AT Persons Proposed rules contain requirements that apply to market participants that are AT Persons. AT Person is defined as: Any person registered or required to be registered as an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in Algorithmic Trading, or A floor trader that engages in Algorithmic Trading through Direct Electronic Access. 74

76 AT Person Requirements Risk Controls. AT persons would be required to implement risk controls on orders submitted through Algorithmic Trading, including pre-trade risk controls (maximum order message and execution frequency per unit time, order price and maximum order size parameters), and order cancellation systems that can disengage algorithmic trading, cancel selected or all resting orders, and prevent submission of new orders. Development, testing, and monitoring. AT persons would be required to implement standards for development, testing and monitoring of algorithmic trading systems, including complete separation of the environment used for system development and the one used for production, testing before implementation, real-time monitoring of such systems, and standards to ensure that systems comply with CFTC regulations, and must designate and provide training for algorithmic trading staff responsible for ensuring compliance. 75

77 AT Person Requirements Source Code Repository. AT persons would be required to establish and maintain a source code repository that includes the documenting of strategy and design of proprietary algorithmic trading software used and any changes implemented, including an audit trail that shows who made a change, when it was made, and its coding purpose. Repository records must be kept under the CFTC s recordkeeping regulation and made available for inspection upon request by the CFTC or DOJ (for any reason without a subpoena). This requirement has provoked controversy within the industry due to concerns about the CFTC/DOJ being able to protect sensitive proprietary information. Commissioner Giancarlo raised these concerns at the open meeting and in his concurring statement. 76

78 AT Person Requirements Compliance Reports. AT persons would be required to annually prepare and submit to DCMs compliance reports regarding their risk controls as well as copies of written policies and procedures developed to comply with testing and other requirements. They would also be required to keep books and records regarding their Algorithmic Trading procedures for inspection by DCMs. Notification Requirement/Use of Self-Trade Prevention Tools. AT persons would be required to notify applicable clearing member FCMs and DCMs that the AT person will engage in Algorithmic Trading, and calibrate or otherwise implement DCM-provided selftrade prevention tools. 77

79 Requirements for Clearing Member FCMs Risk Controls. Clearing member FCMs would be required to implement risk controls for Algorithmic Trading orders originating with AT persons, including pre-trade risk controls applicable to AT persons. Pre-trade risk controls would have to be set the level of each AT person, or more granular level as each clearing member FCM may determine. Clearing member FCMs would have to implement DCM-provided risk controls for Direct Electronic Access orders. They would also be required to have policies and procedures reasonably designed to ensure that natural person monitors at the FCM are promptly alerted when pre-trade risk control parameters are breached. 78

80 Requirements for Clearing Member FCMs Compliance Reports. Clearing Member FCMs would be required to annually prepare and submit to DCMs compliance reports that describe how they comply with maintenance of risk controls on their AT person customers. The report would have to be certified by the CEO or CCO that the report is accurate and complete to the best of his/her knowledge and reasonable belief. Clearing member FCMs would also be required to keep, and provide to a DCM upon request, books and records regarding their risk controls for Algorithmic Trading orders for inspection by DCMs. 79

81 Requirements for DCMs Risk Controls. DCMs would be required to implement risk controls on orders submitted through Algorithmic Trading (and parallel controls for manual orders), including maximum order message and execution frequency per unit time, order price and size parameters, and order cancellation systems. Compliance Reports. DCMs would have to require risk control compliance reports from AT persons and their clearing member FCMs. DCMs would be required to periodically review compliance reports, identify outliers and provide instructions for remediation, as well as review, as necessary, books and records of AT persons and clearing member FCMs concerning Algorithmic Trading procedures. Test Environments. DCMs would be required to provide test environments where AT persons can test algorithmic trading systems. 80

82 Requirements for DCMs Self-Trade Prevention. DCMs would be required to establish selftrade prevention tools, and either apply such tools or provide them to all market participants (not just AT persons) and require their use. The rules would define self-trading as the matching of orders for accounts with common beneficial ownership or under common control. DCMs would be required to determine which accounts will be prohibited from trading with each other, or require market participants to identify such accounts. Exemptions would be provided for order matching for accounts with common beneficial ownership but initiated by independent decision makers or for certain orders that comply with a DCM s cross-trade, minimum exposure requirements or similar rules. Prior approval from the DCM would need to be obtained to rely on these exemptions. 81

83 Requirements for DCMs Disclosure Regarding Trade Matching. DCMs would be required to provide public disclosure regarding certain elements of their electronic trade matching systems that materially affect order execution. Market Maker and Incentive Programs. DCMs would be required to provide disclosures of market maker and incentive programs submitted to the CFTC as rule filings. Such disclosures would have to specify all of the products or services to which they apply, eligibility requirements, and payment benefits or incentives received (e.g., fee rebates) and non-financial benefits (e.g., enhanced trading priorities or preferential access to market data). Payments would be prohibited for trades between accounts under common beneficial ownership. 82

84 Requirements for RFAs The proposal would require registered futures associations to adopt membership rules, as deemed appropriate by the registered futures association, relevant to algorithmic trading for each category of member. AT persons would be required to become members of a registered futures association (currently, the only registered futures association is the National Futures Association). 83

85 CFTC Preliminary Report on De Minimis Threshold Dodd-Frank directs the CFTC and the SEC jointly to further define, among other terms, the term swap dealer and to exempt from designation as a swap dealer an entity that engages in a de minimis quantity of swap dealing Pursuant to that statutory requirement, the CFTC and SEC jointly issued CFTC Regulation 1.3(ggg), which defines the term swap dealer and provides for a de minimis exception Under the de minimis exception, a person is not deemed to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold The level of the de minimis threshold is important to non-dealers who have a substantial presence in the swaps market but who have not been required to register as swap dealers and do not wish to be required to register as swap dealers 84

86 CFTC Preliminary Report on De Minimis Threshold In November of last year, the CFTC issued a preliminary report regarding the swap dealer de minimis exception The report addresses the exception and possible changes to it We are still in the phase-in period, during which the de minimis threshold is $8 billion in notional amount (measured over a 12-month period) Under Regulation 1.3(ggg)(4), the phase-in period will terminate on December 31, 2017, and the de minimis threshold will fall to $3 billion in notional amount, unless the CFTC takes prior action to set a different termination date or to modify the de minimis exception Regulation 1.3(ggg)(4) further provides that nine months after the publication of a staff report and after giving due consideration to the report and any associated public comment, the CFTC may either set a termination date for the phase-in period or issue a notice of proposed rulemaking to modify the de minimis exception 85

87 CFTC Preliminary Report on De Minimis Threshold In the report, the CFTC staff sought comment on many aspects of the de minimis exception If the CFTC takes no action, then the de minimis threshold will fall to $3 billion The preliminary report states that, after the CFTC staff considers the comments that it receives on the preliminary report, staff will complete and publish a final report Comments are due by January 19,

88 CFTC Preliminary Report Highlights The preliminary report does not appear to indicate whether or not the CFTC is leaning toward terminating the phase-in period or modifying the de minimis exception The extent to which the CFTC appears to view questions regarding the exception as open appears to mean that there may be a genuine possibility that the much lower $3 billion post-phase-in period threshold will not go into effect or will be modified Report addresses, among other things: the data used in the preparation of the preliminary report and methodology the policies underlying swap dealer registration and regulation and the de minimis exception Possible alternative approaches to the de minimis exception 87

89 CFTC Preliminary Report Highlights Originally, the CFTC took the view that a $3 billion notional value standard for the de minimis exception was appropriate because it equaled approximately percent of the estimated overall domestic market for all swaps between all counterparties However, a higher initial threshold amount was appropriate to permit market participants and regulatory agencies to become familiar with the application of the swap dealer definition and regulatory requirements afford the regulatory agencies time to study the swap market as it evolves and to consider new information about the swap market that becomes available, including through swap data reporting provide potential swap dealers that engage in smaller amounts of activity additional time to adjust their business practices; and address comments suggesting that the de minimis threshold be set higher initially to provide for efficient use of regulatory resources and that implementation of swap dealer requirements overall be phased in 88

90 CFTC Preliminary Report Data The data used in the Preliminary Report was sourced primarily from data reported to the four registered SDRs SDR data is still relatively new, and there is still significant ongoing work to improve it in various ways Data is accordingly of somewhat limited value Covered five asset classes CDS, IRS, commodities, FX and equities Issues include: Lack of data indicating whether transactions are entered into for dealing purposes Lack of legal entity identifiers (LEIs) (14% of reported transactions lacked these for one or both counterparties) Confusion over unique swap identifiers (USIs), which were sometimes reused for multiple swaps Issues in connection with swaps that do not count toward de minimis threshold, such as certain inter-affiliate swaps Notional amounts not always clear 89

91 CFTC Preliminary Report Policy Considerations General policy goals for swap dealer registration and regulation: reduction of systemic risk, counterparty protections, and market efficiency, orderliness, and transparency. Policy goals for de minimis exception : careful balancing that considers the regulatory interests that could be undermined by an unduly broad exception as well as those regulatory interests that may be promoted by an appropriately limited exception. A narrow de minimis exception (i.e., too low a de minimis threshold) would likely mean: that a greater number of counterparties would be required to register as swap dealers and become subject to the regulatory framework, but it could discourage certain market participants, including small and midsized banks, from engaging in swap dealing activity in order to avoid the burdens associated with swap dealer regulation. 90

92 CFTC Preliminary Report Highlights The Preliminary Report also considers whether alternative approaches to the de minimis exception would more effectively promote the regulatory goals associated with a de minimis exception. Possibility of a higher or lower gross notional de minimis threshold Data appears to indicate that an additional 80 or so entities might be subject to swap dealer registration requirements if the de minimis threshold drops to $3 billion as currently scheduled, but, at the same time, that lower threshold would capture only another one or two percent more activity, measured by notional amount Similarly, the de minimis threshold would also need to be raised to a much higher number in order to capture significant less activity, measured by notional amount 91

93 CFTC Preliminary Report Highlights Possible alternative approaches: a notional de minimis threshold specific to each asset class a multi-factor approach that would potentially include number of counterparties and/or number of transactions metrics in the de minimis exception, in addition to a gross notional dealing threshold Energy firms have expressed discomfort over this possibility a multi-tiered approach where the regulatory requirements associated with swap dealer registration are commensurate with an entity s level of dealing activity Potentially Tier 1 and Tier 2 dealers, with Tier 1 being subject to the full scope of swap dealer regulations and Tier 2 subject to a lesser set of regulations the exclusion of swaps that are traded on a registered or exempted swap execution facility ( SEF ) or designated contract market ( DCM ), and/or cleared from an entity s de minimis calculation 92

94 Expectations for 2016 Swap market participants (other than commercial end users) will devote significant resources next year to compliance with the rules requiring margin for uncleared swaps, which are scheduled to be phased into effect starting in September of this year Status of capital rules for non-bank swap dealers unclear Position limit rules Expected to be finalized this year, but highly controversial SEC Rules preparation for SBS dealer registration in 2017? Cross-border harmonization Cleared swaps (clearinghouse recognition) Uncleared timing for substituted compliance determinations not clear Compliance with regulatory requirements parallel to provisions contained in ISDA 2015 Universal Resolution Stay Protocol Additional ISDA protocol(s) expected to address these 93

95 Questions? Julian E. Hammar (202) James E. Schwartz (212)

96 About Morrison & Foerster We are Morrison & Foerster a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life sciences companies. We ve been included on The American Lawyer s A-List for 10 straight years, and Fortune named us one of the 100 Best Companies to Work For. Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at Morrison & Foerster LLP. All rights reserved. For more updates, follow Thinkingcapmarkets, our Twitter feed: Because of the generality of this presentation, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. 95

97 Client Alert January 13, 2016 CFTC Proposes Regulation of Automated Trading By Julian E. Hammar On November 24, 2015, the Commodity Futures Trading Commission ( CFTC ) approved the issuance of proposed rules to implement a framework of registration, reporting, recordkeeping and other compliance requirements for market participants engaged in algorithmic trading, referred to as Regulation AT. If adopted, the proposed rules would impose requirements on proprietary trading firms, designated contract markets ( DCMs ), clearing member futures commission merchants ( FCMs ) and other CFTC registrants that use algorithmic trading systems. It also proposes to require the registration of certain proprietary traders under a new definition of the term Floor Trader due to their algorithmic trading through direct electronic access (as defined in the proposed rules) to a DCM. The proposed rules, which were published in the Federal Register on December 17, 2015, are available here, and are open for public comment (including with respect to 164 questions contained in the release) until March 16, DEFINITION OF ALGORITHMIC TRADING The CFTC defines the term Algorithmic Trading broadly under the proposal as trading in any commodity interest (e.g., futures, options or swaps) on or subject to the rules of a DCM, where: One or more computer algorithms or systems determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order, including but not limited to: the product to be traded; the venue where the order will be placed; the type of order to be placed; the timing of the order; whether to place the order; the sequencing of the order in relation to other orders; the price of the order; the quantity of the order; the partition of the order into smaller components for submission; the number of orders to be placed; or how to manage the order after submission; and Such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM. The proposed rules would exclude from the definition of algorithmic trading any orders modifications, or cancellations that are manually entered into a front-end system by a natural person with no further discretion by any computer system or algorithm, prior to their electronic submission to a DCM. PURPOSE OF THE PROPOSED RULES The CFTC believes that the proposed rules are needed to prevent persons from using Algorithmic Trading to violate the Commodity Exchange Act ( CEA ) or CFTC regulations, including by disrupting the market. The proposed rules would require risk controls and other requirements in order to address the risks of Algorithmic Morrison & Foerster LLP mofo.com Attorney Advertising

98 Client Alert Trading, including the potential for market disruptions arising from system malfunctions, other errors, or intentional disruptive conduct. Under the proposal, risk controls and other requirements must be adopted at three levels: Market participants using algorithmic trading systems (AT persons in the proposed rule); Clearing member FCMs with respect to their AT Person customers; and DCMs executing AT person orders. The proposed rules would apply whether or not a market participant engages in or facilitates high frequency trading; their requirements would apply to algorithmic trading irrespective of the speed of such trading. The proposal does not apply to trading on swap execution facilities. REGISTRATION REQUIREMENT Under current CFTC regulations, persons that engage in proprietary trading (i.e., not on behalf of customers) are not required to register unless they trade for their own account in or around a trading pit, ring, post, or other place provided by a DCM, and, in that case, they must register as a Floor Trader. The proposed rules would amend the definition of the term Floor Trader to include persons who trade commodity interests at a DCM for their own account through Direct Electronic Access. Direct Electronic Access is defined as an arrangement where a person transmits an order electronically to a DCM, without the order first being routed through a clearing member FCM of a derivatives clearing organization to which the DCM submits transactions for clearing. The CFTC requests comment as to whether the Floor Trader definition should be expanded to all firms operating algorithmic trading systems in CFTC-regulated markets that are not otherwise required to register (not just through Direct Electronic Access). REQUIREMENTS FOR AT PERSONS The proposed rules contain requirements that apply to market participants that are AT Persons. An AT Person is defined as: Any person registered or required to be registered as an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in Algorithmic Trading, or A Floor Trader that engages in Algorithmic Trading through Direct Electronic Access. Risk Controls. AT persons would be required to implement risk controls on orders submitted through Algorithmic Trading, including pre-trade risk controls (e.g., maximum order message and execution frequency per unit time, order price and maximum order size parameters) and order cancellation systems that can disengage algorithmic trading, cancel selected or all resting orders, and prevent submission of new orders. Development, Testing, and Monitoring. AT persons would be required to implement standards for the development, testing and monitoring of algorithmic trading systems, including complete separation of the environment used for system development from the one used for production, testing before implementation, real Morrison & Foerster LLP mofo.com Attorney Advertising

99 Client Alert time monitoring of such systems, and standards to ensure that systems comply with CFTC regulations, and must designate and provide training for algorithmic trading staff responsible for ensuring compliance. Source Code Repository. AT persons would be required to establish and maintain a source code repository that includes the documenting of strategy and design of proprietary algorithmic trading software used and any changes implemented, including an audit trail that shows who made a change, when it was made, and its coding purpose. Repository records must be kept under the CFTC s recordkeeping regulation and made available for inspection upon request by the CFTC or the Department of Justice ( DOJ ) (for any reason without a subpoena). This requirement has provoked controversy within the industry due to concerns about the CFTC/DOJ being able to protect sensitive proprietary information. Commissioner Giancarlo raised these concerns at the open meeting and in his concurring statement. Compliance Reports. AT persons would be required to annually prepare and submit to DCMs compliance reports regarding their risk controls, as well as copies of written policies and procedures developed to comply with testing and other requirements. They would also be required to keep books and records regarding their Algorithmic Trading procedures for inspection by DCMs. Notification Requirement/Use of Self-Trade Prevention Tools. Prior to an AT person s initial use of Algorithmic Trading to submit an order to a DCM, such AT person would be required to notify applicable clearing member FCMs and DCMs that the AT person will engage in Algorithmic Trading, and calibrate or otherwise implement DCM-provided self-trade prevention tools. REQUIREMENTS FOR CLEARING MEMBER FCMS Risk Controls. The proposed rules would require that clearing member FCMs implement risk controls for Algorithmic Trading orders originating with AT persons, including pre-trade risk controls applicable to AT persons. Pre-trade risk controls would have to be set at the level of each AT person, or at a more granular level as each clearing member FCM may determine. Clearing member FCMs would have to implement DCM-provided risk controls for Direct Electronic Access orders. They would also be required to have policies and procedures reasonably designed to ensure that natural person monitors at the FCM are promptly alerted when pre-trade risk control parameters are breached. Compliance Reports. Clearing member FCMs would be required to annually prepare and submit to DCMs compliance reports that describe how they comply with maintenance of risk controls on their AT person customers. The report would have to be certified by the CEO or CCO that the report is accurate and complete to the best of his/her knowledge and reasonable belief. Clearing member FCMs would also be required to keep, and provide to a DCM upon request, books and records regarding their risk controls for Algorithmic Trading orders for inspection by DCMs Morrison & Foerster LLP mofo.com Attorney Advertising

100 Client Alert REQUIREMENTS FOR DCMS Risk Controls. Under the proposed rules, DCMs would be required to implement risk controls on orders submitted through Algorithmic Trading (and parallel controls for manual orders), including maximum order message and execution frequency per unit time, order price and size parameters, and order cancellation systems. Compliance Reports. DCMs would have to require risk control compliance reports from AT persons and their clearing member FCMs. DCMs would be required to periodically review compliance reports, identify outliers and provide instructions for remediation, as well as review, as necessary, books and records of AT persons and clearing member FCMs concerning Algorithmic Trading procedures. Test Environments. DCMs would be required to provide test environments where AT persons can test algorithmic trading systems. Self-Trade Prevention. DCMs would be required to establish self-trade prevention tools, and either apply such tools or provide them to all market participants (not just AT persons) and require their use. The rules would define self-trading as the matching of orders for accounts with common beneficial ownership or under common control. DCMs would be required to determine which accounts will be prohibited from trading with each other, or require market participants to identify such accounts. Exemptions would be provided for order matching for accounts with common beneficial ownership but initiated by independent decision makers, or for certain orders that comply with a DCM s cross-trade, minimum exposure requirements or similar rules. Prior approval from the DCM would need to be obtained in order for a market participant to rely on these exemptions. Disclosure Regarding Electronic Trade Matching Systems. DCMs would be required to provide public disclosure regarding certain elements of their electronic trade matching systems that materially affect order execution, including the ability to cancel, modify, or limit display of orders; the ability to cancel or modify orders; and the transmission of market data and order or trade confirmations to market participants. Market Maker and Incentive Programs. DCMs would be required to provide disclosures of market maker and incentive programs submitted to the CFTC as rule filings. Such disclosures would have to specify all of the products or services to which they apply, eligibility requirements, and payment benefits or incentives received (e.g., fee rebates), as well as non-financial benefits (e.g., enhanced trading priorities or preferential access to market data). Payments would be prohibited for trades between accounts under common beneficial ownership. REGISTERED FUTURES ASSOCIATIONS The proposal would require registered futures associations to adopt membership rules, as deemed appropriate by the registered futures association, relevant to algorithmic trading for each category of member. AT persons would be required to become members of a registered futures association (currently, the only registered futures association is the National Futures Association) Morrison & Foerster LLP mofo.com Attorney Advertising

101 Client Alert Contact: Julian E. Hammar (202) About Morrison & Foerster: We are Morrison & Foerster a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We ve been included on The American Lawyer s A-List for 12 straight years, and Fortune named us one of the 100 Best Companies to Work For. Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome Morrison & Foerster LLP mofo.com Attorney Advertising

102 Client Alert December 23, 2015 CFTC Adopts Uncleared Swaps Margin Rules By Julian Hammar On December 16, 2015, the Commodity Futures Trading Commission ( CFTC or Commission ) adopted final rules to impose margin requirements on uncleared swaps entered into by swap dealers and major swap participants subject to CFTC regulation, referred to as Covered Swap Entities or CSEs in the rules. The CFTC also adopted an interim final rule to exclude from the requirements most uncleared swaps that swap entities enter into with commercial end users, financial institutions with $10 billion or less in total assets, and certain other entities consistent with the requirements of the Business Risk Mitigation and Price Stabilization Act of The CFTC s regulations are largely the same as the rules and interim final rule adopted by the Prudential Regulators (the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency) in October 2015 for swap entities subject to their supervision, with a few important differences noted below. The CFTC s and Prudential Regulators rules will significantly impact the economics of the swaps market. Both sets of rules become effective on April 1, 2016, with a compliance schedule discussed below. The CFTC s final rules are available here, while the Prudential Regulators final rules and interim final rule have been published in the Federal Register. 1 BACKGROUND One of the criticisms of the swaps market in the wake of the 2008 financial crisis was that it did not require swaps counterparties to provide margin (that is, collateral) to secure their obligations to each other. In practice, in many cases before and (even more so) after the crisis, parties have provided collateral ( variation margin ) to cover the current ( mark-to-market ) value of their obligations to each other. Though less common, some parties have also provided upfront collateral ( initial margin ) to cover the potential for further changes in mark-to-market value that could occur over some period (such as 5 business days). The Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank Act ) 2 requires the Prudential Regulators, the CFTC and the Securities and Exchange Commission ( SEC ) to draft rules requiring margin for bilateral swaps that will not be cleared at a clearinghouse (cleared swaps, in contrast, are subject to margin requirements imposed by clearinghouses and their members). In fulfillment of the statutory mandate, the CFTC and Prudential Regulators released in the fall of 2014 re-proposed rules for margin requirements for uncleared swap transactions subject to their regulation, which they first proposed in The re-proposed rules were issued in response to an international framework for uncleared swaps margin stated in a series of papers released by the Basel Committee on Banking Supervision and the Board of the International Organization of 1 See Margin and Capital Requirements for Covered Swap Entities; Final Rule, 80 Fed. Reg. 74,839 (Nov. 30, 2015) and Interim Final Rule, 80 Fed. Reg. 74,915 (Nov. 30, 2015). 2 Pub. L. No , 124 Stat (2010) Morrison & Foerster LLP mofo.com Attorney Advertising

103 Client Alert Securities Commissions, the last of which was issued in September 2013 (the BCBS/IOSCO Framework ). For more information on the Prudential Regulators and CFTC s proposed rules, please see our alert here. FINAL RULES EXECUTIVE SUMMARY Overview of the final rules Like the Prudential Regulators final rules, the CFTC s final rules in general would: Require Covered Swap Entities 3 to bilaterally exchange, subject to a $50 million threshold below which it need not be exchanged, initial margin with other swap entities and with a broad range of financial end users, whose use and affiliates use of uncleared swaps meet a notional amount-based exposure ( material swaps exposure ); Mandate that all such initial margin, which is intended to secure potential future exposure or adverse changes in value that may arise during the period of time when a swap is being closed out, must be segregated generally with a third-party custodian (not affiliated with either counterparty) and not subject to re-hypothecation or other use by the custodian; 4 Permit the calculation of initial margin by means of either a model-based method, subject to regulatory approval, or a table-based method provided for in the rules; Impose a significantly higher initial margin requirement on uncleared swaps as compared to cleared swaps by requiring that initial margin models use a 10 business day closeout horizon for most uncleared swaps as opposed to a 5 business day horizon for most cleared swaps; and Require swap entities to exchange variation margin with swap entities and with a broad array of financial end users without regard to the existence of material swaps exposure and without any threshold. Relief provided from the re-proposals in the final rules Also like the Prudential Regulators rules, the CFTC s rules provide some relief from the re-proposal in certain areas, as well as some harmonization with the BCBS-IOSCO Framework. Specifically, the Prudential Regulators and CFTC s rules, as discussed in more detail below, would: Increase the material swaps exposure amount for financial end users from $3 billion to $8 billion of average daily aggregate notional amount of swaps activity over a three-month period, thereby decreasing the number of entities from and to which Covered Swap Entities must post and collect initial margin and aligning the amount with the BCBS/IOSCO Framework; 3 Under the CFTC s rules, Covered Swap Entities are swap dealers and major swap participants for which there is no Prudential Regulator, while under the Prudential Regulators rules, Covered Swap Entities include swap dealers, major swap participants, security-based swap dealers and major security-based swap participants that are regulated by a Prudential Regulator. 4 However, the Prudential Regulators and the CFTC clarify that cash collateral may be held in a general deposit account with the custodian if the funds in the account are used to purchase other forms of eligible collateral, such eligible non-cash collateral is segregated, and the purchase of which takes place within a time period reasonably necessary to consummate such purchase after the cash collateral is posted as initial margin. See 17 C.F.R (c) and Prudential Regulators Rule.7(c) Morrison & Foerster LLP mofo.com Attorney Advertising

104 Client Alert Harmonize dollar amounts for the initial margin threshold and minimum transfer amount with the BCBS- IOSCO Framework in light of changed exchange rates; Revise the definition of affiliate to eliminate a test of affiliation based on control in favor of consolidation under accounting rules, which should make certain calculations easier, such as for material swaps exposure, required by the rules; Expand the eligible collateral for initial and variation margin by permitting redeemable securities in certain money market mutual funds for initial margin and providing that variation margin collateral, which under the re-proposals could only be in cash, may be in any form that is eligible for initial margin for swaps between CSEs and financial end users; Modify treatment of pre- and post-compliance date swaps under eligible master netting agreements (agreements meeting certain requirements under which variation margin can be calculated on a net basis and risk offsets recognized for calculating initial margin); and Amend the phased-in compliance schedule for the rules in accordance with delay of the schedule announced by BCBS and IOSCO earlier this year by 9 months. Notable differences between the CFTC s and Prudential Regulators rules The CFTC s final rules have a few notable differences from the Prudential Regulators rules, including: Providing for a broader exemption from swaps between Covered Swap Entities and their affiliates than the more limited exemption provided by the Prudential Regulators, but with an anti-evasion provision; Delegating authority to the National Futures Association ( NFA ), the self-regulatory organization in the futures and swaps industry, to approve initial margin models, which could also be approved by the CFTC (the Prudential Regulators would undertake their own approvals); Excluding from the financial end user definition treasury affiliates that qualify for an exemption from mandatory clearing that the CFTC has exempted by rule (the Prudential Regulators have stated that they will include this provision if the CFTC acts to exempt such entities, which currently qualify for an exemption under CFTC staff no-action letters, by rule); Requiring that the variation margin calculation use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, and other objective criteria (the Prudential Regulators rules do not contain this provision); and Not addressing cross-border application of the rules, which are being considered by the CFTC in a separate proposal. Even with the relief provided for in the CFTC s and the Prudential Regulators rules, however, the obligations of the rules represent a significant regulatory burden and cost on the OTC swaps market that did not exist before. It remains to be seen how the swaps market will respond to these requirements Morrison & Foerster LLP mofo.com Attorney Advertising

105 Client Alert SCOPE OF THE FINAL RULES Financial end users Under both the CFTC s and Prudential Regulators rules, a Covered Swap Entity will not be required to collect or post specified amounts of initial or variation margin on swaps with counterparties that are not swap entities or financial end users. Such counterparties are described in the final rules as other counterparties by the Prudential Regulators and non-financial end users by the CFTC. The final rules retain the financial end user definition used in the re-proposal (a list of enumerated financial market status types under various U.S. statutes and regulations including banks, broker-dealers, investment companies, insurance companies, commodity pools and ERISA plans), 5 which was intended to provide greater clarity than the financial entity definition used in the statutory exemption from mandatory clearing in the Commodity Exchange Act ( CEA ). Expressly excluded from the financial end user definition are sovereign entities (central governments or an agency or department thereof), the Bank for International Settlements, multilateral development banks, 6 entities exempt from the definition of financial entity under section 2(h)(7)(C)(iii) or (D) of the CEA or section 3C(g)(4) of the Securities Exchange Act of 1934 ( Exchange Act ), and, as noted above, the CFTC s rules include an exclusion for treasury affiliates that qualify for an exemption from mandatory clearing that the CFTC has exempted by rule (currently exempted by staff no-action letters). The Prudential Regulators and the CFTC declined to exclude structured finance vehicles or covered bond issuers that had been requested by commenters. Requirements for swaps with non-financial end users Swaps with entities that are not financial end users are exempt from the margin requirements under both the CFTC s and the Prudential Regulators rules, except under the Prudential Regulators rules, a Covered Swap Entity must collect margin (if any) from such non-financial end users as the CSE determines is appropriate in its overall credit risk management of its exposure to the customer. 7 CSEs must make this determination for entities that do not qualify for the separate interim final rule (e.g., a commercial end user that is not hedging or mitigating commercial risk), as well as with respect to initial margin for financial end users without material swaps exposure (who are not subject to the rule s initial margin requirements). The CFTC s release does not require this determination, and also removes the requirement contained in the CFTC s re-proposal that CSEs calculate 5 See 17 C.F.R and Prudential Regulators Rule.2 (definition of financial end user). The Prudential Regulators and the CFTC added to the financial end user definition a U.S. intermediate holding company established or designated for purposes of compliance with the Federal Reserve Board s Regulation YY (12 C.F.R ), and three CFTC-registered entities to the enumerated list: floor brokers, floor traders, and introducing brokers. The CFTC also added business development companies to align its financial end user definition with that of the Prudential Regulators. Both sets of rules include a provision that would cover an entity, person, or arrangement that is, or holds itself out as, as entity, person, or arrangement that raises money from investors, accepts money from clients, or uses its own money primarily for the purpose of investing or trading or facilitating the investing or trading in loans, securities, swaps, funds, or other assets for resale or other disposition, or otherwise trading in loans, securities, swaps, funds, or other assets. See (xi) of the financial end user definition. The final rules also remove the provision contained in the re-proposals that would have included any other entity that the relevant agency determined should be treated as a financial end user. 6 Multilateral development banks are separately defined in the rule to include certain specified entities. 7 See 80 Fed. Reg. at 74, Morrison & Foerster LLP mofo.com Attorney Advertising

106 Client Alert hypothetical margin requirements for swaps with non-financial end users, citing the administrative burden and that other CFTC rules should address monitoring of risk exposures for these entities. 8 Interim final rule exemption The CFTC, like the Prudential Regulators, also adopted an interim final rule in accordance with the Business Risk Mitigation and Price Stabilization Act of 2015, which provides that the requirements of the uncleared swaps margin rules do not apply where the counterparty would be eligible for: An exemption from mandatory clearing under Section 2(h)(7)(A) of the CEA or Section 3C(g)(1) of the Exchange Act (i.e., a non-financial entity using the swap to hedge or mitigate commercial risk, certain small financial institutions and captive finance companies); An exemption under CEA Section 4(c)(1) for cooperative entities that would otherwise be subject to the requirement to clear; or The exemption for affiliates under CEA Section 2(h)(7)(D) or Exchange Act Section 3C(g)(4) (i.e., affiliates that act as an agent). 9 KEY MODIFICATIONS TO THE RE-PROPOSALS IN THE FINAL RULES The CFTC s and the Prudential Regulators final rules make a number of modifications to the re-proposals, as noted above, which provide relief in some cases as well as some harmonization with the BCBS/IOSCO Framework. The discussion of these modifications below also highlights differences between the CFTC s and Prudential Regulators rules. Material swaps exposure Under both the CFTC s and the Prudential Regulators final rules, the threshold for determining whether a financial end user has material swaps exposure has been increased from $3 billion to $8 billion of average daily aggregate notional amount of swaps activity for June, July, and August of the previous calendar year (determined by reference to the swaps activity of the financial end user and its affiliate(s) on business days), which is more closely aligned with the BCBS-IOSCO Framework. This change will reduce the number of entities from which swap entities must post and collect initial margin, which is required under the rules for swaps between swap entities and financial end users with material swaps exposure, and level the playing field between swap entities subject to U.S. rules and those subject to rules of foreign jurisdictions, such as the European Union and Japan, which have more closely followed the BCBS-IOSCO Framework. Both sets of rules also clarify that swaps eligible for an exemption under the interim final rule do not count toward this threshold and that swaps entered into between an entity and its affiliate are counted only once to prevent double counting. A new provision common to both the CFTC s and Prudential Regulators rules not contained in the re-proposals clarifies the consequences of a change in a counterparty s status. Under the new provision, if a change would 8 See CFTC Final Rule Release at C.F.R ; Prudential Regulators Interim Final Rule Morrison & Foerster LLP mofo.com Attorney Advertising

107 Client Alert make the rules stricter, such as when a financial end user becomes a financial end user with material swaps exposure, the stricter rules would apply for new swaps entered into after the change. Where a change would make the rules less strict (such as when the exposure of a financial end user with material swaps exposure falls below the $8 billion threshold), the swap entity may comply with less strict requirements for all outstanding swaps. Accordingly, initial margin, which is not required for swaps with financial end users that do not have material swaps exposure, would no longer be required with respect to all swaps under this provision if a financial end user drops below the $8 billion threshold. 10 Changes to other numerical amounts In addition to the modification to the material swaps exposure amount, both the CFTC s and the Prudential Regulators rules modify other numerical amounts contained in the re-proposals to take into account changed exchange rates that have occurred since the re-proposals were issued. Specifically, the initial margin threshold amount i.e., the amount under which initial margin need not be collected has been reduced from $65 million in the re-proposals to $50 million in the final rules due to changed exchange rates. 11 Similarly, the minimum transfer amount across initial and variation margin or the amount below which initial and variation margin need not be exchanged until it is exceeded has been reduced from $650,000 to $500,000 in the final rules. 12 Definition of affiliate Under both the CFTC s and the Prudential Regulators final rules, the definition of affiliate ( margin affiliate in the CFTC s rules) has been aligned with established accounting standards rather than relying on the control test contained in their re-proposals. The re-proposals contained a low level of control for affiliation to exist only 25 percent (not 50 percent or more) of the ownership or control, directly or indirectly, of a class of voting securities or total equity. The final rules provide that affiliation exists if a company consolidates the other (or both companies are consolidated with a third company) on financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles, the International Financial Reporting Standards, or other similar standards. 13 The change may make it easier for companies to determine whether, for example, a financial end user has material swaps exposure (which must be calculated to include the exposures of its affiliates), as well as determine compliance deadlines under the phased-in compliance schedule discussed below. The CFTC did not include in its affiliate definition a provision included in the Prudential Regulators definition of the term affiliate pursuant to which the relevant Prudential Regulator may determine that a company is an affiliate of another company based on the regulator s conclusion that either company provides significant support to, or is materially subject to the risk of losses of, the other company. 10 See 17 C.F.R (c) and Prudential Regulators Rule.1(g). 11 See 17 C.F.R and Prudential Regulators Rule.2 (definition of initial margin threshold amount). 12 See 17 C.F.R and Prudential Regulators Rule.2 (definition of minimum transfer amount). In addition to these modifications, the CFTC s and Prudential Regulators rules provide clarification about when margin must be collected, when counterparties are in different time zones or observe different legal holidays. See CFTC Final Rule Release at and 80 Fed. Reg. at See 17 C.F.R (definition of margin affiliate ) and Prudential Regulators Rule.2 (definition of affiliate) Morrison & Foerster LLP mofo.com Attorney Advertising

108 Client Alert Expansion of eligible collateral for initial and variation margin The CFTC s and Prudential Regulators rules also expand the types of eligible collateral for initial and variation margin. Eligible collateral types for initial margin include U.S. Treasury securities, government sponsored enterprise securities, securities issued or guaranteed by the Bank for International Settlements, the European Central Bank, the International Monetary Fund and multilateral development banks, publicly traded debt (other than asset-backed securities), publicly traded equities in certain indices and gold, but not securities issued by the pledgor or its affiliate or banks and similar entities. The final rules also permit collateral (not permitted in the reproposals) of redeemable securities in certain money market mutual funds that meet specific requirements. 14 The CFTC s and Prudential Regulators final rules also provide that variation margin may include major currencies (defined in the final rules) 15 in addition to U.S. dollars and the currency of settlement, while the re-proposals would not have permitted major currencies. An 8 percent cross-currency haircut applies if margin is denominated in a currency different from settlement currency, except that variation margin in immediately available cash funds in the major currencies is not subject to the haircut. Both sets of final rules also permit non-cash collateral eligible to be used for initial margin to serve as variation margin for swaps between a Covered Swap Entity and a financial end user (but not for swaps with other swap entities), while the re-proposals only permitted cash collateral for variation margin for all counterparties. 16 This change may be welcomed by certain financial entities, such as insurance companies, that hold significant reserves of bonds and other securities and commented that the restriction to cash-only variation margin would reduce their investment returns. The CFTC s rules include a provision, not included in the Prudential Regulators rules, that requires that variation margin calculations use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, or other objective criteria. 17 Approval of initial margin models The CFTC s and the Prudential Regulators final rules differ in terms of the approval of initial margin models. Both sets of final rules, like the re-proposals, impose stringent regulatory requirements on initial margin models, including written approval of the relevant regulator for use of initial margin models, demonstration on an ongoing basis that the model satisfies all of the requirements under the rules, and prior notice to the relevant regulator before making changes to the model or its assumptions. However, the CFTC s final rules would provide a 14 See 17 C.F.R and Prudential Regulators Rule The major currencies are United States Dollar (USD); Canadian Dollar (CAD); Euro (EUR); United Kingdom Pound (GBP); Japanese Yen (JPY); Swiss Franc (CHF); New Zealand Dollar (NZD); Australian Dollar (AUD); Swedish Kronor (SEK); Danish Kroner (DKK); Norwegian Krone (NOK); and any other currency designated by the CFTC or relevant Prudential Regulator. See 17 C.F.R and Prudential Regulators Rule.2 (definition of major currency). 16 See 17 C.F.R (b)(1)(ii) and Prudential Regulators Rule.6(b). 17 Both releases clarify, in response to comments that the re-proposals appeared to require calculation of variation margin based on the market value of the swap calculated from the Covered Swap Entity s perspective, that the market value used to determine the cumulative mark-to-market change will be mid-market prices, if that is consistent with the agreement of the parties. CFTC Final Rule Release at , 80 Fed. Reg. at 74, Morrison & Foerster LLP mofo.com Attorney Advertising

109 Client Alert registered futures association (the NFA is the only registered futures association) with authority to approve initial margin models in addition to the CFTC. 18 The Prudential Regulators final rules do not contain a similar provision; all approvals of initial margin models for Covered Swap Entities subject to their supervision will have to be approved by the relevant Prudential Regulator. 19 The CFTC notes that it or the NFA will coordinate with the Prudential Regulators in order to avoid duplicative efforts and to provide expedited approval of Prudential Regulator-approved models. 20 Eligible master netting agreements Relief was also provided by the CFTC and the Prudential Regulators from their re-proposals with respect to precompliance date and post-compliance date swaps subject to a single eligible master netting agreement ( EMNA ). For swaps subject to an EMNA, variation margin can be calculated on a net basis and risk offsets can be recognized within asset classes for calculating initial margin. Under the re-proposals, although the rules applied only to swaps entered into after the relevant compliance date, transactions subject to an EMNA applicable to precompliance date transactions would be subject to margin requirements for all swaps under the EMNA. Accordingly, without the relief provided for in the final rules, counterparties would have had to enter into a separate EMNA for new swaps, which received criticism from commenters who argued that this would reduce netting sets and thus increase systemic risk. Both sets of final rules permit counterparties to document pre- and post-compliance date swaps as separate portfolios for netting purposes under the same EMNA covered by separate credit support annexes. 21 Accordingly, netting portfolios that contain only uncleared swaps entered into before the applicable compliance date are not subject to the final rules. EMNAs, as provided under the re-proposals, are subject to a requirement that a swap entity conduct sufficient legal review to conclude with a well-founded basis that, among other things, the contract would be found legal, binding, and enforceable under the law of the relevant jurisdiction. Although unqualified legal opinions are not required, the legal review must be in writing. 22 Also with regard to EMNAs, the definition of EMNA is amended in the final rules to provide that impermissible walk away clauses do not include clauses that only suspend payment obligations when a counterparty defaults. 23 A provision included in the Prudential Regulators final rules that, if a netting agreement does not qualify as an EMNA, the Covered Swap Entity must collect variation margin on a gross basis but may post on a net basis, is not contained in the CFTC s final rules. 18 See 17 C.F.R (b). 19 See Prudential Regulators Rule.8(c). 20 See CFTC Final Rule Release at See CFTC Final Rule Release at and 80 Fed. Reg. at 74, See generally CFTC Final Rule Release at and 80 Fed. Reg. at 74,862. A similar legal review requirement applies to custodial agreements with third party custodians for initial margin. The CFTC and Prudential Regulators provide guidance that, for that purpose, the relevant jurisdictions include that of the custodian as well as that of the Covered Swap Entity s counterparty. See CFTC Final Rule Release at 139 and 80 Fed. Reg. at 74, In this regard, the definition of EMNA has been modified to align it with the definition of qualifying master netting agreement in the risk-based capital rules that was modified earlier this year. See 80 Fed. Reg. at Morrison & Foerster LLP mofo.com Attorney Advertising

110 Client Alert Inter-affiliate swaps Neither the CFTC s nor the Prudential Regulators re-proposals contained an exemption from the margin requirements for swaps between a Covered Swap Entity and its affiliates. As mentioned above, the Prudential Regulators and the CFTC s final rules differ on the treatment of such inter-affiliate swaps. Under the Prudential Regulators final rules, the margin requirements generally apply to swaps between a Covered Swap Entity and its affiliates (unless otherwise exempt), except that a Covered Swap Entity is not required to post initial margin to an affiliated counterparty. 24 The Covered Swap Entity is required to calculate the amount of initial margin that would be required to be posted under the rules to an affiliate (that is a financial end user with material swaps exposure) and provide documentation of such amount on a daily basis. The threshold for collecting initial margin from an affiliate that is a financial entity with material swaps exposure is $20 million (rather than the generally applicable $50 million threshold). The Prudential Regulators rules do not provide relief from variation margin, which must be posted to and collected from financial end user affiliates by swap entities. Initial margin in the form of non-cash collateral for swaps between a swap entity and its affiliates may be held by a custodian that is an affiliate of the Covered Swap Entity or by the Covered Swap Entity itself (rather than an unaffiliated third party as required for uncleared swaps with non-affiliates). The Prudential Regulators final rule allows a Covered Swap Entity to use a 5 business day close-out time horizon for modelling the initial margin requirement, rather than the generally applicable 10 business day horizon, for swaps that are required to be cleared but which are exempt because of a clearing exemption for inter-affiliate swaps. It should be noted that, if an affiliate of a swap entity is itself a swap entity, then the Prudential Regulators rules require that both swap entities must collect margin, and thus there is no relief from the posting requirement. Under the CFTC s final rules, a Covered Swap Entity is generally not required to collect initial margin from a margin affiliate (including another swap entity), provided that the CSE meets the following conditions: The swaps are subject to a centralized risk management program that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps; and The CSE exchanges variation margin with the margin affiliate. 25 The CFTC s final rules provide, however, that a Covered Swap Entity must collect initial margin from non-u.s. affiliates that are financial end users that are not subject to comparable initial margin collection requirements on their own outward-facing swaps with financial end users. In addition, in order to facilitate compliance with the Prudential Regulators rules, the CFTC s rules would require a Covered Swap Entity to post initial margin with a swap entity that is subject to the Prudential Regulators rules (and required to collect initial margin from its affiliates). As is the case under the Prudential Regulators rules, the CFTC s rules would require that variation margin be exchanged with respect to swaps between a Covered Swap Entity and its affiliates. 24 See Prudential Regulators Rule See 17 C.F.R Morrison & Foerster LLP mofo.com Attorney Advertising

111 Client Alert Phased-in compliance schedule Both the CFTC s and the Prudential Regulators final rules adopt the phase-in schedule announced by BCBS/IOSCO in March 2015, which delays implementation of initial margin and variation margin requirements by nine months compared with the re-proposals, starting in September 1, The compliance schedule is nonetheless aggressive in light of the legal, operational, and regulatory approval requirements imposed by the rules. The final rules provide for phased-in implementation for initial margin depending upon swaps exposure of the Covered Swap Entity and its affiliates and its counterparties and their affiliates starting from September 1, 2016 (for entities with the largest exposure) through September 1, 2020, after which swaps with all financial end users with material swaps exposure will be subject to the initial margin requirements. The CFTC s and Prudential Regulators final rules also provide for a delayed-implementation schedule with regard to variation margin for Covered Swap Entities belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives is less than $3 trillion for March, April and May 2016, until March 1, For all other Covered Swap Entities, the compliance date for variation margin is September 1, The final rules clarify that, once a CSE and its counterparty (and their affiliates) become subject to the margin requirements under the schedule, they remain subject to the requirements even if they have a change in status due to a reduction in notional exposure (this differs from the rule explained earlier when a financial end user with material swaps exposure changes status and the less strict margin requirements apply). The Prudential Regulators and the CFTC declined to provide guidance in response to commenters requests that certain swaps be considered to be entered into before the applicable compliance date. Cross-border application The Prudential Regulators final rules contain provisions governing the cross-border application of the margin rules, while the CFTC has proposed a separate rulemaking to address cross-border application, which has not yet been finalized. 27 The Prudential Regulators final rules, as under the re-proposal, exempt foreign swap entities (but not their U.S. branches or agencies) with respect to the foreign non-cleared swaps from the margin requirements. The exemption is not available where the foreign counterparty is, or is guaranteed by, a U.S. entity, a U.S. branch or subsidiary of a foreign bank, or a foreign swap entity that is a subsidiary of a U.S. entity. Substituted compliance (i.e., compliance with non-u.s. rules rather than U.S. rules) may be available for a foreign bank, U.S. branch or agency of a foreign bank, or an entity that is a foreign subsidiary of a depository institution, Edge corporation or agreement corporation. However, substituted compliance would be available only if the Prudential Regulators have made a comparability determination for the jurisdiction the rules of which would apply to the uncleared swap. Moreover, substituted compliance would not be available if the swap is guaranteed by a U.S. entity. 26 See 17 C.F.R and Prudential Regulators Rule.1(e). 27 See Prudential Regulators Rule.9. For more information on the CFTC s proposed rules regarding cross-border application of the uncleared swaps margin requirements, please see our client alert here Morrison & Foerster LLP mofo.com Attorney Advertising

112 Client Alert All swap entities (including U.S. entities) under the Prudential Regulators rules will be deemed to satisfy the initial margin posting requirement under the final rules if they post the amount of initial margin that each of their counterparties is required to collect under non-u.s. rules, provided that the Prudential Regulators have made a substituted compliance determination with respect to those rules and the swap is not subject to a guarantee from a U.S. entity. The Prudential Regulators final rules also provide relief in certain circumstances from the segregation requirements to foreign branches and subsidiaries of U.S. banks and Edge corporations where inherent limitations in the legal or operational infrastructure in a foreign jurisdiction make it impracticable to segregate collateral. 28 CONCLUSION The CFTC s and Prudential Regulators final rules provide some welcome relief to market participants when compared with the re-proposals, and the harmonization efforts with non-u.s. regulators should help to create a more level playing field. Nonetheless, the margining requirements imposed by the rules represent a significant regulatory burden and cost on the OTC swaps market that did not exist before, in particular as it pertains to initial margin, which, due to the segregation and re-hypothecation restrictions, will impose a significant new cost for swap dealers and financial end users with material swaps exposure. Because of the 10 business day close-out requirement for calculating initial margin, this cost will be substantially higher than other derivative products, such as cleared swaps or futures. It remains to be seen how the swaps market will respond to these requirements and whether, as a result of their cost, the use of other derivative products, such as cleared swaps and futures, may be used in place of OTC swaps. Contact: Julian E. Hammar (202) jhammar@mofo.com David H. Kaufman (212) dkaufman@mofo.com James Schwartz (212) jschwartz@mofo.com Chrys A. Carey (202) ccarey@mofo.com About Morrison & Foerster: We are Morrison & Foerster a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We ve been included on The American Lawyer s A-List for 12 straight years, and Fortune named us one of the 100 Best Companies to Work For. Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome. 28 See Prudential Regulators Rule.9(f) Morrison & Foerster LLP mofo.com Attorney Advertising

113 Client Alert August 28, 2015 The SEC s Registration Rules for Security-Based Swap Dealers Early this month the U.S. Securities and Exchange Commission ( SEC ) released final rules (the Registration Rules ) for the registration of security-based swap dealers ( SBSDs ). 1 The Registration Rules, released more than three years after the release by the U.S. Commodity Futures Trading Commission ( CFTC ) of its parallel rules for the registration of swap dealers, 2 set out the formal requirements for SBSD registration and are instructive for financial institutions that may be required to register as SBSDs when such registration comes to be required. Timing for Registration and for Related Calculations The Registration Rules have little immediate effect. Their compliance date, when the SBSD registration requirement will go into effect, will occur only after the occurrence of several events that, taken together, have not yet occurred, cannot occur for a minimum of six months, and seem relatively unlikely to occur until after significantly more than six months have passed. 3 Moreover, market participants are not required to register as SBSDs until after their security-based swap activity exceeds certain de minimis thresholds. 4 The Registration Rules Release states that, for purposes of complying with registration requirements, entities engaging in security-based swaps activities are not required to begin calculating whether their activities meet or exceed such thresholds until two months prior to the compliance date of the Registration Rules. 5 1 Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, 80 Fed. Reg. 48,963 (August 14, 2015) (the Registration Rules Release ). The Registration Rules Release is available here. Under the Registration Rules, registration requirements are very similar for SBSDs and for major security-based swap participants ( MSBSPs ). For clarity and ease of reading, and in view of the likely rarity of MSBSPs, this client alert generally refers to SBSDs and not to MSBSPs. 2 Registration of Swap Dealers and Major Swap Participants, 77 Fed. Reg (January 19, 2012). Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act gives the CFTC jurisdiction over swaps and swap dealers and the SEC jurisdiction over securitybased swaps and security-based swap dealers. 3 Specifically, the compliance date will occur on the later of: (i) six months after the date of publication in the Federal Register of a final rule release adopting rules establishing capital, margin and segregation requirements for SBSDs; (ii) the compliance date of final rules establishing recordkeeping and reporting requirements for SBSDs; (iii) the compliance date of final rules establishing business conduct requirements for SBSDs; or (iv) the compliance date for final rules establishing a process for a registered SBSD to make an application to the SEC to allow an associated person who is subject to a statutory disqualification to effect or be involved in effecting security-based swaps on the SBSD s behalf. Registration Rules Release at 48, See generally Further Definition of Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant, 77 Fed. Reg. 30,596, 30,756 (May 23, 2012). 5 Registration Rules Release at 48, Attorney Advertisement