Post-Dodd-Frank Derivatives Regulatory Environment

Transcription

1 2013 Morrison & Foerster LLP All Rights Reserved mofo.com Post-Dodd-Frank Derivatives Regulatory Environment July 16, 2013 Presented By James Schwartz NY

2 Overview of Presentation Overview of Title VII of Dodd-Frank The Rulemaking Process Major areas in which CFTC rulemaking is reasonably complete: Extraterritoriality Swap Dealer and Major Swap Participant registration Swap data recordkeeping and reporting Business conduct standards Mandatory swap clearing Swap Execution Facilities Major unfinished rulemaking areas: OTC margin requirements Additional mandatory clearing designations SEC Title VII implementation Related areas: Volcker Rule, Lincoln Amendment Proposed legislation/future prospects 2

3 Overview of Dodd-Frank Title VII Dodd-Frank was passed by Congress and signed into law in July, 2010 The law represents a fundamental change in the regulatory approach to derivatives Prior to Dodd-Frank, derivatives were a largely unregulated market Dodd-Frank makes the swaps market a highly regulated market The legislation left an unusually large amount of discretion to the government agencies charged with implementing the law. CFTC Swaps (approximately 90-95% of the market) SEC Security-Based Swaps (approximately 5-10% of the market) 3

4 Overview of Dodd-Frank Title VII Title VII of Dodd-Frank was drafted based on a narrative in which the unregulated bilateral (OTC) derivatives market was in significant part a cause of the 2008 financial crisis The narrative was based in part on events relating to AIG, which insured mortgage-backed securities by entering into complex credit default swaps and selling protection on them The swaps proved difficult to value and appeared to leave AIG s counterparties, major financial institutions, highly exposed to AIG s credit risk In addition, in the Lehman bankruptcy, regulators were surprised and unhappy to discover how difficult it was to determine who Lehman s counterparties were and the nature of Lehman s swap transactions 4

5 Overview of Dodd-Frank Title VII Because the perceived risks of bilateral derivatives, Dodd-Frank is intended to drive the swaps business away from a bilateral model and toward a futures-like model in which swaps are centrally cleared Regulations apply in some form or another to all instruments generally known as swaps, not just to the highly complex types of transactions that proved problematic Regulations apply even though a party to a swap must generally be an eligible contract participant (an ECP ), that is, generally a party with a substantial net worth and presumably at least somewhat sophisticated. 5

6 Overview of Dodd-Frank Title VII Because of the importance in the conception of Dodd-Frank of moving bilateral transactions to a centrally-cleared, futures-like model, it made sense to make the CFTC the primary U.S. regulator for futures contracts the primary regulator for swaps. Bilateral: what it sounds like two contracting parties entering into transaction. Typically transactions are underpinned by an ISDA Master Agreement or other similar agreement, which provides terms for defaults, netting and closeout. Cleared transactions: can be entered into bilaterally, but each party contracts with a futures commission merchant (FCM) and the FCM takes that party s side of the transaction to a clearinghouse. Each party s side of the swap is novated to the clearinghouse, resulting in two new swaps, each between the clearinghouse and a party to the original swap. 6

7 Overview of Dodd-Frank Title VII The extent to which it is appropriate to house swap-related risks in clearinghouses is hotly debated. Fundamentally, clearinghouses pool risks associated with swaps, so it becomes significant who backs up the clearinghouse. Clearinghouse members typically contribute to default funds. Typically clearinghouse rules state what happens if the clearinghouse s losses exceed the amount of its default fund To the extent that swap dealers are clearinghouse members, dealers may have large risk to clearinghouse defaults Swaps, especially complex, illiquid swaps, may pose significant issues that the simpler futures contracts historically houses in clearinghouses do not pose To date, the CFTC has required the clearing only of vanilla, liquid interest rate swaps and credit default swaps. 7

8 The Rulemaking Process Regulators have had an immensely heavy workload, given the discretion that Congress gave them and the sheer number of rules that they must make. Deliberations and regulators public comments regarding rules have had political overtones Wall Street vs. the people. 8

9 The Rulemaking Process CFTC has moved forward with implementation, while at the same time setting up a parallel process for issuing no-action letters exempting various market participants from complying with many of its rules CFTC Commissioner Scott O Malia: there are many unintended, overreaching and technologically infeasible provisions in our rules [so] we have in effect been forced to set up a parallel exemptive process to provide relief from these rules. In contrast, the SEC has taken a more deliberative approach, finalizing few rules and postponing the effectiveness of much of Dodd-Frank with respect to security-based swaps until at least early next year 9

10 Extraterritoriality Generally A big, complicated issue The derivatives market is international, with counterparties in different countries and parts of the world transacting regularly As a result, the question arises of how transactions involving two (or more) jurisdictions are to be regulated 10

11 Extraterritoriality Generally With respect to swaps, the application of Dodd-Frank is limited to activities that have a direct and significant connection with activities in, or effect on, commerce of the United States or that are contrary to CFTC anti-evasion rules Similarly, under EMIR, certain obligations apply to parties outside the EU if the relevant contract has a direct, substantial and foreseeable effect within the EU or when the obligation is necessary or appropriate to prevent evasion of EMIR s provisions Given the cross-jurisdictional nature of the swap market, and the apparent long reach of the regulations of both the CFTC and the EU, there is little alternative to cross-border cooperation among the regulators 11

12 Extraterritoriality the Path Forward The question of how cross-border transactions are to be regulated became clearer late last week On July 11, the CFTC released a document called Cross-Border Regulation of Swaps/Derivatives Discussions between Commodity Futures Trading Commission and the European Union a Path Forward The path forward document highlighted areas of commonality between the CTC and the EU and stated that coordination between regulators in Europe and the US had ensured that the rules for the swaps market would pursue the same objectives and generate the same outcomes 12

13 Extraterritoriality the Path Forward The path forward document stated, among other things, that: the CFTC would issue a no-action letter stating that when a swap is subject to joint jurisdiction under US and EU rules, compliance with EU law will achieve compliance with the CFTC s rules for entity-level requirements, the CFTC had proposed a regime of substituted compliance, under which the CFTC would accept compliance with reasonably similar foreign rules as compliance with its own rules substituted compliance may also apply to certain transaction-level requirements for swaps between non-us swap dealers and US persons. in many areas, such as confirmation requirements, portfolio reconciliation, portfolio compression valuation and dispute resolution, the EU and US regimes are essentially identical with regard to margin requirements, regulators around the world are working to harmonize requirements, which may also be administered on the basis of substituted compliance and with regard to mandatory clearing, the EU and the US will apply a stricter-rule applies approach 13

14 Extraterritoriality the Path Forward In addition, the path forward document stated that the CFTC s definition of US person will include offshore hedge funds and collective investment vehicles that are majority owned (directly or indirectly) by US Persons this seems likely to require such funds and vehicles to increase compliance efforts to determine which investors are, or are owned by, US Persons 14

15 Extraterritoriality Exemptive Order Last Friday, July 12, was an important day because, absent action by the CFTC, it would have marked the expiration of an important exemptive order If the order had expired without any action by the CFTC, that would have caused confusion in the market Instead of permitting the previous order to expire with no action, the CFTC issued an order providing for the phase-in of its US Person definition, and both transaction-level and entity-level requirements for non-us swap dealers (both of which may be subject to substituted compliance) For non-us swap dealers, relief under the order may extend as late as December 21, 2013 The CFTC is still seeking comments on issues that are not fully addressed in the exemptive order 15

16 Extraterritoriality Final Guidance The CFTC yesterday released its final interpretive guidance regarding cross-border issues The guidance states that, in issuing comparability determinations for purposes of substituted compliance, the CFTC will rely upon an outcomes-based approach to determine whether foreign requirements achieve the same regulatory objectives as Dodd-Frank comparability determinations may be made on a requirement-by-requirement basis, rather than on the basis of the foreign regime as a whole parties that may apply for substituted compliance may include foreign regulators, non-us entities, banks that are US entities with respect to foreign branches and trade associations on behalf of their members CFTC expects to enter into MOUs with foreign regulators in relation to information sharing and the ongoing supervision of swap dealers and MSPs. 16

17 Swap Dealer/MSP Registration Dodd-Frank applies most strictly to the most sophisticated market participants, swap dealers and major swap participants. For example, it is SDs and MSPs who are required to adhere to the CFTC external and internal business conduct rules. Generally, an SD or an MSP is defined as an entity who has registered with the CFTC as such If an entity transacts a certain amount of swaps counted against a threshold, then generally it will be required to register as an SD or MSP Certain FX transactions and certain hedging transactions do not count against the thresholds 17

18 Swap Dealer/MSP Registration First wave of registrations occurred on December 31, 2012 Close to 70 swap dealers provisionally registered, no MSPs Since then, a number of additional registrants (at least seven) A decision point for mid-market banks: try to stay exempt from registration, or register? 18

19 Recordkeeping Recordkeeping requirements are in effect for all market participants Important that even non-registered end-users appreciate that they are subject to recordkeeping requirements For registered entities, recordkeeping requirements are more extensive In particular, Rule imposes some of the most challenging technological recording and search function requirements that swap dealers and MSPs face, including the requirement to record pre-execution trade information, including records of all oral and written communications provided or received concerning quotes, solicitations, bids, instructions, trading and prices, that lead to the execution of a swap, whether communicated by telephone, voic , facsimile, instant messaging, chat rooms, electronic mail, mobile device or other digital or electronic media 19

20 Swap Data Reporting Full reporting obligations are now in effect for swap dealers and MSPs, subject only to various no-action relief Reporting obligations for other counterparties are now being phased in, in accordance with CFTC no-action relief Three separate parts of the CFTC s regulations relate to swap data reporting: Part 43: Real-time Public reporting. This relates to the requirement to report in Real-time most transactions (other than transactions above certain size thresholds), with the data (but not the identities of the transacting parties) being publicly disseminated. Part 45: Swap transaction data for new swaps. Part 45 provides somewhat different data fields than does Part 43. Part 46: Swap transaction data for historical swaps (entered into prior to April 10). 20

21 Swap Data Reporting (cont d) Generally, the more sophisticated party, the dealer, is required to fulfill reporting requirements. A number of troublesome issues have arisen relating to swap data reporting Under Part 45 and 46 of CFTC regulations, if neither party to an off-exchange swap is a swap dealer or MSP and only one party is U.S. Person, the U.S. Person generally has the reporting obligation This has been a particular issue for non-registered foreign banks with U.S. clients For smaller entities, systems burdens can be excessively costly Has spawned a market for third-party service providers to offer reporting services Engaging a service provider, however, does not relieve reporting party of compliance responsibility 21

22 Swap Data Reporting (cont d) Value and use of data are also being called into question Commissioner O Malia has been very vocal in expressing his displeasure with the reporting requirements as well as many other aspects of the CFTC s regulatory rollout. In March, O Malia complained about an impending data nightmare Immediately after no-action relief was granted on April 9 th, he issued a statement listing various complaints, including his concern that the CFTC is facing immense challenges in using data that the three SDRs are reporting due to inconsistent and incomplete reporting, technology shortfalls and integration issues 22

23 Business Conduct Standards External and Internal Business Conduct Standards have, other than as provided in CFTC no-action relief, generally come into effect External Business Conduct: relates to dealings with counterparties Internal Business Conduct: includes such matters as Chief Compliance Officer requirement, risk management program, conflict of interest rules. Business Conduct requirements are applicable to, and create compliance burdens for, SDs and MSPs But other market participants are indirectly affected in several ways: End-users may need to take certain actions in order to continue to be able to trade with swap dealers and MSPs and to elect the end-user clearing exception to mandatory clearing Non-registered financial entities may need to consider whether the market practices observed by swap dealers and MSPs compel them to adopt some or all practices on a voluntary basis 23

24 Business Conduct Standards (cont d) For External Business Conduct Standards, effective date was generally May 1, 2013 after being delayed through CFTC relief External Business Conduct Standards include: General standards covering verification of counterparty status, KYC and institutional suitability requirements, disclosure obligations relating to material risks, characteristics and conflicts of interest, daily mark-to-market values, clearing disclosures Additional standards apply to interactions with Special Entities such as public entities or pension plans Swap dealers have addressed these requirements in several ways ISDA Protocol Bi-lateral documentation based on or incorporating portions of the ISDA Protocol Standalone bi-lateral onboarding documentation 24

25 Business Conduct Standards (cont d) The ISDA DFA Protocols consist of August DF Protocol and March 2013 DF Protocol II What does the ISDA August 2012 DF Protocol address? Entity status Verify identity Confirm ECP status Special Entity status Identify and verify advisory relationships Confirm essential details Presence of advisor/agent Suitability issues Disclosure requirements Confirm availability of regulatory safe harbors 25

26 Business Conduct Standards (cont d) How does the ISDA August 2012 DF Protocol function? The protocol, in effect, establishes a set of standard amendments to ISDA Master Agreements or other agreements governing swap transactions Submit adherence letter via ISDA website $500 fee An agent may adhere on behalf of multiple entities In addition, an adhering entity must complete the Questionnaire forming part of the Protocol and deliver it to those trading parties for which it wishes the Protocol to be effective ISDA and Markit have established ISDA Amend, an online system, to facilitate the delivery of Questionnaires by pairs of counterparties It is also possible to deliver Questionnaires outside of the online system. By adhering to the Protocol and exchanging completed Questionnaires with a counterparty, a party will have amended its covered agreements with such counterparty to include various representations that address many external business conduct requirements and, in particular, are geared to satisfying certain regulatory safe harbors available to SDs and MSPs. 26

27 Business Conduct Standards (cont d) March 2013 DF Protocol II This second ISDA protocol, which was finalized in late March 2013, addresses rules relating to (1) the end-user exception to clearing; (2) portfolio compression and reconciliation; and (3) swap trading relationship documentation rules, as well as certain related matters. These rules were not addressed in the ISDA August 2012 DF Protocol, because they were finalized by the CFTC after its publication. Mechanics of compliance are similar to those of ISDA August 2012 DF Protocol, including an exchange of questionnaires and a separate $500 fee. Exchange of March Protocol Questionnaire via ISDA Amend started May 20,

28 Business Conduct Standards (cont d) ISDA has been pursuing other initiative to help address the compliance challenges presented by business conduct and reporting requirements, including 2013 Reporting Protocol (with alternative side letters), which is designed to assist market participants (not just registered entities) in compliance with trade reporting requirements by facilitating the procurement of written consents to disclosure by counterparties Exclusionary Terms and Keepwell Terms, which are designed to help recipients of guarantees deal with the risk of a non-ecp swap guarantor Protocol for Intermediated FX Transactions, which is designed to help market participants verify applicability of CFTC no-action letter in relation to external business conduct rules as applied to certain prime brokered FX transactions 28

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

30 Mandatory Clearing (cont d) Mandatory clearing of standard IRS and CDS products commenced on March 11, 2013 for Category 1 entities, with Category 2 entities facing a start date of June 10, End-users will be required to clear these swaps (subject to applicable exceptions) starting September 9, To Clear, or Not to Clear? Possible that some end-users may prefer to clear Some factors end-users may consider when deciding whether to clear: Desire to replace dealer credit risk with CCP credit risk Depending on final OTC margin requirements and the margin levels dealers impose, it may not be much more expensive to clear than not (though until these rules are finalized, hard to make any firm assessment of this). Clearing will require new infrastructure and relationships (SEFs, FCMs). Clearing will require new documentation Some products are not amenable to clearing (i.e., too bespoke and/or illiquid). 30

31 Mandatory Clearing (cont d) Futurization of Swaps Many swaps are the functional equivalent of a series and/or combination of individual futures contracts or options on futures contracts Futurization of swaps refers to an effort by some in the industry to restructure swaps as futures in order to avoid certain Dodd-Frank regulatory requirements, including: possibly higher initial margin requirement (swaps have a longer value-at-risk (or, VaR ) charge than futures) for potential SDs and MSPs, futurizing swaps may facilitate avoiding registration (futures do not count toward registration thresholds) No EBC rules Reporting (at least no worse than swaps) LSOC (legally separate but with operationally commingled) requirement for initial margin posting relating to cleared swaps 31

32 Mandatory Clearing (cont d) Futurization of Swaps (cont.) Some exchanges have begun to produce new exchange traded futures products that mimic the behavior of swaps. In some markets, such as the energy market, the vast majority of swaps have been futurized into futures. In 2012, ICE announced it was converting all of its energy swaps into energy futures. CME has also announced it intends to do the same. How far beyond energy swaps will futurization extend? The delay in the finalization of the recently released SEF rules arguably pushed the cleared swap markets towards futurization. An unintended consequences of Title VII to OTC swaps market. Trading on ICE reportedly commenced last month in US credit futures contracts, alternatives to CDS for the relevant indices (Markit CDX and itraxx). Further indication of the potential for futures markets supplanting significant portions of the OTC swaps market 32

33 Mandatory Clearing (cont d) As mandatory clearing progresses, the debate over its utility has become more intense Many argue it will impose an unwarranted liquidity drain on the derivatives market ISDA has made this point on multiple occasions Some market participants have complained that excessive clearing will result in the demise of the customized/bespoke derivatives market which many end-users valued End users have been among the groups raising this concern Others contend that expanding swaps clearing will, as an unintended consequence, result in the shifting to and concentration of risk at CCPs, rather than the elimination of systemic risk as many presume A clearinghouse that clears inappropriate instruments (i.e., swaps that are too illiquid with abrupt price movements) or that are exposed to wrong-way risk could create an unintended risk to the entire clearinghouse with vast systemic consequences Such clearinghouses would likely be the new too big to fail entities 33

34 Mandatory Clearing (cont d) Establishing a clearing relationship As swap clearing becomes a reality, additional or modified documentation will be required by some non-registered entity types (although true corporate end-users may never need to use them) CFTC regulations place certain constraints on clearing-related documentation Clearing firms currently are proposing the following three types of documents: Futures Account Agreement ( FAA ) Customer agreement for setting up a futures account between an FCM and a customer Cleared OTC Derivatives Addendum to FAA Necessary because FAAs do not address swaps or close-out rights in relation to cleared swaps Execution Agreement New documentation must address consequences if a transaction that is expected to clear is not accepted for clearing 34

35 Mandatory Clearing (cont d) FAA Sets out the bilateral relationship between the clearing member and its customer Not standardized, differs among dealers Historically used for trading futures or options on futures Sell-side friendly and, in relation to futures, not highly negotiated In negotiations to clear derivatives under the FAA, customer typically attempts to make FAA more like an ISDA Master Agreement by: limiting defaults against customer; including cure periods for defaults; and limiting the amount of margin that FCM may require its customer to post (for example, by requiring FCM to rely on clearinghouse margin calculations). In addition, customers frequently attempt to negotiate for a commitment to clear (with mixed results). 35

36 Mandatory Clearing (cont d) Cleared OTC Derivatives Addendum to FAA Addendum makes FAA applicable to cleared swaps The final standardized document was published in August 2012 Covers all derivatives transactions amenable to clearing (including forwards and options), not just swaps The final document elaborates on close-out of swaps upon termination Liquidation provision (Section 7) provides detailed liquidation and close out methodology for clearing members All such close out activity is to occur in accordance with a defined Liquidation Standard that is based on good faith and commercially reasonable procedures, though it is also recognized that a clearing member may have to effect a close out in circumstances where no prevailing market prices or bona fide quotations are available The document also contains representations as to authority, non-reliance language and tax provisions. Require a clearing member to transfer ( port ) the customer s trades to another clearing member upon client s request in accordance with National Futures Association rules. 36

37 Mandatory Clearing (cont d) Cleared Swaps Execution Agreement This agreement sets out the procedure for trade affirmation or rejection and states what happens if a transaction that is expected to clear is not accepted for clearing Each of the parties to the original transaction (dealer and client) represents that it has a clearing agreement with a clearing member Once a transaction is accepted for clearing, neither dealer nor client has any obligation to the other (DCO becomes a party to both sides of transaction) If a trade does not clear, then unless otherwise agreed, at the option of the dealer: The dealer (if it is a clearing member) may elect to accept the transaction in its capacity as clearing member, or have a clearing member affiliate do so; If the transaction is not legally required to be cleared, the dealer may enter into the transaction on a bilateral (uncleared) basis; or The transaction may be terminated 37

38 Mandatory Clearing/End-User Exception Clearing exception for end-users An end-user may be eligible for an exception from the clearing and trade execution requirements under CEA Section 2(h)(7) and CFTC Rule In order to qualify for the end-user exception, an end-user: Cannot be a financial entity (with limited exceptions); Must use swap to hedge or mitigate commercial risk ; and Must notify the CFTC of how the entity meets its financial obligations associated with entering into non-cleared swaps 38

39 Mandatory Clearing/End-User Exception (cont d) A financial entity includes: SDs, MSPs; Commodity pool operators; Private funds; ERISA plans; or Persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature (defined under Section 4(k) of the Bank Holding Company Act), including securities underwriting and dealing, investment advisory activities, insurance agency or brokerage, and extending credit. 39

40 Mandatory Clearing/End-User Exception (cont d) Financial entity exceptions: Captive finance affiliate and the 90% rule Primary business of subsidiary is providing financing; Subsidiary uses derivatives for the purpose of hedging commercial risks related to interest rate or FX exposure; 90 percent or more of which arise from financing that facilitates the purchase or lease of products; and 90 percent or more of such products are manufactured by the parent company or another subsidiary of the parent company The subsidiary acts as an agent for its non-financial affiliates and uses swaps used to hedge or mitigate commercial risk Small financial institution banks, savings associations, farm credit system institutions, and credit unions with total assets of $10 billion or less 40

41 Mandatory Clearing/End-User Exception (cont d) To qualify for the end-user exception, a swap must be used to hedge or mitigate commercial risk, which requires that a swap: qualifies as a bona fide hedging under the CEA position limit rules, or qualifies for hedging treatment under FASB, or be economically appropriate to reduce, in the ordinary course of business, risks arising from a change in: the value of assets that the entity owns, produces, manufactures, processes or merchandises; the value of liabilities due to fluctuations in interest, currency or foreign exchange rates, or the interest, currency or foreign exchange rate exposures arising from a person s assets, services or liabilities; and not be used for a purpose that is in the nature of speculation, investing or trading and not be used to hedge or mitigate the risk of another swap, unless that other swap itself is used to hedge or mitigate commercial risk. 41

42 Mandatory Clearing/End-User Exception (cont d) Actions to be taken by end-users in connection with the end-user exception: Board/Committee approval (public companies only) Reporting Enter into the ISDA DF Protocol (or similar arrangement) Obtain an LEI/CICI Evaluate margining arrangements Corporate actions to be taken by end-users that are reporting companies Board or an authorized committee must approve decision to rely on end user exception A committee may be authorized by the Board to review the company s swaps policies and evaluate the company s reliance on the end user exception Also covers a reporting company s controlled subs 42

43 Mandatory Clearing/End-User Exception (cont d) Reporting for End-Users Reporting counterparty reports the following data points to an SDR (or the CFTC): whether the swap is subject to the end-user exception; the identity of the exempt end-user; and whether the end-user has filed an annual filing with the SDR (or the CFTC). End-user is required to report annually (or, if it chooses, on a trade-by-trade basis) to an SDR (or the CFTC) containing the following information: whether it is a financial entity or a finance affiliate; whether the swap hedges or mitigates commercial risk; whether it is an SEC reporting company, and, if so, whether the appropriate committee of its board of directors has reviewed and approved the decision to enter into swaps that are exempt from clearing; and how it generally expects to meet its financial obligations: a credit support agreement; pledged assets; a third-party guarantee; its own available financial resources; or other means. 43

44 Mandatory Clearing/End-User Exception (cont d) The second ISDA Protocol is partially responsive to the election of the end-user exception: end-user to notify SD/MSP counterparty if it intends not to clear a swap based on the end-user exception (may be a standing notice for multiple swaps); end-user represents that it is eligible for the exception; and either end-user is deemed to represent that it has filed an annual end-user report with an SDR (or the CFTC) in a filing that is still effective; or it has notified its counterparty that it has not filed an annual report; it is not a financial entity; it is using the swap to hedge or mitigate commercial risk; and it generally meets its financial obligations associated with entering into swaps. And what about non-financial entity inter-affiliate trades? Inter-affiliate trades would appear to be able to take advantage of the end-user exception, subject to complying with SDR reporting and other requirements However, an additional rule exempting interiaffiliate trades should simplify this area 44

45 Mandatory Clearing/Affiliate Exception The CFTC released final Rule on April 1, 2013 CFTC has made clear it anticipates that the exemption will be used primarily for trades between affiliated financial entities that are less likely to be able to use the end-user exception The rule allows the eligible affiliate counterparties to a swap to elect not to clear a swap that would otherwise be subject to mandatory clearing, subject to the following limitations: Only majority-owned affiliates eligible for exemption Both counterparties would have to elect not to clear the swap Swap trading relationship documentation required between the parties Swap must be subject to a centralized risk management program within the group of affiliated entities that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps 45

46 Mandatory Clearing/Affiliate Exception (cont d) Eligible Affiliate Counterparties one counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties; and the financial statements of both counterparties are consolidated under GAAP or International Financial Reporting Standards. Swap Trading Relationship Documentation For SDs/MSPs, an agreement that contains all terms governing the trading relationship between the affiliates, incl. payment obligations, netting of payments, events of default or other termination events, calculation and netting upon termination, transfer of rights and obligations, governing law, valuation and dispute resolution procedures (compliance with business conduct rule satisfies the rule). For non-sds/msps, the terms of the swap must be documented in a written swap trading relationship document that includes all terms governing the trading relationship between the counterparties. 46

47 Mandatory Clearing/Affiliate Exception (cont d) Cross-Border Issues If one of the affiliates is located outside the U.S., and such affiliate enters into any swaps with unaffiliated third parties, one of the following conditions must be satisfied with respect to such third party swaps: Cleared under CEA Section 2(h); Cleared under a comparable and comprehensive but not necessarily identical foreign clearing regime; They are subject to an exception or exemption from clearing pursuant to CEA Section 2(h)(7) or Part 50 of the CFTC s regulations; They are subject to a comparable and comprehensive but not necessarily identical exception or exemption from clearing pursuant to a comparable and comprehensive but not necessarily identical foreign clearing mandate; or Cleared on a DCO or a clearing organization assessed as being in compliance with the Principles for Financial Market Infrastructures. 47

48 Mandatory Clearing/Affiliate Exception (cont d) Cross-Border Issues (cont.) 1-year phase-in for cross-border requirement (EU/Japan/Singapore) Until March 11, 2014, collection of full VM required on all swaps between the EU/Japanese/Singaporean counterparty and unaffiliated third parties. During the phase-in period, the entire cross-border restriction (incl. VM) does not apply where (i) neither counterparty is affiliated with an SD or MSP and (ii) the affiliate that majority owns the other (or the third party affiliate that majority owns both counterparties) is not a financial entity. 1-year phase-in for cross-border requirement (Other Foreign Jurisdictions) Until March 11, 2014, collection of full VM required on all swaps between the non-u.s. counterparty and unaffiliated third parties. Phase-in relief only available if the aggregate notional of swaps of a class subject to mandatory clearing under CEA Section 2(h) entered into by a U.S. entity with its affiliates in such jurisdictions does not exceed 5% of the aggregate notional amount of swaps of such class executed by such U.S. affiliate (calculated on a quarterly basis). 48

49 Mandatory Clearing/Affiliate Exception (cont d) Centralized Risk Management Program The adopting release suggests that if a corporate group already has a centralized risk management program in place that performs this function, that it is likely that the program would fulfill the requirements of the final rule. If at least one of the eligible affiliate counterparties is an SD or MSP, this requirement can be satisfied by complying with the requirements of CFTC Regulation Margin The final rule does not require marking-to-market or payment of IM or VM 49

50 Mandatory Clearing/Affiliate Exception (cont d) Reporting Requirements Reporting counterparty (selected pursuant to Part 45) must provide the following information to an SDR or, if no SDR exists, to the CFTC: Confirmation that both counterparties to the swap are electing not to clear the swap and that each of the counterparties satisfies the requirements to claim the exemption (may not be reported annually); For each counterparty, how it generally meets its financial obligations associated with entering into uncleared swaps (may be reported annually); and If a counterparty is a public company, (i) the SEC Central Index Key number for that counterparty and (ii) acknowledgment that an appropriate committee of the board of directors of that counterparty has reviewed and approved the decision not to clear the swap (may be reported annually). 50

51 Mandatory Clearing/Treasury Affiliate Exception For Treasury affiliates of end-users, the CFTC issued an no-action letter on June 4, 2013 providing relief from mandatory clearing for certain swaps between such Treasury affiliates and unaffiliated counterparties. Treasury affiliates refers to entities that may undertake hedging activities on behalf of affiliates within a corporate group, or act in a wider capacity as treasury centers that provide financial services for all or most of the affiliates within a corporate group, including daily cash management, debt administration, and risk hedging and mitigation. 51

52 Mandatory Clearing/Treasury Affiliate Exception Numerous conditions must be satisfied for this relief to apply, including: The Treasury entity seeking the exception must not be owned by a financial entity; The relevant swap must be for the purpose of hedging or mitigating the commercial risk of one or more affiliates of the Treasury entity; and Reporting requirements, comparable to those applicable in connection with the end-user exception to mandatory clearing, must be satisfied. ISDA recently released a Treasury Affiliate Representation Letter to be used by swap dealers and MSPs with treasury affiliate counterparties to facilitate compliance with this no-action relief. 52

53 Mandatory Clearing/Securitizations Last week the American Securitization Forum (ASF) submitted to legislators in both the House of Representatives and the Senate proposed statutory changes that include an exception to mandatory clearing for securitization vehicles. Exception as proposed would apply to issuers of asset-backed securities that own certain financial assets with an aggregate value equal to or greater than the notional amount of the swap or swaps hedging the same characteristic of the assets, where the issuer provides a first-priority security interest to its swap counterparty, along with a senior position in any distribution waterfall. Previously, in May of this year, the ASF submitted a no-action request to the CFTC seeking an explicit exemption for securitization swaps from mandatory clearing requirements ASF stated that the relief it was seeking is confirmation that swaps used in securitizations that include special provisions to support their legal structures and/or credit ratings are NOT subject to the clearing mandate if no derivatives clearing organization clears swaps with such provisions. In response, the CFTC gave informal, oral guidance to the effect that securitization swaps including such bespoke features as non-petition clauses and limited recourse provisions are not required to be cleared if not cleared by any derivatives clearing organization. 53

54 SEF Structure and Requirements Swap Execution Facilities (SEFs) To promote pre-trade price transparency, Dodd-Frank requires that all swaps that are required to be cleared be executed on a designated contract market ( DCM ) or a SEF, unless the swap type is not available for trading on any DCM or SEF, or another clearing exception applies. SEFs are a new type of regulated marketplace created by Dodd-Frank. On May 16 th, the CFTC approved final rules for SEFs and related matters, in particular addressing the following key points For required transactions (except block trades), must use Order Book or RFQ system, and for RFQ system, initially two and eventually after phase in period three quotes will be required Available to trade status of a swap will be determined and certified by SEFs/DCMs, and then subject to public comment during CFTC review process Voice execution is permissible but must still comply with other minimum execution requirements, so it is likely to be useful only for transactions not subject to mandatory DCM or SEF trade execution (i.e., block trades or permitted transactions ) Determination of block sizes permitting trades not to be executed on SEFs 54

55 SEF Structure and Requirements (cont d) Some immediate criticisms of new rules include: Basic requirement for RFQs not mandated by statute and initial RFQ and block requirements are based on inadequate data Increases in RFQs and block sizes occur automatically, without regard to data that accumulate during interim period Available to trade determination effectively left to SEFs and DCMs Overly restrictive and prescriptive regime may drive more trading offshore 55

56 Margin Requirements There will be margining requirements for uncleared (OTC) swaps. The margin requirements have not been finalized, although it is anticipated that levels could be comparable to or higher than those for cleared swaps (keeping in mind, however, that clearing houses and FCMs can increase the level of margin on a cleared swap). Once margin requirements are finalized, market participants will need to evaluate their credit support arrangements and determine whether any modifications are necessary. Title VII gives an end-user the right to require that any initial margin that it posts be segregated and, if it chooses, held by a third-party custodian. If the end-user opts to have collateral held by a custodian, it will need to negotiate and enter into custodial arrangements. 56

57 Margin Requirements (cont d) Cleared Swaps Margin posted in respect of cleared swaps is required to be legally separate but operationally commingled ( LSOC ) to limit fellow customer risk. For cleared swaps, clearinghouses will drive how much margin will be required for swaps. 57

58 Margin Requirements (cont d) Basel Committee on Banking Supervision ( BCBS ) and the International Organization of Securities Commissions ( IOSCO ) several months ago came out with a second position paper on margin. While not law, it is influencing the discussion on margin First BCBS/IOSCO position paper s high margin recommendations caused widespread liquidity and pricing concerns Second paper still causing heartburn Mandatory two-way exchange of IM on a gross basis Mandatory full segregation No re-hypothecation/re-use of IM Limits on portfolio margining Mandatory IM and VM exchanges for inter-affiliate trades Continued market concerns regarding liquidity and systemic risk Mandatory margin for non-cleared trades would profoundly affect end-users Increased cost of hedging 58

59 Margin Requirements (cont d) ISDA submitted a 27-page comment letter to BCBS/IOSCO detailing its concerns, including Liquidity drains and cyclicality concerns with proposed IM levels Inappropriateness of imposing margin requirements on highly liquid FX transactions The need for cross-product and portfolio margining Concerns over proposed collateral eligibility and haircuts The need for international coordination and appropriate phase in periods OTC margin is proving to be one of the most contentious areas of swap regulation. Market participants and regulators continue to debate Will excess levels of IM for OTC swaps in effect lead to the end of the highly customized swaps market? Will the margin regimes in the global market have a collective adverse liquidity effect that result in less hedging and greater risk retention by entities that otherwise would hedge their risks? 59

60 Additional Clearing Determinations First set of clearing determinations covered only plain vanilla IRS and index CDS These instruments were already being cleared in most cases, thus did not present a challenge to the market Regarding future clearing determinations, many questions arise: Will the CFTC, together with the cooperation of clearinghouses, move to designate more complex and potentially less liquid IRS and CDS for clearing Will the CFTC and clearinghouses next focus on commodity swaps and in doing so first focus on plain vanilla highly liquid instruments To what extent if any will the CFTC seek to mandate clearing of FX swaps, which is strongly disfavored by much of the international banking community What, if any, mandatory clearing determinations will the SEC eventually decide upon 60

61 SEC Title VII Rulemaking SEC is taking a different approach to Title VII rulemaking It appears that no registration requirements will be imposed until all substantive Title VII rulemaking by SEC is complete SEC s substantive rulemaking has lagged significantly behind the CFTC s In some cases, the SEC is yet to publish a proposed rule on matters that the CFTC has long since published proposed rules on or even proceeded to adopt final rules Even where SEC has published proposed rules, the timeline for finalizing these rules is unclear SEC s recent proposed cross-border rules plus reopening of comment period on all other proposed rules confirms SEC s intention to continue this approach 61

62 CPO/CTA Developments Dodd-Frank s inclusion of swaps as commodity interests means that pooled investment vehicles trading in swaps (and their operators or advisors) must consider whether they may be subject to regulation as a Commodity Pool, a Commodity Pool Operator or a Commodity Trading Advisor As amended by Dodd-Frank, the Commodity Exchange Act ( CEA ) now defines the term commodity pool to include any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any commodity for future delivery, security futures product, or swap; agreement, contract, or transaction described in section 2(c)(2)(C)(i) of the CEA or section 2(c)(2)(D)(i) of the CEA; commodity option authorized under section 6c of the CEA; or leverage transaction authorized under section 23 of the CEA 62

63 CPO/CTA Developments The CFTC has issued a number of no-action letters providing certain relief to various types of entities, including: Business development companies, Family offices, Mortgage REITs, Equity REITs, Securitization vehicles, Legacy securitizations, Pension plan group trusts, and Fund of fund operators. It is important to understand the limitations associated with the various letters issued by the CFTC. Transactions using a collective investment vehicle, trust or partnership vehicle should be examined closely. 63

64 Volcker and Lincoln The implementation of the Volcker Rule and the Lincoln Amendment, including any revisions to these provisions, are likely to have a significant impact on the development and structure of the derivatives market, both in the U.S. and globally Volcker Rule provides that, except for certain permitted activities, a banking entity cannot engage in proprietary trading, or acquire or retain any equity, partnership or other ownership interest in or sponsor a hedge fund or private equity fund. The state of play on the Volcker Rule has been very hard to assess The agencies are still trying to develop the final rule, which they hope to have out later this year, maybe even later this spring or this summer. The expectation is that what is developed with be materially different from what was first proposed, but there is no good insight as to the nature of these differences Seems clear that the agencies are having a hard time coming to consensus on what the final rule should look like and are being deliberately very close-mouthed at this stage 64

65 Volcker and Lincoln (cont d) Lincoln Amendment Provides that no Federal assistance (e.g., advances from any Federal Reserve credit facility or discount window that is not part of a broad-based eligibility program, FDIC insurance, or guarantees) may be provided to any swaps entity (i.e., swap dealers and non-bank major swap participants, or MSPs). The banking agencies and the CFTC have indicated that the effective date for this provision is July 16, However, in accordance with Section 716(f) of the Dodd-Frank Act, both the OCC (with respect to insured Federal depository institutions) and the Federal Reserve Board (with respect to U.S. branches and agencies of foreign banks) have provided entities subject to the push-out rule with an opportunity for a transition period of up to 24 months before the rule takes effect for such entities. According to media reports, several banks were granted the additional two years. There are legislative proposals that also would address the Swaps Pushout Rule. 65

66 Title VII Litigation Developments Title VII has spawned a growing roster of legal disputes and challenges, including Recent suit by Bloomberg challenging different initial margin regimes that apply or will apply to futures (and swap futures) as compared to OTC swaps Recent suit by DTCC challenging anticompetitive effects of decision by CFTC to permit ICE and CME to send trade data to their proprietary SDRs Appeal by CFTC of District Court decision vacating new Part 151 position limits for certain futures and related swaps In addition, CFTC is expected to propose a new version of Part 151 in the near future (unclear how this action will affect pending appeal) The Investment Company Institute and the U.S. Chamber of Commerce sued CFTC on CPO rules (specifically Rule 4.5); U.S. District Court (DC) rejected challenge, and Court of Appeals affirmed that decision late last month. Other suits have been threatened 66