US OTC derivatives reforms Impact on UK and other non-us asset managers. Second update October 2013

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1 US OTC derivatives reforms Impact on UK and other non-us asset managers Second update October 2013

2 Table of contents Important notes 1. Dodd Frank decision tree 2. What is regulated as a swap? 3. When will Dodd Frank apply? What is a US person? 4. CFTC regulation of asset managers and counterparties 5. Counterparty and client regulatory status 6. Regulated activities under Dodd Frank 7. Extraterritorial scope of Dodd Frank 8. Anti-fraud and anti-manipulation provisions 9. Glossary Annex I: regulatory requirements Annex II: regulatory requirements for commodity pool operators Annex III: overview of asset management 2

3 Important notes 3

4 Important Notes References in this guide to Dodd Frank are, unless otherwise stated, to the provisions relating to regulation of the derivatives markets in Title VII the Wall Street Transparency and Accountability Act of Statements made in this guide are accurate as of August 1, Not all regulations referenced in this guide are final. The final rules may differ in important ways. Key areas in which final rules are awaited are marked with (the absence of a does not signify that a final rule has been released). In this guide, the capitalised term Swap is used to refer to a swap as defined in section 721 of Dodd Frank, as distinct from a Security-based Swap defined in section 761 of Dodd Frank. The uncapitalised term swap is used for convenience to refer to Swaps and Security-based Swaps generally. On July 12, 2013, the US Commodity Futures Trading Commission ("CFTC") approved final interpretive guidance on the crossborder application of its swap regulations (the CFTC Rules ). Simultaneously, the CFTC approved a new exemptive order (the "Exemptive Order"), which provides temporary relief and establishes phase-in periods for compliance with certain of the CFTC Rules. On May 1, 2013, the U.S. Securities and Exchange Commission ("SEC") published for public comment proposed rules regarding the application of U.S. laws and regulations to cross-border securities-based swaps ( SBS ) (the SEC SBS Release ). Based on the SEC s current timetable, the proposed rules in the SBS Release are not likely to take effect before February Other Dodd Frank provisions relating to swaps are likely to be implemented according to a more accelerated timetable. This guide is intended as general information only and does not constitute legal advice. It is a selective guide and does not cover any aspect of Dodd Frank in detail. Users of this guide should take specific legal advice with respect to their own regulatory status. This guide assumes that asset managers will, in general, trade on behalf of their clients with counterparties that are financial institutions and that are, where applicable, registered Swap Dealers or Security-based Swap Dealers for Dodd Frank purposes. A glossary of certain terms not otherwise defined in the core of this guide is set out at the end of this guide. 4

5 Dodd Frank decision tree 5

6 Dodd Frank Application decision tree for asset managers Are you entering into a derivative trade for your client? Yes Is the trade a regulated swap? i e Swaps (Rates, commodities, non-exempt FX, broad-based security indices of >9 names) Security-Based Swaps (single-name or narrow-based security indices of <=9 names) Yes Are you trading with a regulated counterparty or for a regulated client? Yes What is your counterparty's regulatory category? What is your client's regulatory category? Are you an SBS Dealer that does not qualify for the de minimis exemption? Dodd Frank applies No SEC registration required either i e Swap Dealer MSP Financial Entity or No Are any of the counterparty, the client, or a guarantor a US person for the purposes of that swap? Is the trade an SBS conducted in the US? Yes Dodd Frank applies All rules apply including: Clearing Trading Margin Reporting End user Dodd Frank applies No Clearing and Trading rules do not apply. Other rules, including Margin and Reporting, apply Yes Dodd Frank applies Analysis needed caseby-case to determine which rules apply Anti-Evasion and Extraterritorial tests apply to trades that are substantively Swaps and Security- Based Swaps Is the trade constructed to evade Dodd Frank? Yes No A further test applies for trades that are substantively Swaps only (see below) Does the trade have a direct and significant connection with activities in, or effect on, US commerce? No Trade is outside the scope of Dodd Frank 6

7 What is regulated as a swap? 7

8 What is regulated as a swap statutory definition Section 721 of Dodd Frank defines a Swap as an agreement, contract or transaction that: i. is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind; ii. provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence; or iii. provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred, including specified types of transaction (summarised on next page) Section 761 of Dodd Frank defines a Security-based Swap as a swap that is based on: i. an index that is a narrow-based security index, including any interest therein or on the value thereof; ii. a single security or loan, including any interest therein or on the value thereof; or iii. the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer. Swaps are regulated by the CFTC; Security-based Swaps are regulated by the SEC Note that the definitions of Swap and Security-based Swap do not distinguish between swaps that have some US nexus (for example, US$ rate or currency swaps or CDS on Ford or Boeing) and those that do not (for example Euro/Sterling rate or currency swaps or CDS on Daimler or EADS) 8

9 What is regulated as a swap certain transaction types Note this is not an exhaustive list of applicable transaction types 1. CFTC jurisdiction: Rates products Commodities (non-physical) Swaps on broad-based security indices with more than 9 names Non-exempt FX trades (see page 10) 2. SEC jurisdiction: Single-name security-based swaps (e.g., CDS, equity swaps, TRS) Swaps on narrow-based security indices based on 9 or fewer names LMA-style loan participations (i.e. no transfer of beneficial ownership) Options on government and municipal securities 3. Not-regulated or low regulation Hybrid securities generally regulated as securities, not as swaps FX trades subject to Treasury exemption (see page 10) 9

10 Foreign Exchange and Currency Swaps Regulation under Dodd-Frank Product Type Description Exempt? Foreign Exchange Swap A transaction that solely involves (A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and (B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange Foreign Exchange Forward A transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange Non-Deliverable Forward A cash-settled forward transaction involving any currency pair (not only emerging market currencies) No Deliverable Forward Currency Swap FX or Currency Option A physically-settled (or primarily physically settled) currency forward transaction that does not meet the definition of Foreign Exchange Forward A currency swap transaction that does not meet the definition of Foreign Exchange Swap (for example, a transaction involving periodic currency exchanges to convert loan interest payments) An option on any of the above Yes* Yes* Unclear No No * The U.S. Treasury has exempted Foreign Exchange Swaps and Foreign Exchange Forwards from most CFTC regulations, other than reporting and external business conduct rules The Treasury exemption will only cover Foreign Exchange Swap and Foreign Exchange Forward transactions that fall into the narrow definitions set out above Transactions that do not fit exactly into those definitions are generally regulated (for example, dollar-roll transactions) The Treasury exemption does not extend to business conduct and reporting requirements: Foreign Exchange Swaps and Forwards will remain subject to business conduct rules and anti-fraud provisions and will be required to be reported. 10

11 When will Dodd Frank apply? What is a US person? 11

12 When will Dodd Frank apply? Dodd Frank will apply in 3 circumstances: If either party (i.e. the client or the counterparty, as principals) to the swap is a US person, regardless of the domicile of the other party In some cases under the CFTC Rules, and the SEC SBS Release, even if neither party to the swap is a US person (see pages 35 and 38) If the swap is arranged to evade Dodd Frank regulations or (in the case of CFTC-regulated Swaps only) has a direct and significant connection with activities in, or effect on, commerce of the US (see page 32) Pages set out factors for determining whether either party is a US person. The CFTC s definition of US person is set out on pages The proposed definition of US person included in the SEC SBS Release is set out on page 49. The determination of the applicability of Dodd Frank is generally based on the status of the principals to the trade (i.e. the client and the counterparty) The rules for determining whether a party is a US person will depend on the swap type and whether that swap type is regulated by the CFTC or the SEC The location of the client s assets, bank accounts, custodians or other service providers should not be relevant; however, under the CFTC s final guidance and the SEC s proposals, activity by a US manager (and possibly a sub-manager) may subject a swap between non-us persons to US regulations. 12

13 What is a US person under the CFTC Rules? (1) Financial institutions and non-fund entities For these purposes, a financial institution generally means a bank, a branch of a bank or similar entity that is acting as counterparty to a client Non-fund entity means a corporate entity, trust, partnership or other entity that is not a fund or investment vehicle. It includes insurance companies and would apply to many segregated mandates where the client is not a fund or investment vehicle or US municipality A financial institution or non-fund entity which is not established or operating from a presence in the United States, and does not have US investors or beneficiaries, should not be considered to be a US person Non-US branches of US financial institutions: Non-US branches of US financial institutions are US persons (see pages 35 and 38). US parent or affiliates: A counterparty would not be considered to be a US person simply because it has a US parent or US affiliates. However, a non-us entity that is directly or indirectly majority owned by a US person that has unlimited responsibility for its liabilities would be subject to Dodd-Frank US credit support provider: A counterparty would not be considered to be a US person simply because its swaps obligations are guaranteed or otherwise supported (for example, by a letter of credit) by an unaffiliated US person, however many CFTC regulations will apply A non-us affiliate guaranteed by a US person would not be considered a US person, however many CFTC regulations will apply US accounts or assets: A counterparty would not be considered to be a US person simply because it maintains assets or bank accounts, or has custodians, in the United States Regulation in the US: A counterparty will be considered a US person if it is carrying on certain US-regulated business For example, the London branch of a European bank that routinely deals in swaps with US counterparties is, subject to de minimis tests, required to register as a Swap Dealer and subject to Dodd Frank in that capacity In such case, the non-us Swap Dealer is subject to Dodd-Frank for all Swaps with a US person or a non-us person whose Swaps-related obligations are guaranteed or otherwise supported by a US person, and is permitted to comply under a substituted compliance regime in lieu of compliance with certain Dodd-Frank requirements if the requirements in the jurisdiction in which the non-us Swap Dealer is located are deemed comparable to Dodd-Frank requirements by the CFTC, but the non-us Swap Dealer would remain subject to Dodd-Frank (see page 39) Other types of US regulation (for example, status as an SEC reporting company) are not expected to confer US person status for Dodd Frank purposes 13

14 What is a US person under the CFTC Rules? (2) Funds or investment vehicles For these purposes, a fund or investment vehicle generally means a collective or pooled investment scheme, including unregulated funds and regulated funds such as UCITS, US mutual funds, pooled pension funds and commodity pools. This predominantly relates to asset managers clients, rather than to counterparties Determining whether a fund or investment vehicle is a US person is likely to depend on what swap type it is engaged in, and whether that swap type is regulated by the CFTC or the SEC. Entities which trade both Swaps and Security-based Swaps will be subject to both CFTC and SEC rules. CFTC regulation: A fund or investment vehicle would be considered to be a US person (see pages 47-48) if : it is organized or incorporated under the laws of the US or has its principal place of business in the US, the direct or indirect owners of the fund have unlimited responsibility for the fund s liabilities and the majority of the owners are US persons, or its majority ownership is held, directly or indirectly, by any US Person except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-us persons and not offered to US persons. Non-US publicly offered funds not offered to US-persons fall outside the scope of the US person definition. A fund will have its principal place of business in the US if the persons responsible for (a) its formation and promotion or (b) implementing its investment strategy are in the US, subject to facts and circumstances of centre of direction, control and coordination. The same analysis should apply to a master feeder fund with US investors (even if those US investors are investing indirectly through a non-us feeder fund) Persons who do not fall within one of the listed categories of the US person definition should periodically evaluate the following factors provided by the CFTC (particularly the first two): the strength of the connections between the person's swap-related activities and US commerce; the extent to which the person's swap-related activities are conducted in the United States; the importance to the United States (as compared to other jurisdictions where the person may be active) of regulating the person's swap-related activities; the likelihood that including the person within the interpretation of 'US person' could lead to regulatory conflicts; and considerations of international comity. 14

15 What is a US person under the CFTC Rules? (3) ERISA funds, US municipalities, and other special entities ERISA funds and US municipalities are US persons for Dodd Frank purposes Additional rules apply to ERISA funds, US municipalities, and other entities that are classified as special entities for Dodd Frank purposes Special entities A special entity is defined as: a Federal agency; a State, State agency, city, county, municipality, or other political subdivision of a State; any employee benefit plan that is subject to Title I of the Employee Retirement Income Security Act of 1974 ( ERISA ), and any other employee benefit plan under Section 3 of ERISA that elects to be treated as a special entity ; any governmental plan, as defined in section 3 of ERISA; or any endowment, including an endowment that is an organisation described in section 501(c)(3) of the Internal Revenue Code of 1986 Swap Dealers and Major Swap Participants executing swaps as counterparty to special entities must comply with additional business conduct rules, including making special disclosures and ensuring that the special entity has an independent advisor acting on its behalf and advising as to the risks involved in the swap transaction In practice, Swap Dealers require counterparties to make a representation as to whether they are or are not special entities 15

16 What is a US person under the CFTC Rules? Principal Place of Business Legal entities are also US persons if their principal place of business is in the United States. For these purposes, the principal place of business of a legal entity (that is not a collective investment vehicle) is the location of its centre of direction, control and coordination of its business activities, and so in most instances will be the place where the entity maintains its headquarters. In the case of a collective investment vehicle, the CFTC considers the principal place of business to be the location of the senior personnel responsible for either: 1. the formation and promotion of the collective investment vehicle, or 2. the implementation of the vehicle's investment strategy, subject to facts and circumstances relating to centre of direction, control and coordination of the fund. The CFTC views the location of the administrator, prime broker, custodian and placement agents as irrelevant to the determination of whether the investment vehicle is a US person. Such vehicles must look to where the persons responsible for setting the investment objectives of the fund are located as well as the location of the persons that maintain overall control of the vehicle's investment strategies are located. 16

17 What is a US person under the SEC SBS Release? Swaps transacted in the US The SBS Release proposes that the term US person would include: a natural person resident in the United States; any corporation, partnership, trust, or other legal person incorporated or organized under the laws of the United States; any corporation, partnership, trust, or other legal person that has its principal place of business in the United States; and any account, whether discretionary or not, of any of the above described persons. Funds are not explicitly covered by the SEC's proposed principal place of business test. However, under the SEC s proposals, a swap will be subject to the SEC s Dodd Frank rules if it is a transaction conducted in the United States - regardless whether the principals are US persons. A transaction is conducted in the United States if it is solicited negotiated, executed or booked in the US For example, a securities-based swap between two non-u.s. persons where the SBS transaction is conducted in the United States (e.g., a fund manager located in the United States negotiates the SBS transaction for a non-u.s. fund), would be subject to Dodd Frank. 17

18 Dodd Frank applicability to sub-managers CFTC Under the CFTC Rules, an entity would not be a US person solely because it retains an asset management firm located in the United States to manage its assets or provide other financial services unless the level of that activity rises to a principal place of business in the US Where a swap is arranged by a US sub-manager between a non-us client and a non-us counterparty It should not make the two non-us principals to the swap subject to mandatory clearing and exchange-trading if the client s investment strategy is controlled by its non- US manager CFTC s final guidance does not elaborate on the extent of the investment discretion that can be delegated to a US sub-manager without triggering the Dodd Frank rules A non-us sub-manager appointed by a US manager for a non-us fund may be subject to Dodd Frank if the fund was formed and promoted by the US manager A manager or sub-manager is a US manager or a US sub-manager if it is incorporated or organised in the United States or acting out of an office in the United States SEC Under the SEC s proposals, a swap will be subject to the SEC s Dodd Frank rules if it is a transaction conducted in the United States - regardless whether the principals are US persons A transaction is conducted in the United States if it is solicited negotiated, executed or booked in the US The SEC s proposal is potentially wider than the CFTC s 18

19 CFTC Regulation of Asset Managers and Counterparties 19

20 Commodity Pool Operators Commodity pool operator: A commodity pool operator includes any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests, including futures, security futures, swaps, retail forex transactions, commodity options and leverage transactions. Registration: Any person that operates a fund or investment vehicle which uses swaps and has at least one US investor would be required to register with the CFTC as a commodity pool operator, unless it is exempt. Registration requirements for commodity pool operators are summarised in Annex II herein. Exemption from US Person definition: The CFTC s definition of a US person excludes any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-us persons and not offered to US persons 20

21 Eligible Contract Participant Status Required to Engage in Off-exchange Swaps The Commodity Exchange Act sets out provisions to force swap execution on an exchange. Only an entity that is an eligible contract participant ( ECP ) under the Commodity Exchange Act can execute swaps bilaterally or on a swap execution facility. Therefore, unless each counterparty (including any fund or investment vehicle) to a swap transaction qualifies as an ECP, the swap must be transacted on an exchange A commodity pool will be an ECP if its operator is registered or exempt from registration as a commodity pool operator (see page 20) (or a foreign person performing a similar role that is subject to foreign regulation). An FSA-registered manager will qualify as such a person A commodity pool that does not have any US investors and that is operated outside of the US qualifies as an ECP A corporation or other entity that has at least $10 million in assets or has a net worth exceeding $1 million qualifies as an ECP Swap Dealers will be required to verify (i.e., by written representation) that their counterparty is an ECP prior to engaging in a Swap 21

22 Regulatory Categories Swap Dealers and SBS Dealers A Swap Dealer is an entity that: Holds itself out as a dealer in swaps Makes a market in swaps Regularly enters into swaps with counterparties in the ordinary course of business for its own account or Engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps The definition of Security-Based Swap Dealer follows the definition of Swap Dealer An entity may be a Swap Dealer for one or more types of swap product but not for others The CFTC and SEC have specified de minimis thresholds below which entities need not register as Swap Dealers or SBS Dealers. Standard swap documentation requires each counterparty to make a representation about whether it is a Swap Dealer or an SBS Dealer Swap Dealers are required to register with the CFTC; SBS Dealers are required to register with the SEC Standard swap documentation requires a Swap Dealer (or SBS Dealer) to make a representation that it is validly registered It is not expected that many asset management clients (or the asset managers of such clients) would qualify as a Swap Dealer or as an SBS Dealer 22

23 Regulatory Categories Major Swap Participants and Major SBS Participants A Major Swap Participant is an entity that is not a Swap Dealer and: That maintains a substantial position in swaps of any major swap category except positions held for hedging or mitigating commercial risk or Whose positions create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets or That is highly leveraged and not subject to Federal banking capital requirements and maintains a substantial position in swaps of any major swap category The definition of Major Security-based Swap Participant follows the definition of Major Swap Participant The SEC and CFTC have published final rules that set quantitative definitions for substantial position and substantial counterparty exposure see the Glossary Standard swap documentation requires each counterparty to make a representation about whether it is an MSP or MSBSP MSPs are required to register with the CFTC; MSBSPs are required to register with the SEC Standard swap documentation requires an MSP or MSBSP to make a representation that it is validly registered An entity may be an MSP for one or more types of swap product but not for others The asset manager will either need to determine that each client is not an MSP or MSBSP, or to obtain a representation from the relevant client that it is not An MSP or MSBSP. The likely number of MSPs or MSBSPs is unknown; the CFTC has expressed a view that there are not likely to be many, but it is unclear whether this is correct 23

24 Regulatory Categories Financial Entities For the purposes of mandatory clearing and exchange-trading, a Financial Entity is an entity that is any of: a Swap Dealer or a Security-Based Swap Dealer a Major Swap Participant or a Major Security-based Swap Participant a commodity pool a private fund under the Investment Advisers Act an ERISA fund (an employee benefit plan as defined in paragraphs (3) and (32) of section 3 of ERISA) a person predominantly engaged in activities that are in the business of banking or in activities that are financial in nature The US Federal Reserve has issued guidance as to what constitutes being predominantly engaged in activities that are financial in nature There are some limited exceptions, including for entities that are primarily financing vehicles that use derivatives to hedge commercial interest rate and FX exposures Non-US defined benefit plans and institutions for occupational retirement provision are not specifically covered by Dodd Frank but will be subject to the tests applicable to other entity types to determine whether they are caught 24

25 Regulatory Categories End Users An End User is an entity that: is not a Financial Entity, and is using swaps to hedge or mitigate commercial risk, and has notified the CFTC or SEC (as applicable) how it generally meets its financial obligations associated with entering into non-cleared swaps The End User category creates a limited exemption to the requirement to submit swaps for clearing and to execute swap trades on registered exchanges. Other Dodd Frank provisions continue to apply to swaps with End Users 25

26 Regulated Activities under Dodd Frank 26

27 Key obligations under Dodd Frank Title VII of Dodd Frank imposes a number of obligations on entities entering into OTC derivatives. We have set out a summary of the key obligations below. Clearing Trading Margining Generally, all swaps regulated under Dodd Frank that are executed by a US person must be cleared through a derivatives clearing organisation regulated by the CFTC (with respect to Swaps) or a clearing agency regulated by the SEC (with respect to Security-based Swaps). A swap is not required to be cleared if (a) no derivatives clearing organisation or clearing agency is willing, and has been approved, to clear it or (b) one party to the swap is an End User. All swaps that are required to be cleared are also required to be executed on a regulated exchange or a swap execution facility ( SEF ) unless no exchange or SEF has made the swap available for trading. Swaps which are exempt from the clearing requirement will also be exempt from the execution requirement. All cleared swaps will be subject to margin rules set out by the relevant derivatives clearing organisation or clearing agency see Annex I: regulatory requirements For non-cleared swaps, margin requirements for both initial and variation margin will be imposed in accordance with guidelines to be published by the CFTC, SEC and Federal banking regulators (as applicable). The margin requirements established for non-cleared swaps are likely to be set at levels that reflect the perceived higher risk associated with non-cleared swaps. The margin requirements will also differentiate between high-risk financial entities and low-risk financial entities, and set out rules for the types of margin that can be posted, the use to which margin can be put and the type of custody arrangements that must be used. See Annex I: regulatory requirements Current proposals would require US Swap Dealers to comply with US margin requirements for all non-cleared swaps, including non-cleared swaps with non-us persons. It is not clear if this requirement will appear in the final rules Reporting Detailed terms of any swap (whether cleared or non-cleared) must be reported to a Swap Data Repository or a Security-based Swap Data Repository, or, if there is no repository that will accept such a swap, to the CFTC or SEC, as applicable. For cleared swaps, data will generally be reported by the relevant derivatives clearing organisation or clearing agency and, where applicable, by the relevant exchange or SEF. For non-cleared swaps, if only one party to a swap is a US person, that entity must make the report. If one party is a US Swap Dealer, the Swap Dealer must make the report. If one party is a US Major Swap Participant and the other party is not a US Swap Dealer, the Major Swap Participant must make the report. Otherwise, the parties shall agree which party will report These obligations are subject to detailed regulations by the CFTC (see page 34) and the SEC (not yet finalized) Other obligations are not covered here (e.g. record keeping, position limits, antifraud provisions) 27

28 Which provisions of Dodd Frank will apply? If either party to a swap falls into one of the four regulated categories, the Dodd Frank obligations referred to on the previous page will apply as set out below (also see pages 34-41). Obligation Entity Type Swap Dealer Major Swap Participant Financial Entity End User Clearing and trading Clearing Applicable Applicable Applicable Not Applicable Trading Applicable Applicable Applicable Not Applicable Margining Cleared Swaps Applicable Applicable Applicable Non-cleared Swaps Applicable Applicable Applicable Cleared Swaps Automatic Automatic Automatic Applicable (if End User voluntarily executes cleared trades) Applicable but proposals permit threshold to be set by parties below which no margin required Automatic (if End User voluntarily executes cleared trades) Reporting Non-cleared Swaps Swap Dealer must report MSP must report unless swap is with a Swap Dealer One Financial Entity must report unless swap is with a Swap Dealer or MSP (if one party is a US Person, it must report) Swap Dealer or MSP must report; otherwise, parties must agree which party reports 28

29 Extraterritorial scope of Dodd Frank 29

30 Extraterritoriality under Dodd Frank direct and significant connection Dodd Frank extends and expands the existing extraterritorial effect of US futures and securities laws to swaps Swaps Security-based swaps The Securities Exchange Act is amended to read: Dodd Frank amends the Commodity Exchange Act to clarify that: The provisions of this Act relating to swaps... shall not apply to activities outside the United States unless those activities: 1)have a direct and significant connection with activities in, or effect on commerce of, the United States; or 2)contravene such rules or regulations as the [CFTC] may prescribe or promulgate... to prevent... evasion. No provision [of this Act] or any rule or regulation thereunder, shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the [SEC] may prescribe... to prevent... evasion. Dodd-Frank does not provide guidance on what would be considered to be a direct and significant connection with activities in, or effect on commerce of, the United States. However, the CFTC has proposed interpretive guidance regarding the extraterritorial application of the Swaps rules. There is no equivalent provision regarding activities with a direct and significant connection with the US in relation to Security-based Swaps. Activities which take place outside the jurisdiction of the US in relation to security-based swaps will only be caught if they contravene rules prescribed by the SEC. The Commodity Exchange Act already contains references in other provisions to activities with a direct and significant connection to the United States. This has been interpreted broadly in the past. For example, the CFTC has conducted investigations into allegations of LIBOR fixing where all the relevant activities took place outside the US, on the basis that there was a direct and significant connection to US futures and other products. The Commodity Exchange Act and the Securities Exchange Act contain extensive anti-fraud and anti-manipulation provisions. Breach of these provisions is a criminal offence, so where a client of an asset manager commits a breach the Department of Justice may allege conspiracy on the part of the asset manager. There is also aiding and abetting liability for many offences under these Acts Compliance procedures and training should be adopted to make traders aware of the US impact of their transactions 30

31 Requirements applied by the CFTC on an extraterritorial basis The CFTC has divided its rules relating to extraterritorial activity (which the CFTC refers to as cross-border activity) by Swap Dealers and Major Swap Participants into two broad categories: entity-level requirements (see below) and transaction-level requirements (see pages 34-41) Entity-level Requirements for Swap Dealers (and Major Swap Participants) The entity-level requirements relate to the internal risk management and operations of a Swap Dealer. These requirements apply to Swap Dealers on a firm-wide basis (irrespective of whether their counterparty is a US person ). Compliance with the entity-level requirements is the responsibility of the Swap Dealer, and not its counterparty. The entity-level requirements include: Capital adequacy of the Swap Dealer, Designation of a chief compliance officer by each Swap Dealer, The Swap Dealer s internal risk management program, Large trader reporting of physical commodity Swaps positions, Swap data recordkeeping, and Swap data reporting. With respect to Swap data reporting, where a non-us person s counterparty is a Swap Dealer or US person, the reporting obligation will fall on the Swap Dealer or US person. Otherwise, the non-us person and counterparty must agree on which counterparty is responsible for fulfilling the reporting requirement. 31

32 CFTC Transaction-level Requirements The transaction-level requirements relate to risk mitigation and market transparency. These requirements apply to Swaps on a transaction-by-transaction basis. The extent to which the transaction-level requirements will apply to a Swap and the means by which they can be satisfied will depend on the identity and status of the parties (see page 35). The transaction-level requirements will affect both parties to a Swap, although in practice the burden of proving compliance with the transaction-level requirements will largely fall on the Swap Dealer. The transaction-level requirements are divided into two categories and include (which are the detailed implementation rules of the general obligations referred to on page 29): Category A Requirements Clearing and Swap processing, Margin and segregation for uncleared Swaps, Trade execution, Swap trading relationship documentation, Portfolio reconciliation and compression, Real-time public reporting, Trade confirmation, and Daily trading records. Category B Requirements External business conduct standards 32

33 Extraterritorial application of CFTC transaction-level requirements If the client is a US person, the CFTC transaction-level rules will apply directly. In contrast, if the client is not a US person, the extent to which the transaction-level requirements will apply, and the ability of the parties to comply by applying non-us rules, will depend on the identity of the counterparty, as shown below. Counterparty Type Applicability of Transaction-level Requirements to a client which is a Non-US Person Swap Dealer that is a US person Both Category A and Category B CFTC transaction-level requirements apply directly Foreign Branch of a Swap Dealer that is a US person Foreign Affiliate of a Swap Dealer that is a US person Swap Dealer that is not a US person US person that is not a Swap Dealer or Major Swap Participant Category A CFTC transaction-level requirements apply directly. However, substituted compliance may be permitted (see pages 39-40) CFTC transaction-level requirements do not apply. However, if the non-us person s swap obligations are guaranteed by a US person (see pages 47-48), the CFTC transaction-level requirements may apply. If that is the case, substituted compliance may be permitted (see pages 37-38) CFTC transaction-level requirements do not apply. However, if the non-us person s Swap obligations are guaranteed by a US person (see pages 47-48), the CFTC transaction-level requirements may apply. If that is the case, substituted compliance may be permitted (see pages 39-40) Only the following Category A CFTC requirements apply: clearing, trade execution, real-time public reporting, large trader reporting, swap data repository reporting, and recordkeeping. 33

34 Extraterritorial application of CFTC requirements: CFTC Exemptive Order Transitional Relief for Entity-Level Requirements Under the Exemptive Order, non-us Swap Dealers and Major Swap Participants established in one of the six jurisdictions for which the CFTC is currently considering a Substituted Compliance Determination: Australia, Canada, the European Union, Hong Kong, Japan and Switzerland ( the Six Jurisdictions ) may delay compliance with the certain Entity-Level Requirements until the earlier of December 21, 2013; or 30 days following the issuance of an applicable Substituted Compliance Determination for the relevant Entity-Level Requirement for the non-us Swap Dealer s or non-us Major Swap Participant's jurisdiction; except that such relief is qualified for SDR Reporting and does not apply to Large Trades Reporting. Transitional Relief for Transaction-Level Requirements The Exemptive Order provides relief from compliance with certain Transaction-Level Requirements until December 21, 2013 or 30 days after a substituted compliance determination is made (for the relevant counterparty type in the Six Jurisdictions) or for 75 days after publication of the CFTC Rules, October 9, 2013 (for the relevant counterparty types outside the Six Jurisdictions), with certain exceptions. Such relief applies to swap transactions between: A non-us SD/MSP and a Non-US Counterparty that is a US Guaranteed or Conduit Affiliate or Foreign Branch; and A Foreign Branch and a Non US Person (including a Guaranteed or Conduit Affiliate of a US Person) or Foreign Branch. For swap transactions in which both parties are Guaranteed/Conduit Affiliates of US Persons, the Exemptive Order grants relief for 75 days from publication of the CFTC Rules, which is October 9,

35 Extraterritorial application of CFTC requirements: Risk Mitigation No-Action Letter On July 11, 2013, the CFTC issued a no-action letter (No ) that permits an entity organized under the laws of the EU and registered as a Swap Dealer or Major Swap Participant with the CFTC to satisfy its obligations under certain CFTC risk mitigation rules by complying with similar rules enacted under Article 11 of the European Market Infrastructure Regulation (EMIR) and the related EMIR Technical Standards. The no-action relief provided in this letter applies to swap transactions that are subject to both CFTC risk mitigation rules and EMIR risk mitigation rules, as the relevant CFTC and EMIR rules are essentially identical for regulatory purposes. Swap transactions covered by the no-action letter include: Uncleared swaps, or physically-settled foreign exchange forwards and swap agreements that have been exempted from the definition of swap by the U.S. Department of the Treasury. 35

36 Requirements applied by the SEC on an extraterritorial basis The SEC generally takes a similar approach to the CFTC in the application of compliance obligations to cross-border SBS activities, dividing swap rules into entity-level requirements and transaction-level requirements The transaction-level requirements listed in the SEC SBS Release as specifically applicable to SBS Dealers are: external business conduct standards; and segregation of assets. The SEC is proposing to treat the following rules as entity-level requirements. These entity-level requirements would, under the proposed rule, apply to non- U.S. SBS Dealers, subject to the application of substituted compliance. capital; margin; risk management; recordkeeping and SEC reporting; internal systems and control; diligent business supervision; conflicts of interest; chief compliance officer; inspection and examination; and licensing requirements for associated persons and statutory disqualification. 36

37 Substituted Compliance CFTC Rules In certain cases, compliance with an equivalent non-us regulation will satisfy a CFTC transaction-level requirement, if the CFTC has determined that the non-us requirement is comparable to the Dodd-Frank requirement ( substituted compliance ). The CFTC transaction-level rules will always apply. Substituted compliance is just a means of satisfying the rules. The CFTC will make comparability determinations on a rule-by-rule basis. The absence of a comparable rule would mean that the parties must comply with the CFTC transaction-level rule. The absence of an equivalent non-us rule would not preclude substituted compliance with other rules. Where substituted compliance is permitted by the CFTC, the Swap would nevertheless remain subject to Dodd-Frank and the jurisdiction of the CFTC. Substituted compliance would be permitted for all of the transaction-level requirements (see page 34) other than the external business conduct standards. The external business conduct standards will not apply to a Swap with a non-us person, unless its counterparty is a US Swap Dealer. Where the CFTC has determined that a Swap is subject to mandatory clearing, the CFTC has stated that a non-us regime would be deemed comparable only where the Swap is also subject to mandatory clearing in the non-us jurisdiction and cleared through a clearing house that is exempt from registration with the CFTC. Australia, Canada, the EU, Hong Kong, Japan, Switzerland have applied for comparability determinations. Case Study - Whose rules apply? For purposes of substituted compliance, the CFTC will assess the comparability of the rules in the non-us jurisdiction of the Swap Dealer (or other CFTCregulated counterparty). For example, consider a Luxembourg fund that enters into a Swap with the London branch of a US Swap Dealer. The relevant regulations that will be assessed by the CFTC for substituted compliance purposes are the UK rules, because those are the rules applicable in the jurisdiction in which the foreign branch of the US Swap Dealer is located. 37

38 Substituted Compliance SEC SBS Release If an applicable determination is made by the SEC, non-u.s. SBS Dealers may comply with the rules and regulations of their home jurisdiction to satisfy relevant entity-level requirements under Section 15F of the Exchange Act. A non-u.s. registered SBS Dealer (or a group of non-u.s. registered SBS Dealers of the same class of SBS) may apply to the SEC for a determination that a non-u.s. swap regulation regime is equivalent to the SEC's rules (an "SC Determination"). Such an application would need to include an opinion of counsel that an SBS Dealer in the relevant non-u.s. jurisdiction can, as a matter of law, provide the SEC with prompt access to its books and records and can, as a matter of law, submit to onsite inspection and examination by the SEC. The SEC would have the discretion to issue an SC Determination subject to various conditions, and may provide an SC Determination with respect to only some of the SBS rules or only certain classes of non-u.s. SBS Dealers. In considering such an application for an SC Determination, the SEC would consider whether the requirements of the non-u.s. regulatory system are comparable to the applicable SEC requirements, including with respect to the effectiveness of supervisory compliance programs and the enforcement authority of non-u.s. regulators. In addition, the SEC would also seek to enter into a supervisory and enforcement memorandum of understanding with the appropriate non-u.s. regulator addressing the oversight and supervision of applicable SBS Dealers. If the SEC issues an SC Determination with respect a particular non-u.s. regulatory system and a particular class of SBS Dealers, non-u.s. SBS Dealers that are part of the relevant class would be able to rely on that SC Determination to satisfy a specified SEC SBS rule by complying with the corresponding requirement of such regulatory system, as long as they satisfy any conditions specified in that SC Determination. It is unclear at this stage whether in practice the SEC s approach on substituted compliance would lead to a materially different outcome from the CFTC s approach. 38

39 Application of CFTC Transaction-level requirements to swaps with clients Is the client a US person (see pages 47-48)? Yes Swap subject to all CFTC transaction-level requirements (see page 34) No Is the swap counterparty a Swap Dealer that is a US person? Yes No Is the swap counterparty a foreign branch of a Swap Dealer that is a US person? No Yes Swap subject to all CFTC transaction-level requirements (other than external business conduct standards), but substituted compliance may be permitted by CFTC (see page 39) Are the client s swap obligations guaranteed or supported by a US person? Yes No Swap not subject to CFTC transactionlevel requirements (see page 34) 39

40 Anti-fraud and anti-manipulation provisions 40

41 Anti-fraud and anti-manipulation provisions Dodd Frank extended existing anti-fraud and anti-manipulation provisions from the futures and securities regimes to swaps, and created certain new offences. These provisions include: Extension of 10b-5 liability to Swaps and Security-based Swaps. This makes it an offence to make an untrue or incomplete statement, or omit a material fact that, in light of the circumstances in which a statement is made, render the statement incorrect or misleading. There is no affirmative obligation to make statements (except where mandatory disclosure is required, for example, with respect to swaps with special entities), but where a statement is made, it must be true and complete. In particular, it is worth noting that, with respect to Swaps, the offence is not limited to the acquisition of the Swap, but to any statement in connection with the Swap, potentially covering life-cycle events Potentially manipulative trade practices, including fictitious or wash trades (where no risk is actually assumed), spoofing (opening and simultaneously closing positions, giving the impression of greater liquidity than may actually exist) and reckless disregard for orderly closing (a new offence directed at trading during the closing minutes of the trading day) The standard of care for many of these offences is recklessness: manipulation does not need to have been intentional or in fact to have occurred. These offences may affect many current practices used for legitimate business purposes Compliance training and procedures should be adopted to address and mitigate potentially manipulative activity 41

42 Glossary 42

43 Glossary Major Swap Participant definitions (equivalent terms apply to Major Security-based Swap Participants): Substantial Position means, in the determination of whether an entity is a Major Swap Participant, EITHER of the following: a. a daily average current uncollateralised exposure of $1 billion or more in any applicable major category of swaps, except that the threshold for the rate swap category would be $3 billion; OR b. daily average current uncollateralised exposure plus potential future exposure of $2 billion or more in any applicable major swap category, except that the threshold for the rate swap category would be $6 billion For purposes of this definition major category of swaps means (i) rate swaps (any swap based on reference rates such as interest rates or currency exchange rates), (ii) credit swaps (any swap based on instruments of indebtedness or related indices), (iii) equity swaps (any swap based on equities or equity indices) and (iv) other commodity swaps (any swap not included in the first three categories, including any swap based on physical commodities) Substantial Counterparty Exposure means, in the determination of whether an entity is a Major Swap Participant, has an aggregate current uncollateralised exposure of $5 billion, or a sum of current uncollateralised exposure and potential future exposure of $8 billion, across the entirety of a person s swap positions Daily average current uncollateralised exposure, aggregate current uncollateralised exposure and potential future exposure have specific and detailed definitions in the proposed rules 43