It s Not Just Registration: New Regulation of Swap Transactions by US and non-us Banks under the Dodd-Frank Act

New York Seminar Series It s Not Just Registration: New Regulation of Swap Transactions by US and non-us Banks under the Dodd-Frank Act Tuesday, June 12, 2012 arnoldporter.com

New York Seminar Series Financial Markets Regulatory Roundtable It s Not Just Registration: New Regulation of Swap Transactions by US and non-us Banks under the Dodd-Frank Act Tuesday, June 12, 2012 12:00 2:00 p.m. Table of Contents Agenda... Tab 1 Presentation Slides... Tab 2 Moderator/Speaker Biographies... Tab 3 Kathleen A. Scott, Michael Griffin, Daniel Waldman, Andrew Shipe Practice Overviews... Tab 4 Derivatives and Commodities, Financial Services, Hedge Fund and Private Equity Investment in Financial InstitutIions

Tab 1: Agenda arnoldporter.com

New York Seminar Series Financial Markets Regulatory Roundtable It s Not Just Registration: New Regulation of Swap Transactions by US and non-us Banks under the Dodd-Frank Act Agenda 12:00 12:30 p.m. Lunch and Registration 12:30 12:40 p.m. Introductions and Overview 12:40 1:45 p.m. Presentation and Discussion 12:40 12:50 p.m. Title VII - Background and Implementation 12:50 1:10 p.m. Entity Definitions and Registration Requirements 1:10 1:35 p.m. Extraterritoriality issues, including unique issues for non-u.s. banks 1:35 1:55 p.m. Overview of Recordkeeping, Reporting and Compliance Issues 1:55 2:00 p.m. Questions and Answers

Tab 2: Presentation Slides arnoldporter.com

I' It's Not Just Registration: i New Regulation of Swap Transactions by US and non-us Banks under the Dodd-Frank Act Michael Griffin, Partner, Arnold & Porter LLP Daniel Waldman, Partner, Arnold & Porter LLP Andrew Shipe, Counsel, Arnold & Porter LLP 6/11/2012 June 12, 2012 AGENDA Title VII Background and Implementation, including Mandatory Clearing and Exchange Trading Entity and Product Definitions; Registration Requirements Extraterritoriality issues, including unique issues for non-u.s. banks Overview of Recordkeeping, Reporting and Compliance Issues 2

Title VII Background and Implementation June 12, 2012 General Overview Of Title VII Of Dodd-Frank Central Principles: Comprehensive regulation of swaps dealers and major swap participants Mandatory clearing and exchange trading of standardized swaps Increased transparency both to the public and to the regulators Enhanced regulatory authority Exchanges and Clearinghouses Position Limits Anti-manipulation and anti-disruptive practices prohibitions Whistleblower provisions 4

Significant Issues That Will Affect Financial Institutions Swap Dealer and MSP regulation Bank push out provision Mandatory clearing and exchange trading Margin rules for uncleared swaps Special forex rules Position limits Enforcement authority Volcker Rule 5 Regulatory Requirements Applicable to Swap Dealers and Major Swap Participants Registration Margin and capital Reporting and recordkeeping Business conduct standards Documentation standards Risk management standards, position limit monitoring, diligent supervision, business continuity and disaster recovery CCO obligations Collateral management standards Conflicts of interest 6

Bank Push Out Provision Swap dealing activity will have to be put in a separately capitalized affiliate Initial legislative proposal would have forced banks to divest all swaps activities to an affiliate Last minute compromise: Banks may maintain their derivatives business in products that are tied to hedging for the banks own risk or certain rate or credit products Such products would likely include interest rate and foreign exchange instruments as well as certain credit products held for hedging purposes or cleared CDSs However, dealing in agriculture products, energy swaps, and uncleared credit would likely have to be spun off to the bank s affiliates 7 Clearing Requirements Mandatory Clearing of Swaps and Security-Based Swaps for those swaps that are eligible for clearing Title VII of the Dodd-Frank Act mandates that the regulators (CFTC and SEC) determine which type or category of swaps are eligible for clearing Most of the swaps that will be eligible for clearing will be standardized swaps; swaps that are liquid and not too complex. Some estimates are 70-80% of the market is clearable The regulators have not yet designated any swaps that must be cleared 8

Clearing Exemptions Non-financial entities who use swaps to hedge commercial risk are exempt from mandatory clearing CFTC and SEC are also considering an exemption for small banks, savings associations, farm credit institutions and credit unions with less than $10 billion in assets 9 Exchange Trading Requirements Mandatory Trading on Registered Exchanges: If a contract is listed for trading and required to be cleared it must also trade on a registered exchange, if the swap is available for trading on an exchange. Registered exchanges include Designated Contract Markets (DCMs) or newly-created Swap Execution Facilities (SEFs). 10

Swap Execution Facilities A SEF is defined in the Dodd-Frank Act as: A facility in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that facilitates the execution of swaps between two persons and is not a designated contract market 11 Margin for Uncleared Swaps Regulators have proposed p minimum initial and variation margin requirements for uncleared swaps Swap dealers and MSPs must post and collect margin from other dealers and MSPs and segregate the initial margin with third party custodians Swap dealers and MSPs must collect margin from high risk financial end users Swap dealers that are banks must collect margin from low risk financial end users and non-financial end users subject to permissible credit thresholds 12

OTC Forex Under Dodd-Frank OTC FOREX = SWAPS If it s OTC and it s not spot, Dodd-Frank calls it a swap The definition of swaps expressly excludes forward contracts on non-financial commodities and securities intended to be physically settled Treasury Secretary has authority to exclude Forex forwards and swaps between eligible contract participants from the statutory definition of swaps and has proposed such an exemption. However, the exemption has not been finalized and is being discussed among regulators internationally. Other non exempt OTC Forex products, such as options, nondeliverable forwards and cross currency swaps would be subject to same regulatory regime applicable to other swaps (including swaps dealer/major swap participant registration and regulation, capital requirements, margin rules, disclosure requirements, position limits, clearing, ECP counterparty restrictions, etc.) 13 OTC Retail Forex What is retail Forex? Dodd-Frank amends the definition of eligible contract participant and thereby increases the retail forex market Hedge funds/commodity pools as retail Forex customers: The new look-through requirement 14

OTC Retail Forex (cont d) Dodd-Frank extends the Commodity Exchange Act ban on retail Forex transactions to regulated financial institutions unless the applicable Federal banking agencies issue rules authorizing retail Forex transactions. Bank regulators have issued authorizing rules that include requirements relating to disclosure, recordkeeping, financial reporting, business conduct, capital and margin. 15 Position Limits Position limits will be imposed by the regulators on any swaps on nonfinancial commodities (e.g., energy, metals, agricultural commodities) that perform a significant price discovery function Considerations for significant price discovery include: price linkage to traded contracts the potential for price arbitrage between the swap and a contract on the traded platform position limits are being challenged in court 16

Enforcement Authority In OTC Context Title VII substantially increases the CFTC s enforcement authority in the context t of derivatives trades New Liability Provisions for OTC trades New fraud liability provisions that parallel Section 10(b) of the Exchange Act with respect to securities. Section 4b of the Commodity Exchange Act amended, adding language that prohibits derivatives participants from: employing any device, scheme, or artifice to defraud; making any untrue statement of material fact or omitting any statement of material fact necessary in order to make the statements made misleading; or engaging in any act, practice or course of business which operates as a fraud or deceit upon any person. 17 Enforcement Authority In OTC Context (cont d): Disruptive Practices : Dodd-Frank provides the CFTC with enforcement authority over market participants p that engage g in disruptive practices. The Act defines such disruptive practices to include: activities violating bids or offers; intentional or reckless disregard for the orderly execution of transactions during the closing period of a market; and spoofing (bidding or offering with the intent to cancel the bid or offer before execution) Anti-Manipulation: Dodd-Frank also expands the CFTC s anti-manipulation authority, and broadens the types of activities that are considered manipulation. For instance, it reduces the scienter requirement for manipulation in the reporting context by changing the standard of such conduct to include acting in reckless disregard of the fact that such report is false, misleading, or inaccurate 18

Volker Rule (Title VI of Dodd-Frank) Subject to certain exemptions, federal regulators must issue regulations to prohibit banking entities (i.e., insured depository institutions, their holding companies, non-us banks with branches or agency offices in the US, and any affiliate or subsidiary of such entities) from engaging in proprietary trading, sponsoring or investing in hedge funds and private equity funds, and having certain financial relationships with those hedge funds or private equity funds for which they serve as investment manager or investment adviser 19 Volker Rule (Title VI of Dodd-Frank) (cont d) A systemically significant non-bank financial company supervised by the Federal Reserve that engages in such activities would be subject to rules establishing enhanced capital standards and quantitative limits, but such activities would not be prohibited 20

Entity and Product Definitions; Registration Requirements Definition of Swap Dealer The Dodd-Frank Act defines a swap dealer broadly as an entity that: holds itself out as a dealer; makes a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for its own account; or engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. 22

Swap Dealer Exclusions Swap dealing activity does not include: Swaps entered into with majority-owned affiliates; Swaps entered into by insured depository institutions with a customer in connection with the origination of a loan (must be within 90 days before or 180 days after and relate to the financial terms of the loan or be a credit condition of the loan) Swaps entered into for the purpose of hedging physical positions (interim final rule). 23 Swap Dealer: De Minimis Exception Entity may conduct a de minimis amount of swap dealing without being required to register CFTC set the de minimis annual notional thresholds at $3 billion but with a phase-in period of up to 5 years where the threshold is $8 billion Thresholds for security-based swaps somewhat lower $25 million threshold for swaps with special entities 24

Definition of Major Swap Participant Entity that maintains a substantial position in swaps (excluding hedge positions) that t create substantial ti counterparty exposure and that could have serious adverse effects on financial stability on banking system or financial markets or; Entity that has a substantial swaps position and is highly leveraged and not subject to capital requirements imposed by a federal banking regulator Regulators define a substantial position as either current uncollateralized exposures above certain thresholds or potential future exposures above specified exposures Highly leveraged is defined as a 12 to 1 or greater 25 Extraterritoriality issues, including unique issues for non-u.s. banks

Sections 722 of Dodd-Frank: Extraterritoriality Section 722 states that the provisions of the Act relating to swaps do not apply to activities outside the US unless those activities: Have a direct and significant connection with activities in, or effect on, commerce of the US, or; Contravene such rules or regulations as the CFTC may prescribe as are necessary or appropriate to prevent the evasion of the Act 27 Sections 772 of Dodd-Frank: Extraterritoriality Section 772 states that the provisions of the Act relating to security-based swaps under the jurisdiction of the SEC do not apply to any person insofar as such person transacts business in security-based swaps without the jurisdiction of the US, unless such person transacts business in contravention of rules that may be promulgated by the SEC to prevent evasion of the Act 28

Sections 722 and 772 cont. Guidance on the scope of sections 722 and 772 and the extraterritorial application of the new derivatives rules is expected from the SEC and CFTC in June or July, 2012 29 Extraterritoriality: General Principles Dodd-Frank regulations will generally apply to Swaps involving at least one US person; Swaps executed in the US or; Swaps cleared in the US 30

US Person Defined: No definition of US person in Title VII. US Person will include: natural persons resident in the US partnerships and corporations organized or incorporated under the laws of the US But will it include: branches or affiliates of US persons located outside the US? branches or divisions of non-us persons located in the US? 31 Status of Branches or Affiliates of US Persons Located Outside the US? Persons organized outside the US doing business with non-us persons are usually not subject to direct US securities or futures regulation US regulators have expressed concern that US persons may evade Title VII regulation by booking their swaps through non-us affiliates or that the risks of non-us affiliates will ultimately be borne by the US parent Will US regulation of a non-us entity be triggered by a guarantee from a US affiliate? How about inter-affiliate transactions with a US entity? 32

Status of Branches or Divisions of non-us Persons Located in the US? Conduct by persons located within the US will generally be regulated. But will this subject the entire non-us entity to Title VII regulation? What if the US based employees are simply assisting the home office with respect to swaps booked overseas with non-us counterparties? Will US regulators be willing to apply Title VII selectively? 33 Regulation of Swap Dealers and Major Swap Participants: Extraterritoriality Under Title VII, swap dealers and MSPs are subject to registration, ti capital, margin, conflict of interest, t risk management, diligent supervision, business conduct, margin segregation, documentation, recordkeeping and reporting requirements, among others For non-us dealers and MSPs dealing with US persons, registration will be required Will the US regulators defer to the home country regulator for entity wide regulations, such as capital, risk management, conflict of interests, if the non-us standards are comparable? 34

Regulation of Swap Dealers Will transaction-based ti regulations, such as margin, business conduct standards, collateral management and documentation be applied to non-us dealers who are registered under Title VII when they deal with non-us customers? Should the US defer to the transaction level regulations of the home country regulator of a non-us dealer? 35 Mandatory Clearing and Trade Execution Dodd-Frank requires centralized clearing and exchange trading of most standardized derivatives, subject to exemptions for certain non-financial end users To satisfy the requirement, the swap trader must execute and clear at facilities that are registered with the US regulator Most other G-20 countries are expected to impose similar clearing and trading mandates and to require that the trading and clearing be done at exchanges and clearinghouses regulated locally 36

Mandatory Clearing and Trade Execution cont. Given these potentially conflicting mandates, exchanges and clearinghouses seeking to do cross-border swap business may have to obtain registrations in multiple jurisdictions or seek an exemption from one or more jurisdictions Some commentators have asked the US regulators to waive the clearing and exchange trading mandate of Title VII if the swap is otherwise subject to a mandate from another jurisdiction 37 Trade Reporting All swaps will be required to be reported to trade repositories Each regulator is likely to require that a swap involving its nationals be reported to a repository in its home jurisdiction This creates duplicative reporting Further complications will occur if reporting standards are different 38

Cross Border Swaps Increase the Likelihood That More Than One Jurisdiction Will Have a Legitimate Interest In Regulating the Transaction and/or the Parties. Cross Border Swaps include: swaps involving a US and non-us person or; swaps for which the swaps infrastructure used (the exchange, clearinghouse or swap data repository) is located in a country different from the country of one or both of the swap counterparties 39 Cross Border Swaps May Lead to Inconsistent or Duplicative Regulation To avoid putting unreasonable regulatory burdens on swaps participants and markets, regulators must be willing to recognize the legitimate regulatory claims of other jurisdictions and defer to foreign regulatory requirements, where appropriate 40

Need for Mutual Recognition and Cooperation Individual regulations must be calibrated to account for the claims of other jurisdictions Deference to the regulations of other countries under principles of international comity and mutual recognition will be appropriate when another jurisdiction has a greater or equal regulatory interest and where deference will not undermine an important national objective In addition, greater efforts will be required to harmonize regulation and increase cooperation through, among other things, information sharing among regulators 41 CFTC Staff Proposal on Extraterritoriality Chairman Gensler has indicated that the CFTC staff will recommend the following approach on extraterritoriality: Foreign entities that conduct swap dealing activity with US persons above a de minimis level will be required to register as swap dealers with the CFTC US persons will be defined for this purpose to include overseas branches of US persons and overseas affiliates of US persons that are guaranteed by the a US entity US persons will also include overseas affiliates of US persons who are operating as conduits for the US entity s swap activity 42

CFTC Staff Proposal on Extraterritoriality Cont. CFTC regulation of non-us dealers will vary based on whether the regulations are entity-level regulations (such as capital, recordkeeping, risk management standards) or transaction-level regulations (clearing, margin, trade execution, sales practices, etc.) Entity-level requirements in certain circumstances could be complied with through substituted compliance with comparable home country regulations 43 CFTC Staff Proposal on Extraterritoriality Cont. US transaction-level requirements would apply to all transactions with US persons (as defined above) US transaction-level requirements would not apply to overseas swap dealers (including affiliates of US persons) if their counterparties are not US persons, not conduits for US persons and not guaranteed by US entities. 44

Overview of Recordkeeping, Reporting and Compliance Issues Recordkeeping New rules require SDs and MSPs to keep complete records of all swaps activity sufficient to allow full trade reconstruction. Includes daily trade records, complaints, marketing / sales material, records of filled or unfilled orders, records of oral and written communications re: bids, offers, trading and prices, records of transaction reporting. Includes position records, to be linked with daily trade records. Searchable by transaction and counterparty. Maintenance period: generally 5 years from creation, first two in a readily accessible place. But if records relate to a transaction, 5 years from termination. Location: principal i place of business. If outside of the U.S., production within 72 hours. 46

Regulatory Reporting SDs and MSPs will have to file monthly unaudited financial statements and annual audited financial statements with CFTC and NFA, or with prudential regulators. Periodic Risk Exposure Reports by SDs and MSPs. Reports to senior management and governing body as to risk exposures. Must also be provided to CFTC. Reports must address market, credit, liquidity, foreign currency, legal, operational, settlement, and any other applicable risk exposures. Reports must be quarterly, and immediately upon detection of any material change in risk exposure. Annual Compliance Report. 47 Trade Reporting CFTC has adopted real time public reporting rules for swap transaction data. Similar SEC proposals are pending. Swap Data Repositories: will receive and disseminate swap data. (If there is no SDR for a given swap, the regulator will perform the function). Creation Data: Primary Economic Terms and Confirmation Data. Continuation Data: Life Cycle vs. State Data. Valuation Data: to describe daily mark. SDRs will not publish counterparty identities or affiliate transactions. Responsibility for reporting will depend on counterparty type, whether executed on a SEF or DCM, and clearing status. 48

Trade Reporting II Legal Entity, Product and Unique Swap Identifiers. Compliance Dates For Transaction Reporting. Date One: 60 days after joint SEC / CFTC rules to define the term swap. For SDs and MSPs to provide initial data reports for interest rate and CDs. Date Two: 90 days after Date One. By this date, SDs and MSPs must be in compliance for all other swap data. Date Three: 90 days after Date Two. By this date, all other participants must be in compliance. No SDRs have been recognized (as of June 12, 2012). Legacy swaps: Unexpired swaps executed both before and after DFA s enactment must be reported. 49 Business Conduct Standards Certain duties will only apply where the counterparty identity is known prior to execution (thus excepting SEF / DCM transactions where counterparty identity is unknown). These are the know your counterparty, true name and owner, verification of eligibility, disclosures, suitability and Special Entity Rules. Know your counterparty. SDs must obtain facts concerning counterparties whose identity is known prior to execution. SDs and MSPs must obtain and record true name and owner information. Essential facts: those needed to comply with applicable law, to implement risk management vis-à-vis the counterparty, and to verify authority. Verification of eligibility: SDs and MSPs must verify eligibility for eligible contract participants before offering or entering into a swap. 50

Business Conduct Standards II Suitability: SDs that recommend a swap to a party other than a swap entity must: Undertake diligence as to the transaction and counterparty and have a reasonable basis to conclude the transaction is suitable. Safe harbor for institutions under specific conditions. Special entities. Enhanced protections are triggered when SDs act as advisors, and when SDs and MSPs are counterparties, to special entities. Federal and state government agencies, employee benefit plans, endowments. Protections include best interests standard, enhanced know your counterparty, evaluation of representatives, and enhanced disclosures. 51 Business Conduct Standards - III Counterparty disclosures: Prior to entry into swap, SDs and MSPs must disclose material information for counterparty to assess risks, terms of the swap, conflicts, price, mid-market mark and clearing rights. Scenario analyses depending on whether the transaction is effected on a SEF/DCM. Exceptions for transactions with other SDs and MSPs. Following standards apply even if the trade was effected on a SEF: Daily mark disclosures depending on whether transaction is cleared. Fair dealing. SDs and MSPs must treat counterparty information as confidential. 52

Chief Compliance Officer SDs, MSPs and FCMs must designate a Chief Compliance Officer. Appointed by and reports to the Board or Senior Officer. Duties: develop compliance policies, review and act so as to ensure compliance and address any noncompliance, resolve conflicts of interest. Minimum yearly meeting with Board. Prepare and sign annual compliance report. The annual report is to be furnished to the CFTC or SEC as appropriate and certified as complete and accurate. Compliance dates: depend on current registration status, but generally will only be after SD / MSP registration deadlines are set. 53 Supervision, Risk Management and Conflicts Supervision: SDs and MSPs must implement supervisory programs under management of qualified personnel. Risk management: SDs and MSPs must establish programs to monitor and manage risks of swaps activities. Must address periodic exposure reports, new product policies, daily measurement of market exposures, reliable valuation data, liquidity risks, etc. Conflicts: SDs must implement conflict of interest policies to separate research and analysis from business trading or clearing interests, effect disclosures, and to prevent undue influence on counterparties with respect to decisions as to whether and where to clear or trade on exchange. 54

Questions? Contact: Michael Griffin +1 212.715.1136 Michael.Griffin@aporter.com Daniel Waldman +1 202.942.5804 Dan.Waldman@aporter.com Andrew Shipe +1 202.942.5049 Andrew.Shipe@aporter.com 55

Tab 3: Moderator/Speaker Biographies arnoldporter.com

Tab 4: Practice Overviews arnoldporter.com

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