PRACTICAL IMPLICATIONS OF DERIVATIVES REFORM GORDON F. PEERY and STUART E. FROSS K&L GATES LLP Boston, MA September 21, 2010 1
Agenda Introduction Speakers Late-Breaking Developments: Developments in August and September 2010 Dodd Frank Derivatives Provisions That Require Attention This Year Derivatives Reform Timeline: What to expect in 2011 A Brief History of Reform Summary of Title VII of Dodd Frank and Key Mandates Clearing Conclusion 2
Late-breaking Developments September 21, 2010: September 16, 2010: September 15, 2010: September 13, 2010: August 20, 2010: August present: Gensler speaks on OTC derivatives; Gensler publicly addresses key Dodd Frank derivative terms; CFTC report on CME; CME s test orders; and CFTC and SEC invite public comment on Dodd Frank terms. Ongoing Representation in Washington D.C. 3
Late-breaking Developments 4
Late-breaking Developments 5
Reform Timeline Key Reform Requirements that Apply in the Near Term Regulators may require in the near term that all uncleared Swaps (and SB Swaps) are to be reported to a swap data repository or security-based swap data repository, or, if no repository will accept the report, to the CFTC or SEC, respectively. Dodd Frank directs the SEC and CFTC to adopt an interim final rule within 90 days of enactment of Dodd Frank (i.e., October 19, 2010) to require that uncleared Swaps and SB Swaps that had not expired as of the date of enactment must be reported within 30 days after the issuance of the interim final rule or such other period as the regulators deem appropriate. (See, e.g., CEA Sec 4r) SEC / CFTC must require registration of major participants in swaps market (i.e., Swap Dealers and Major Swap Participants). Reform Timeline: What to expect in 2010-11 Rulemaking Dodd Frank clean-up bill in early 2011 July 18, 2011: First business day following the date of enactment of derivatives mandates, 360 days after the signing of Dodd Frank. 6
Modern Reform Efforts Glass Steagall Act of 1933 1933 and 1934 Acts Commodity Exchange Act of 1936 CFTC Act of 1974 1979: inception of swap markets 1981: first major interest rate swap 1996: OTC derivative market: $55 trillion 1999: Repeal of Glass Steagall 2007: Credit derivatives market: $62 trillion 2010: OTC derivatives market: $615 trillion. 7
Development of Global CDS Market US$62.2trn (+81% y-y) US$54 trn US $35.4trn ~ 30 ~ ~ ~ 2007 2008 Source: Celent Estimate 2004 ISDA Market Statistics 2007, 2008 8
The Great Recession, 2008-09 Private Sector Job Growth Jan. 2008 Aug. 2010, Washington Monthly (Sept. 3, 2010) 9
July 21, 2010 10
Summary of Dodd Frank and Key Mandates The Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ), through Title VII, the Wall Street Transparency and Accountability Act of 2010 ( Title VII ), completely overhauls the trading of over-the-counter ( OTC ) derivatives in the United States. Title VII establishes new requirements for trading, clearing, margining, reporting, and trade data collection of derivatives, as well as the registration of parties to these transactions, which will make the parties subject to capital and business conduct standards. Title VII will generally become effective on July 16, 2011, 360 days following the enactment of the new law 11
Summary of Dodd Frank and Key Mandates Regulates OTC derivatives markets If the SEC or CFTC requires, swaps must be cleared Exception to clearing requirement for certain end users, but the trades need to be reported Customized transactions must be reported to trade repository Joint CFTC and SEC rulemaking authority Registration and recordkeeping requirements for swap execution facilities, swap dealers, and major swap participants Position Limits 12
Summary of Dodd Frank and Key Mandates Need to comply with multiple new regulatory frameworks of the CFTC for Swaps, the SEC for securities-based swaps ( SB Swaps ), and joint CFTC/SEC jurisdiction over mixed swaps. Need to comply with self-regulatory rules of competing exchanges, clearing organizations, swap execution facilities, and swap data repositories. Statutory ambiguities between the definitions of Swaps and SB Swaps will need to be resolved to delineate jurisdictional boundaries between the CFTC and SEC. Statutory ambiguities among the definitions and overlapping regulation of futures, options, swaps and forwards add to legal complexity and may affect trading decisions. 13
SEC Regulates Securities-Based Swaps A Securities-Based Swap ( SB Swap ) is defined to mean any agreement, contract, or transaction that: Is a Swap as that term is defined in the CEA, and Is based on: An index that is narrow-based (e.g., one that has nine or fewer component securities), including any interest therein or on the value thereof; A single security or loan, including any interest therein or on the value thereof; or The occurrence, non-occurrence, or extent of an 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. An SB Swap amends the federal securities laws to include SB Swaps in the definition of security in the Securities Exchange Act. 14
Summary of Dodd Frank and Key Mandates The SEC regulates Securities-Based Swaps, and the CFTC Regulates Nearly Every Other Type of Swap Dodd-Frank adds a definition of Swap to the Commodity Exchange Act ( CEA ) that includes any agreement, contract or transaction that: Is an option based upon the value of one or more commodities, currencies, interest or other rates, securities, debt instruments, indices, quantitative measures, or other financial or economic interests or property of any kind. Provides for the purchase, sale, payment or delivery that is dependent on the occurrence or nonoccurrence, or the extent of an occurrence, of an event or contingency with a potential financial, economic or commercial consequence. Provides for an exchange of payments based upon the value of one or more currencies, commodities, interest or other rates, securities, debt instruments, indices, quantitative measures or other financial or economic interests or property of any kind and that transfers financial risk, but not ownership of an asset or liability. Is commonly known as a swap, including, but not limited to, an interest rate swap, a currency swap, a total return swap, an equity index swap, an equity swap, a debt index swap, a debt swap, a credit default swap, a credit swap, an energy swap, and a metal swap. 15
SEC and CFTC Share Jurisdiction over Mixed Swaps A Mixed Swap has a complicated statutory definition. Generally, it appears to include an agreement, contract or transaction that is based (1) on the value of one or more of the components of an SB Swap and (2) the value of one or more of the (a) non-securities components of a Swap as defined in the CEA (e.g., interest or other rates, currencies, commodities, instruments of indebtedness), or (b) the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence that is not otherwise within the definition of SB Swap The definition generally would include agreements where one counterparty receives a return based on a single security or loan or a narrow-based securities index and the other counterparty receives a return based on the value of a nonsecurities-based measure (e.g., a commodity index). 16
Summary of Dodd Frank and Key Mandates New registration requirements for Swap Dealers, Major Swap Participants, Securities-Based Swap Dealers ( SB Swap Dealers ), and Major Securities- Based Swap Participants ( Major SB Swap Participants ) (collectively, Regulated Swap Entities ). New clearing, exchange trading, margining and reporting requirements for Swaps and SB Swaps. Exemption from clearing and exchange trading requirements for commercial end users. New general business conduct requirements for Regulated Swap Entities. Special business conduct requirements for Regulated Swap Entities that are advisors or counterparties to Special Entities (i.e., employee benefit plans and governmental plans). 17
Summary of Dodd Frank and Key Mandates Implications of Commodities Exchange Act revisions affecting swaps for registered investment company status. Swaps based on commodities (including broad-based securities indices) are excluded from the definition of security, but subject to CFTC jurisdiction. A fund that primarily invests in Swaps based on a broad based securities index, now may be treated as a fund that does not invest in securities, and is specifically subject to CFTC jurisdiction. As a result of the new legislation, registered funds and funds seeking to register with the SEC may have to rethink their use of Swaps if they wish to be regulated as investment companies rather than as commodity pools. 18
Major Swap Participant* Summary of Dodd Frank and Key Mandates MAJOR SWAP PARTICIPANT. (A) IN GENERAL. The term major swap participant means any person who is not a swap dealer, and (i) maintains a substantial position in swaps for any of the major swap categories as determined by the Commission, excluding (I) positions held for hedging or mitigating commercial risk; and (II) positions maintained by any employee benefit plan (or any contract held by such a plan) as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002) for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan; (ii) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or (iii) (I) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate Federal banking agency; and (II) maintains a substantial position in outstanding swaps in any major swap category as determined by the Commission. (CEA 1A(33)(A)) *Major Securities-Based Swap Participant for SB Swaps 19
Exclusions from Definition of MSP Financing Affiliates of Product Manufacturers: The definition excludes certain financing affiliates of product manufacturers. Specifically, it excludes entities whose primary business is to provide financing and that use derivatives to hedge commercial risks related to interest rate and currency exposures, where at least 90 percent of the exposures arise from financing that facilitates the purchase or lease of products, if 90 percent or more of the products are manufactured by the entity s parent company or another subsidiary of the parent company Other exclusions: To Be Determined 20
Swap Dealers A Swap Dealer is defined as: any person who (1) holds itself out as a dealer in Swaps; (2) makes a market in Swaps; (3) regularly enters into Swaps with counterparties as an ordinary course of business for its own account; or (4) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in Swaps. A person may be designated as a Swap Dealer for a single type or single class or category of Swap, but not for other types, classes, or categories of Swaps. Exclusions: Swap Dealer does not include a person that enters into Swaps for such person s own account, either individually or in a fiduciary capacity, but not as part of a regular business. The CFTC is authorized to exempt from designation as a Swap Dealer any entity that engages in de minimis Swap dealing with or on behalf of customers, and to promulgate regulations to establish factors that would govern such an exemption. Title VII has similar definitional provisions for SB Swap Dealers, but with references to Swaps being to SB Swaps and references to CFTC being to SEC. 21
What it means to be a Major Swap Participant and a Major Swap Dealer Asset requirements relating to trading: Minimum capital requirements Minimum initial and variation margin requirements Satisfy business conduct standards Designate a chief compliance officer/responsibilities Implement a conflict of interest system and procedures Other extensive record keeping requirements: Trade retention requirements (for trades, communications relating to trades) Maintain complete audit trail for trade reconstruction Conform with other CFTC / SEC requirements Registration (within one year of enactment) 22
General Duties of Regulated Swap Entities Regulated Swap Entities will have the following duties, in addition to any others prescribed by the CFTC and SEC by regulation: Registration: Register with the CFTC or SEC, or both. It is unlawful to permit associated persons to be subject to statutory disqualification. NFA and FINRA will likely handle registration processing. Registration will be required even if the person is a depository institution or is registered with the other regulatory agency. Capital and Margin Requirements: Non-Bank Regulated Swap Entities must comply with capital and margin requirements to be established by the CFTC and SEC. Bank Regulated Swap Entities must comply with capital and margin requirements established by their prudential regulator. Capital requirements will be based upon all Swaps and SB Swaps, even if an entity is only deemed a Swap Regulated Entity for a particular type, class or category of Swap or SB Swap. Verifying Status of Counterparty: Must verify that every counterparty to an off-exchange swap meets the eligibility standard for an eligible contract participant. Disclosure: Disclose to any counterparty that is not a Swap Regulated Entity: (1) information about the material risks and characteristics of the Swap or SB Swap; (2) any material incentives or conflicts of interest that the entity may have in connection with the Swap or SB Swap; (3) for cleared Swaps and SB Swaps, upon the request of the counterparty, the daily mark from the appropriate derivatives clearing organization; and (4) for non-cleared Swaps and SB Swaps, the daily mark of the Swap (or SB Swap) Dealer or the Major Swap (or SB Swap) Participant. 23
General Duties of Regulated Swap Entities Conflict-of-Interest Protections: Establish structural and institutional safeguards between persons involved with pricing, clearing, or accepting customers and those persons whose involvement in pricing, trading and clearing activities might potentially bias their judgment or supervision and contravene the core principles of open access and the business conduct standards. Establish Chief Compliance Officer: Duties include resolving any conflicts of interest, and preparation of an annual report describing compliance with statutory and regulatory duties, and each policy and procedure, including the code of ethics and conflict of interest policies, of the entity. The CCO must sign the report and certify that it is accurate and complete, and it must accompany each financial report to regulators. 24
General Duties of Regulated Swap Entities Fair Dealing: Communicate in a fair and balanced manner based on principles of fair dealing and good faith. Recordkeeping: Maintain records of swaps and related cash or forward transactions, including email, instant messages and recordings of telephone calls. Documentation: Comply with regulations relating to confirmation, processing, netting, documentation and valuation of all Swaps and SB Swaps. Reporting: Disclose to regulators Swap (and SB Swap) terms and conditions, Swap (and SB Swap) trading operations, mechanisms and practices, and financial integrity protections relating to Swaps (and SB Swaps). Audit Trail: Maintain complete audit trail for conducting comprehensive and accurate trade reconstructions. Risk Management Systems: Establish robust and professional risk management systems. Information Gathering: Establish internal systems to obtain necessary information to perform statutory duties and to provide information to regulators on request. 25
Business Conduct Standards Relating to Special Entities Swap Dealers, SB Swap Dealers, Major Swap Participants and Major SB Swap Participants will be subject to heightened business conduct standards when acting as an advisor or counterparty to a Special Entity. Special Entity is defined to mean a Federal agency, a State, State agency, city, county, municipality, or other political subdivision of a State, an employee benefit plan or a governmental plan as defined in Section 3 of the Employee Retirement Income Security Act of 1974 ( ERISA ), or any endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code. 26
Business Conduct Standards for Advisors to Special Entities Swap Dealers, SB Swap Dealers, Major Swap Participants and Major SB Swap Participants when acting as advisors must not engage in any act that is fraudulent, deceptive or manipulative, including any transaction, practice, or course of business that operates as a fraud or deceit on any Special Entity or prospective customer that is a Special Entity. In addition, Swap Dealers and SB Swap Dealers must act in the best interests of the Special Entity, and make reasonable efforts to obtain information (including information relating to financial status, tax status, investment and financing objectives) as is necessary to make a reasonable determination that any Swap or SB Swap recommended by the Swap Dealer or SB Swap Dealer is in the best interests of the Special Entity essentially, a suitability obligation. 27
Duties Relating to Counterparties to Special Entities A Swap Dealer, SB Swap Dealer, Major Swap Participant or Major SB Swap Participant that acts as a counterparty (but not as an advisor) to a Special Entity must have a reasonable basis to believe that the Special Entity has an independent representative that: 1. has sufficient knowledge to evaluate the transaction and risks; 2. is not subject to a statutory disqualification; 3. is independent of the Swap Dealer, SB Swap Dealer, Major Swap Participant or Major SB Swap Participant ; 4. undertakes a duty to act in the best interests of the counterparty it represents; 5. makes appropriate disclosures; 6. will provide written representations to the Special Entity regarding fair pricing and the appropriateness of the transaction; and 7. in the case of an employee benefit plan subject to ERISA, is a fiduciary as defined in Section 3 of ERISA. 28
Duties Relating to Counterparties to Special Entities A Swap Dealer or SB Swap Dealer must disclose in writing to the Special Entity the capacity in which it is acting prior to initiation of the transaction. The CFTC and the SEC may adopt other requirements for those dealing with Special Entities, and particularly duties that may apply if the counterparty is the United States, a State, a foreign government, a political subdivision of any of the foregoing (provided that any of these government entities owns and invests on a discretionary basis at least $50 million and is not an eligible commercial entity ), or is a multinational or supranational government entity. These special duties will not apply with respect to transactions initiated by a Special Entity on an exchange or swap execution facility, and if the Regulated Swap Entities do not know the identity of the counterparty to the transaction. 29
Other Key Issues in Dodd Frank Bankruptcy treatment: cleared swaps are considered to be commodity contracts under the US BK Code (and are not subject to a stay); uncleared swaps may also qualify because definition of commodity contract was expanded. Anti-Manipulation Provisions: insider trading law expanded to apply to Security-Based Swap Transactions. Oversight of Carbon Markets: An interagency working group is formed to study the development of a carbon market; report due to Congress in early 2011 30
Central Clearing 31
Basic Differences Between the OTC Market and A Centrally-Cleared Market Source: http://www.publications.parliament.uk/pa/ld200910/ldselect/ldeucom/93/9301.gif 32
33
Drivers for the Dodd Frank Central Clearing Mandate New York Federal Reserve Meetings re: Failure of LTCM Failure of Bear Stearns Failure of Lehman Brothers Failure of AIG Common characteristics of those that failed. Source: Chatham Financial 34
The Dodd Frank Clearing Mandate Mandate: If SEC or CFTC mandate that a Swap (or SB Swap) be cleared, it is against the law for it to be traded OTC Exception: One party must (i) not be a financial entity; (ii) use Swaps and SB Swaps to hedge or mitigate commercial risk; and (iii) demonstrate to regulators how it meets financial obligations for noncleared Swaps and SB Swaps. A financial entity for this purpose is a Regulated Swap Entity, commodity pool, private fund, employee benefit plan and a person predominantly engaged in banking activities. Regulators may exempt small banks, savings associations, farm credit system institutions and credit unions with assets of $10 billion or less. Financing affiliates of product manufacturers are not considered to be financial entities, and thus qualify for exemption; and, Possibly other exceptions (via the clean up bill, rulemaking). (Note also reporting obligations for permitted, uncleared swaps) 35
Reporting Obligations for Uncleared Swaps All cleared Swaps and SB Swaps must be reported to a swap data repository or security-based swap data repository, or to the CFTC or SEC, respectively. Cleared Swaps and SB Swaps entered into prior to date of enactment of Title VII must be reported within 180 days after effective date, i.e., by January 12, 2012. Cleared Swaps and SB Swaps entered into on or after date of enactment of Title VII must be reported within 90 days after such effective date (October 14, 2011) or such other time as prescribed by the CFTC or the SEC. 36
Reporting of Swaps If only one party to the Swap or SB Swap is a Swap Dealer or SB Swap Dealer, the dealer must report the Swap or SB Swap; if only one party to the Swap or SB Swap is a Major Swap Participant or Major SB Swap Participant, and the other party is not a Swap Dealer or SB Swap Dealer, the Major Swap Participant or Major SB Swap Participant must report the Swap or SB Swap otherwise, the parties may decide who reports. 37
CENTRAL CLEARING: ADAPTING TO CHANGE. 38
FUNDAMENTAL DIFFERENCES IN OTC AND FUTURES-STYLE DERIVATIVES TRADING 39
Basic OTC Trading Relationships C o ll a t e r a l OTC derivative Swap Dealer End User C o ll a t e r a l 40
Regulated And Protected OTC Trading Relationships Swap Dealer CUSTODIAN End User 41
Basic Differences Legal Documentation in the OTC Market and the Centrally-Cleared Market OTC ISDA Master, Schedule, CSA and as needed, a tri-party control agreement, which set forth the rights and obligations relating to: The means for holding collateral posted to secure the financial performance of the parties, The amount of the collateral, The valuation of the collateral The valuation of the swap obligations and means of valuation (and methods to dispute valuation and obtain access to collateral) and Protections that insulate the collateral from any claims against the counterparties from third persons. FUTURES Legal documentation will depend on the clearing house and clearing member requirements. CME Clearing envisions: FCM Agreement, CME Cleared OTC Give-Up, CME Cleared OTC Derivatives Addendum, Onboarding Documentation, and The ISDA Master Agreement (damage calculations for uncleared, terminated trades) 42
The Clearing Process and CME s Legal Documentation 1. ISDA 6. CEA and Regulations 2. FCM Agreement 3. Give-Up Agreement 5. Exchange Rules 4.EULA (Exchange User License Agreement) 43
Basic Differences in Collateral and Margin OTC Collateral Support Annex (and tri-party control agreement) enable parties to flexibly determine: The means for holding collateral posted to secure the financial performance of the parties, The amount of the collateral, The valuation of the collateral The valuation of the swap obligations and means of valuation (and methods to dispute valuation and obtain access to collateral) and Protections that insulate the collateral from any claims against the counterparties from third persons. FUTURES Key distinguishing feature: end users have no flexibility in setting margin. Once a swap is cleared, the protection of collateral posted as margin is governed by clearing house rules, U.S. Bankruptcy Code or the law governing the clearing house, provisions governing commodity brokers, and, the account agreement with the FCM. Margin is segregated from the FCM, but FCM customers margin is co-mingled. 44
Conclusion 45
Conclusion Recommendations: Inventory derivatives positions Review counterparty risk, FCM Risk and clearing house policies; Consider extraterritorial application of Dodd Frank Monitor SEC, CFTC and Congressional developments Consider public comments / coalitions 46
Inventory Derivative Positions 47
Inventory Derivative Positions Dodd Frank Necessitates an Active, Ongoing Inventory of Positions Before July 18, 2011* Determine gross volume and category volumes of all derivatives Determine OTC versus exchange-traded Determine trading trends to anticipate future clearing needs Determine trade activities involving protected end users Pension plans Endowments Governmental entities *Title VII effectiveness - first business day, 360 days after enactment. 48
Inventory Derivative Positions Inventory of positions after July 18, 2011: Compare positions with CFTC and SEC clearing mandates Report uncleared trades Record keeping requirements Retain all data for audit trail reconstruction and Possible Exchange Act reporting for equity trades Other obligations 49
With Inventory, Prepare for next steps: I. External Action: Public comment (scope of Major Swap Participant, etc.); SIFMA and other industry action; Lobby for next clean up bill in early 2011 II. Internal Action Lincoln Rule in Title VII: are you a swaps entity that receives federal support? (two year phase-in); Inventory will determine need to register as an MSP with the SEC or CFTC, depending on, among other factors that will be set by regulators, the regularity of derivatives activities; Equity swaps and beneficial ownership: registration under Sections 13 and 16 of the Exchange Act; Analyze recordkeeping and retention procedures, including audit trail procedures; Conflict of interest protocols (see, the Goldman hearing); Futures activity and position limit analysis; and If activity outside of the US is deemed to undermine the stability of the financial system in the US, that activity will be prohibited. 50
Last Step: Adjust Policies and Client Documentation Revisit Counterparty Risk Policy Create Exchange and Central Clearing House Policy Revisit Base Documentation (e.g., ISDAs) Add annex for clearing at ICE (for credit and certain other derivatives); Negotiate FCM Agreements and put EULAs in place with CME For money managers, review documentation, for protected end users Pension plans Endowments Governmental entities (Revisit representations, warranties, covenants in a way that puts the onus on money manager clients) 51
52
53
Questions? 54