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

Thursday, January 14, 2016, 12:00PM – 1:30PM EST

Presenters:

Julian Hammar, Of Counsel, Morrison & Foerster LLP James Schwartz, Of Counsel, Morrison & Foerster LLP

1. Presentation

2. Morrison & Foerster LLP Client Alert:

“CFTC Proposes Regulation of Automated Trading” January 13, 2016

3. Morrison & Foerster LLP Client Alert: “CFTC Adopts Uncleared Swaps Margin Rules” December 23, 2015

4. Morrison & Foerster LLP Client Alert:

“The SEC’s Registration Rules for Security-Based Swap Dealers” – August 28, 2015

Morrison & Foerster LLP

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Derivatives Regulation Update:

Latest Developments and What

to Expect in 2016

January 14, 2016

Presented By

Julian Hammar

James Schwartz

2

Overview

• Today’s topics will include the following:

• Final margin rules for uncleared swaps of the CFTC and the

prudential regulators;

• SEC’s proposed rules for investment companies’ use of

derivatives;

• ISDA 2015 Universal Resolution Stay Protocol and related

matters;

• CFTC’s proposed rules for automated trading on U.S. designated

contract markets;

• CFTC’s preliminary report relating to potential changes in the

current de minimis swap dealing threshold for the swap dealer

registration requirement; and

• Expectations for 2016

3

Background Regarding Margin

• Margin is a significant economic issue that the swap market will need

to address in accordance with regulations that have just now been

finalized.

• One of the criticisms of the swap market in the wake of the financial

crisis of 2008 was that it did not require parties to provide margin

(that is, collateral) to secure their obligations to each other.

• In practice, in many cases before and (even more so) after the crisis,

parties have provided collateral (“variation margin”) reflecting the

current (“mark-to-market”) value of their obligations to each other.

• Dodd-Frank requires regulators to draft rules requiring margin for

bilateral swaps that will not be cleared at a clearinghouse (cleared

swaps, in contrast, are subject to margin requirements imposed by

clearinghouses and their members).

4

Background Regarding Margin

• The regulators have drafted rules for swaps that draw heavily on

traditional margin practices in the futures market.

• Most significantly, the regulations will require many parties (other

than commercial end-users) to provide initial margin, which is

intended to account for potential changes in value during the time

when a swap is in the process of being terminated.

• Initial margin, when required, will be segregated and not subject to

rehypothecation or other use – and, as such, a significant new cost

for swap dealers and certain other financial entities.

• It remains to be seen how the market will respond to the margin

requirements, and the extent to which, at the margin (so to speak),

products other than OTC swaps (for example, futures) may

increasingly be used in place of OTC swaps.

5

CFTC and Prudential Regulator Final Rules

• On December 16, 2015, the Commodity Futures Trading Commission

(“CFTC”) adopted final rules to impose margin requirements on

uncleared swaps entered into by swap dealers and major swap

participants subject to CFTC regulation, referred to as “Covered

Swap Entities” or “CSEs,” that were re-proposed last fall (originally

proposed in 2011) in order to take into account the framework

published by the Basel Committee on Banking supervision (“BCBS”)

and IOSCO published in September 2013.

• The CFTC also adopted an interim final rule to exclude from the

requirements most uncleared swaps that swap entities enter into with

commercial end users, financial institutions with $10 billion or less in

total assets, and certain other entities consistent with the

requirements of the Business Risk Mitigation and Price Stabilization

Act of 2015.

6

CFTC and Prudential Regulator Final Rules

• The CFTC’s final rules are largely the same as the final rules and

interim final rule adopted in October 2015 by the Prudential

Regulators (the Board of Governors of the Federal Reserve System,

Office of the Comptroller of the Currency, Federal Deposit Insurance

Corporation, Farm Credit Administration and the Federal Housing

Finance Agency) for swap entities subject to their supervision

(essentially swap dealers, major swap participants, security-based

swap dealers and major security-based swap participants that are

banks), with a few important differences.

• Both sets of rules become effective on April 1, 2016, with a phased-in

compliance schedule beginning in September 2016.

7

Overview of the Final Rules

• In general, the CFTC’s and Prudential Regulators’ Rules will:

• Require swap entities, subject to a $50 million threshold below

which initial margin need not be posted or collected, to bilaterally

exchange “initial margin” with other swap entities and with a

broad range of “financial end users” whose use of uncleared

swaps meet a notional amount-based threshold (“material swaps

exposure”), all such initial margin to be segregated generally with

a third-party custodian (not affiliated with either counterparty) and

not subject to rehypothecation or other use by the custodian*;

• Permit the calculation of initial margin by means of either a

model-based method or a table-based method;

* The final rules clarify that cash collateral may be held in a general

deposit account with the custodian if the funds are used to purchase

other forms of eligible collateral, is segregated, and the purchase

occurs within a reasonable period.

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Overview of the Final Rules

• Impose a significantly higher initial margin requirement on

uncleared swaps as compared to cleared swaps by requiring that

initial margin models use a 10 business day closeout horizon for

most uncleared swaps as opposed to a 5 business day horizon

for most cleared swaps in order to “incentivize clearing” -- this is

not a requirement of Dodd-Frank, which only requires regulators

to issue rules to provide for margin for uncleared swaps; and

• Require swap entities to exchange “variation margin” with swap

entities and with a broad array of financial end users (without

regard to the existence of material swaps exposure) without any

threshold.

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Scope of the Final Rules

• Under both sets of rules, a CSE will not be required to collect or post

specified amounts of initial or variation margin on swaps with

counterparties that are not Swap Entities or “financial end users” –

such counterparties are described in the Prudential Regulators’ rules

as “Other Counterparties,” and as “Non-Financial End Users” in the

CFTC’s rules.

• The final rules retains the “financial end user” definition used in the

Re-Proposal (a list of list of enumerated financial market status types

under various U.S. statutes and regulations including banks, broker-

dealers, investment companies, insurance companies, commodity

pools and ERISA plans) which was intended to provide greater clarity

than the “financial entity” definition used in the statutory exemption

from mandatory clearing in the Commodity Exchange Act (CEA).

• Expressly excluded from the financial end user definition are

sovereign entities (central governments or an agency or department

thereof) and multilateral development banks.

10

Interim Final Rule Exemption

• In addition, in order to implement the requirements of the Business

Risk Mitigation and Price Stabilization Act of 2015, the CFTC’s and

Prudential Regulators’ separate Interim Final Rules provide that the

requirements of the margin rules will not apply where the

counterparty would be eligible for:

• An exemption from mandatory clearing under Section 2(h)(7)(A)

of the CEA or Section 3C(g)(1) of the Securities Exchange Act of

1934 (“Exchange Act”) (i.e., a non-financial entity using the swap

to hedge or mitigate commercial risk, certain small financial

institutions and captive finance companies);

• An exemption under CEA Section 4(c)(1) for cooperative entities

that would otherwise be subject to the requirement to clear; or

• The exemption for affiliates under CEA Section 2(h)(7)(D) or

Exchange Act Section 3C(g)(4) (i.e., affiliates that act as an

agent).

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Other Counterparties/Non-Financial End Users

• Under the Prudential Regulators’ rules, if an “other counterparty”

does not qualify for the interim final rule exemption (e.g., a

commercial end user that is not hedging or mitigating commercial

risk), is exempt from the definition of financial end user (e.g. an

MDB), or is a financial end user without material swaps exposure for

purposes of initial margin (who are not subject to the rule’s initial

margin requirements), a Covered Swap Entity must collect margin, if

any, from such entities as the CSE determines is appropriate in its

overall credit risk management of its exposure to the customer.

• The CFTC’s release does not require this determination, and also

removes the requirement contained in the CFTC’s re-proposal that

CSEs calculate hypothetical margin requirements for swaps with non-

financial end users, citing the administrative burden and that other

CFTC rules should address monitoring of risk exposures for these

entities.

12

Key Changes to the Re-Proposals

• The CFTC’s and Prudential Regulators’ final rules also make a

number of key changes to the rules as they were re-proposed in the

fall of 2014. These changes include:

• Modification to the Material Swaps Exposure amount and Initial

Margin Threshold;

• Revision of the Definition of Affiliate;

• Expansion of eligible collateral for Initial and Variation Margin;

• Modification for Eligible Master Netting Agreements;

• Adoption of an Inter-Affiliate Exemption from Initial Margin; and

• Changes to the phased-in compliance schedule.

13

Notable Differences between the CFTC’s and

Prudential Regulators’ Rules

• The CFTC’s final rules have a few notable differences from the

Prudential Regulators’ final rules, including:

• Providing for a broader exemption from swaps between Covered Swap

Entities and their affiliates than the more limited exemption provided by

the Prudential Regulators;

• Delegating authority to the National Futures Association (“NFA”), the

self-regulatory organization in the futures and swaps industry, to approve

initial margin models, which could also be approved by the CFTC (the

Prudential Regulators would undertake their own approvals);

• Excluding from the financial end user definition treasury affiliates that

qualify for an exemption from mandatory clearing that the CFTC has

exempted by rule;

• Providing for greater specificity regarding variation margin calculations;

and

• Not addressing cross-border application of the rules, which are being

considered by the CFTC in a separate proposal.

14

Financial End Users with Material Swaps Exposure

• The threshold for determining whether a financial end user has

“material swaps exposure” has been increased under the CFTC’s

and Prudential Regulators’ final rules from $3 billion to $8 billion of

average daily aggregate notional amount of swaps activity over a 3-

month period (determined by reference to the swaps activity of the

financial end user and its affiliate(s)), which is more closely aligned

with the BCBS-IOSCO Framework.

• This change will reduce the number of entities from which swap

entities must post and collect initial margin, which is required under

the rules for swaps between swap entities and financial end users

with material swaps exposure.

• It will also level the playing field between swap entities subject to

U.S. rules and those subject to rules of foreign jurisdictions, such as

the European Union and Japan, which have more closely followed

the BCBS-IOSCO Framework.

15

Financial End Users with Material Swaps Exposure

• Final rules also clarify that swaps that are eligible for the exemption

under the interim final rule do not count toward the threshold.

• In a new provision, the Final Rules clarify the consequences of a

change in a counterparty’s status:

• If a change would make the rules stricter, such as when a

financial end user becomes a financial end user with material

swaps exposure, the stricter rules would apply for new swaps

entered into after the change.

• Where a change would make the rules less strict (such as when

the exposure of a financial end user with material swaps

exposure falls below the $8 billion threshold), the swap entity

may comply with less strict requirements for all outstanding

swaps. Accordingly, initial margin, which is not required for

swaps with financial end users that do not have material swaps

exposure, would no longer apply with respect to all swaps.

16

Threshold and Minimum Transfer Amount

• Certain other amounts in addition to the material swaps exposure

threshold have been modified from the re-proposals to take into

account changed exchange rates that have occurred since the re-

proposals were issued:

• The initial margin threshold amount (i.e., the amount under which

initial margin need not be collected) has been reduced from $65

million in the re-proposals to $50 million in the final rules.

• In addition, the minimum transfer amount across initial and

variation margin has been reduced from $650,000 to $500,000.

• Regulators intend to make adjustments to the rules to take into

account changes in exchange rates on a periodic basis as warranted.

17

Definition of Affiliate

• The CFTC’s and Prudential Regulators’ final rules provide for a

definition of “affiliate” that is aligned with established accounting

standards rather than relying on the “control” test contained in the

Re-Proposal.

• The Re-Proposals contained a low level of control for affiliation to

exist:

• Only 25 percent (not 50 percent or more) of the ownership or

control, directly or indirectly, of a class of voting securities or total

equity.

• Final rules provide that affiliation exits if a company consolidates the

other (or both companies are consolidated with a third company) on

financial statements prepared in accordance with U.S. Generally

Accepted Accounting Principles, the International Financial Reporting

Standards, or other similar standards.

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Definition of Affiliate

• For a company not subject to such principles or standards, affiliation

exists if it would have been consolidated under such principles or

standards.

• The change may make it easier for companies to determine whether,

for example, a financial end user has “material swaps exposure”

(which must be calculated to include the exposures of its affiliates).

• Prudential Regulator Rules include a provision that the relevant

regulator has the authority to designate any entity that provides

significant support to, or is materially subject to the risks or losses of,

another company as an “affiliate” of that company (even if the entity

is not otherwise an affiliate under the rule).

• The CFTC’s rules do not contain a similar provision.

19

Eligible Collateral

• The CFTC’s and Prudential Regulators’ final rules also expand the

types of eligible collateral for initial and variation margin.

• Initial margin is intended to secure potential future exposure -- that is,

adverse changes in value that may arise during the period of time

when a swap or group of swaps is being closed out -- and is in

addition to variation margin, which corresponds to changes in mark-

to-market value of a swap.

• Under the final rules, eligible collateral types for Initial Margin include

U.S. Treasuries, GSE securities, securities issued by BIS, ECB, IMF

and MDBs, publicly traded debt (other than asset-backed securities),

publicly-traded equities in certain indices and gold, but not securities

issued by the pledgor or its affiliate or banks and similar entities.

• In addition, the final rules permit redeemable securities in certain

money market mutual funds that meet specific requirements.

20

Eligible Collateral

• Variation Margin may include major currencies (defined in the final rules) in

addition to U.S. dollars and the currency of settlement, while the re-proposal

would not have permitted major currencies.

• In addition, the final rules permit non-cash collateral eligible to be used for

initial margin to serve as variation margin for swaps between a covered swap

entity and a financial end user (but not for swaps between swap entities),

while the re-proposals only permitted cash collateral for variation margin.

• This change may be welcomed by certain financial entities, such as

insurance companies, that hold significant reserves of bonds and other

securities and commented that the restriction to cash-only variation margin

would reduce their investment returns.

• The CFTC’s rules include a provision, not included in the Prudential

Regulators’ rules, that requires that variation margin calculations use

methods, procedures, rules, and inputs that, to the maximum extent

practicable rely on recently executed transactions, valuations provided by

independent third parties, or other objective criteria.

21

Approval of Initial Margin Models

• CFTC’s and Prudential Regulators’ final rules differ in terms of the

approval of initial margin models.

• Both sets of final rules, like the re-proposals, impose stringent

regulatory requirements on initial margin models, including:

• Written approval of the relevant regulator for use of initial margin

models,

• Demonstration on an ongoing basis that the model satisfies all of

the requirements under the rules, and

• Prior notice to the relevant regulator before making changes to

the model or its assumptions.

22

Approval of Initial Margin Models

• However, the CFTC’s final rules would provide a registered futures

association (the NFA is the only registered futures association) with

authority to approve initial margin models in addition to the CFTC.

• The Prudential Regulators’ final rules do not contain a similar

provision.

• All approvals of initial margin models for Covered Swap Entities

subject to their supervision will have to be approved by the relevant

Prudential Regulator.

• The CFTC notes that it or the NFA will coordinate with the Prudential

Regulators in order to avoid duplicative efforts and to provide

expedited approval of Prudential Regulator-approved models.

23

Eligible Master Netting Agreements (EMNAs)

• Relief also was provided from the re-proposals with respect to pre-

compliance date and post-compliance date swaps subject to a single

“eligible master netting agreement” (“EMNA”).

• For swaps subject to an EMNA, variation margin can be calculated

on a net basis and risk offsets can be recognized within asset classes

for calculating initial margin.

• Under the re-proposals, although the rules applied only to swaps

entered into after the relevant compliance date, transactions subject

to an EMNA applicable to pre-compliance date transactions would be

subject to margin requirements for all swaps under the EMNA.

• Accordingly, counterparties would have to enter into a separate

EMNA for new swaps, which received criticism from commenters who

argued that this would reduce netting sets and thus increase

systemic risk.

24

EMNAs

• The CFTC’s and Prudential Regulators’ final rules permit

counterparties to document pre- and post-compliance date swaps as

separate portfolios for netting purposes under the same EMNA

covered by separate credit support annexes.

• Accordingly, netting portfolios that contain only uncleared swaps

entered before the applicable compliance date are not subject to the

final rules.

• Also with regard to EMNAs, the definition of EMNA is amended to

provide that impermissible “walk away” clauses do not include

clauses that only suspend payment obligations when a counterparty

defaults.

25

EMNAs

• EMNAs, as under the re-proposals, are subject to a requirement that

a swap entity conduct sufficient legal review to conclude with a well-

founded basis that among other things, the contract would be found

legal, binding, and enforceable under the law of the relevant

jurisdiction.

• Although unqualified legal opinions are not required, the legal review

must be in writing.

• Prudential Regulator Rules provide that, if a netting agreement does

not qualify as an EMNA, the CSE must collect VM on a gross basis

but may post on a net basis; no similar provision in CFTC Rules.

26

Inter-Affiliate Swaps Exemption

• Neither the CFTC’s nor the Prudential Regulators’ re-proposals

contained an exemption from the margin requirements for swaps

between a Covered Swap Entity and its affiliates.

• Commenters urged the regulators to provide relief in this area,

because such inter-affiliate swaps do not create new risk, but rather

shift risk within a corporate entity and because requiring initial margin

for such trades would unnecessarily tie up capital and would be

inconsistent with the CFTC’s exemption from mandatory clearing for

inter-affiliate swaps, which did not impose such a requirement.

• The Prudential Regulators’ and CFTC’s final rules provide for an

inter-affiliate swaps exemption from the margin requirements, but

differ on the treatment of such swaps.

27


• Under the Prudential Regulators’ final rules, the margin requirements

generally apply to swaps between a Covered Swap Entity and its

affiliates (unless otherwise exempt), except that:

• A swap entity is not required to post initial margin to an affiliated

counterparty.

• The swap entity must calculate the amount of initial margin that

would be required to be posted to an affiliate (that is a financial

end user with material swaps exposure) and provide

documentation of such amount on a daily basis.

• Initial margin must be collected from an affiliate that is a financial

entity with material swaps exposure, but the threshold is $20

million (rather than the generally applicable $50 million

threshold).

28


• No relief for variation margin: Variation margin must be posted to

and collected from financial end user affiliates by swap entities.

• Initial margin in the form of non-cash collateral for swaps

between a swap entity and its affiliates may be held by a

custodian that is an affiliate of the CSE or by the CSE itself

(rather than an unaffiliated third party as required for uncleared

swaps with non-affiliates).

• The Final Rule allows a covered swap entity to use a 5-day time

horizon for modelling the initial margin requirement, rather than

the generally applicable10-day horizon, for swaps that are

required to be cleared but which are exempt because of a

clearing exemption for inter-affiliate swaps.

• Note that if an affiliate of a swap entity is itself a swap entity, then

both swap entities must collect margin, and thus there is no relief

from the posting requirement.

29


• The CFTC’s final rules provide for a broader exemption from initial

margin requirements than the Prudential Regulators’ rules.

• Under the CFTC’s final rules, a CSE is generally not required to

collect initial margin from a margin affiliate (including another swap

entity), provided that the CSE meets the following conditions:

• The swaps are subject to a centralized risk management

program that is reasonably designed to monitor and manage the

risks associated with inter-affiliate swaps; and

• The CSE exchanges variation margin with the margin affiliate.

• The CFTC’s final rules provide, however, that a CSE must collect

initial margin from non-U.S. affiliates that are financial end users that

are not subject to comparable initial margin collection requirements

on their own outward-facing swaps with financial end users.

30


• In addition, to facilitate compliance with the Prudential Regulators’

rules, the CFTC’s rules would require a CSE to post initial margin

with a swap entity that is subject to the Prudential Regulators’ rules

(and required to collect initial margin from its affiliates).

• As is the case under the Prudential Regulators’ rules, the CFTC’s

rules would require that variation margin be exchanged with respect

to swaps between a Covered Swap Entity and its affiliates.

31

Phased-in Compliance

• Final Rules adopts the delayed phase-in schedule announced by

BCBS/IOSCO in March 2015, which delays implementation of initial margin

and variation margin requirements by nine months starting September 1,

2016.

• Phased-in implementation for initial margin depending upon swaps average

daily aggregate notional amounts over a 3-month period of the covered swap

entity and its affiliates and its counterparties and their affiliates starting from

September 2016 (for entities with the largest exposure) through September

2020.

• Delayed-implementation schedule with regard to variation margin for swap

entities belonging to a group whose aggregate month-end average notional

amount of non-centrally cleared derivatives is less that $3 trillion for March,

April and May 2016, until March 1, 2017.

• For purposes of calculating the notional amounts, the final rules clarify that a

swap between an entity and its affiliate counts only once and that swaps

exempt under the interim final rule do not count.

32

Phased-in Compliance Initial Margin

Compliance Date Initial Margin (IM) Requirements

September 1, 2016 IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2016 that exceeds $3 trillion.

September 1, 2017 IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2017 that exceeds $2.25 trillion.

September 1, 2018 IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2018 that exceeds $1.5 trillion.

September 1, 2019 IM where both the CSE combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2019 that that exceeds $0.75 trillion.

September 1, 2020 IM for any other covered swap entity with respect to covered swaps with any other counterparty.

33

Phased-in Compliance for Variation Margin

Compliance Date Variation Margin (VM) Requirements

September 1, 2016 VM where both the covered swap entity combined with all its affiliates and its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April and May of 2016 that exceeds $3 trillion.

March 1, 2017 VM for any other covered swap entity with respect to covered swaps with any other counterparty.

34

Cross-Border Application

• All this would be complex enough if all regulators and market participants

had to think about was how the margin rules applied to U.S. market

participants.

• As with other swaps regulations under Dodd-Frank, however, U.S. regulators

also need to think about the cross-border application of their rules – that is,

how the rules will apply to transactions involving parties organized or located

outside of the United States.

• While there are still unanswered questions, and many complexities and

nuances, the basic rule is that the U.S. regulators are taking the position that

their rules will apply whenever a U.S. market participant is a party to a swap

transaction.

• This sounds simple and commonsensical, but it leaves answered the

question of whether, in the cross-border context, U.S. rules will trump non-

U.S. rules and, if so, why?

• Example: swap between U.S. dealer’s New York office and German

swap dealer’s Frankfurt office

35

Cross-Border Application

• Prudential Regulators’ final rules contain provisions governing the

cross-border application of the margin rules, while the CFTC has

proposed a separate rulemaking to address cross-border application,

which has not yet been finalized.

• Prudential Regulators’ final rules, as under their Re-Proposal, exempt

foreign swap entities (but not their U.S. branches or agencies) with

respect to the foreign non-cleared swaps from the margin

requirements.

• Exemption is not available where the foreign counterparty is, or is

guaranteed by, a U.S. entity, a U.S. branch or subsidiary of a foreign

bank, or a foreign swap entity that is a subsidiary of a U.S. entity.

• Substituted compliance (i.e., compliance with non-U.S. rules rather

than U.S. rules) may be available for a foreign bank, U.S. branch or a

agency of a foreign bank, or an entity that is a foreign subsidiary of a

depository institution, Edge Corporation or Agreement Corporation.

36

Cross-Border Application • However, substituted compliance would be available only if the

Prudential Regulators have made a comparability determination for

the jurisdiction the rules of which would apply to the uncleared swap.

• Moreover, substituted compliance would not be available if the swap

is guaranteed by a U.S. entity.

• For all swap entities (including U.S.), a swap entity will be deemed to

satisfy the initial margin posting requirement if its posts the amount of

initial margin that its counterparty is required to collect under non-

U.S. rules, provided that the Prudential Regulators have made a

substituted compliance determination with respect to those rules and

the swap is not subject to a guarantee from a U.S. entity.

• Final Rules also provide relief in certain circumstances from the

segregation requirements to foreign branches and subsidiaries of

U.S. banks and Edge Corporations where inherent limitations in the

legal or operational infrastructure in a foreign jurisdiction make it

impracticable to segregate collateral.

37

Summary of Key Differences between the CFTC’s and

Prudential Regulators’ Rules

Requirement CFTC Rules Prudential Regulator Rules Inter-affiliate Swaps CSE generally is not required to collect or post initial margin

for a swap with an affiliate (except a CSE under Prudential Regulator supervision) subject to conditions, unless affiliate’s outward-facing counterparty not subject to comparable IM requirements.

CSE is required to collect (but not post) IM for a swap with a non-CSE affiliate that is a financial end user with material swaps exposure; IM requirements differ from generally applicable requirements (shorter close-out period, lower threshold).

Approval of Initial Margin (IM) Models

IM Models may be approved by the NFA as well as CFTC. IM Models must be approved by the relevant Prudential Regulator.

Definition of Financial End User/Treasury Affiliates

Excludes treasury affiliates that qualify for a n exemption from mandatory clearing that the CFTC has exempted by Rule.

No similar provision to CFTC Rule.

Definition of Affiliate No similar provision to Prudential Regulator Rule. Relevant Prudential Regulator may determine that a company is an affiliate of another (that is not otherwise an affiliate under the rule) based on the regulator’s conclusion that either company provides significant support to, or is materially subject to the risk of losses of, the other company.

Netting Agreements No similar provision to Prudential Regulator Rule. If a netting agreement does not qualify as an EMNA, the CSE must collect VM on a gross basis but may post on a net basis.

Variation Margin (VM) Calculation

VM calculations must use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, or other objective criteria.

No similar provision to CFTC rule.

Cross Border Application Addressed in separate proposal. Addressed.

38

Proposed SEC Rules for Investment Companies

• Last December the SEC proposed rules regarding the

use of derivatives by investment companies and business

development companies

• The Proposed Rules, if adopted without substantial

modification, would: • limit the notional amounts of derivatives that funds may enter into,

• require many funds to adopt comprehensive written derivatives risk

management programs, actively overseen by their boards of directors,

• impose substantial recordkeeping requirements and

• would modify and clarify current SEC requirements that funds segregate

assets in connection with their derivatives.

• Comment period is to end on March 28.

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• The SEC’s regulation of funds’ use of derivatives is based on its

longstanding view, reaffirmed in the release accompanying the

Proposed Rules, that derivatives may constitute “senior securities” for

purposes of the Investment Company Act of 1940.

• Section 18 of the 1940 Act generally prohibits an open-end fund from

issuing or selling any “senior security” (although it permits a mutual

fund to borrow from a bank) provided that the fund maintains 300%

“asset coverage” (generally, the ratio of a fund’s total assets less

liabilities and indebtedness not represented by senior securities, to

the aggregate amount of the fund’s senior securities).

• Section 18 also permits a closed-end fund to issue or sell a senior

security, subject to asset coverage requirements (200% for equities

or 300% for debt).

40


• The restrictions on senior securities contained in Section 18 are

intended to prevent funds from exposing themselves and their

shareholders to

• excessive borrowing and unduly increasing the speculative

character of the fund’s junior securities

• operating without adequate assets or reserves and

• potential abuse of the purchasers of senior securities.

• Since 1979, when the SEC issued a general statement of policy

known as “Release 10666,” it has been clear that the term “senior

security” may include an instrument that does not constitute a

“security” for most purposes under U.S. law

41


• Release 10666 applied not to derivatives but to agreements for the

purchase or repurchase of securities, including reverse repurchase

agreements, firm commitment agreements and standby commitment

agreements

• The SEC stated that it would not raise issues under Section 18 with

respect to the types of transactions addressed in the release so long

as funds segregated an amount of highly liquid assets with a value

equal to the full amount of their potential obligations under the

relevant transactions

• The segregated account holding such assets would function as a

“practical limit on the amount of leverage which the investment

company may undertake”

42


• Parts of the new Proposed Rules relate to the most immediate

concern of Release 1066, the assets that should be segregated in

connection with transactions involving “senior securities”

• However, other parts of the Proposed Rules relate more broadly to

the regulation of derivatives as “senior securities”

• Intended to prevent excessive borrowing and unduly speculative

nature of funds by restricting use of derivatives

• Proposed rules would also require that many funds adopt

formalized derivatives risk management program, including

policies and procedures designed to assess and manage the

particular risks presented by a fund’s use of derivatives

43


• Release 10666 applied not to derivatives but to agreements for the

purchase or repurchase of securities

• For such transactions, the amount of assets requiring segregation

was reasonably clear, and based on the purchase price of the

relevant security.

• Derivatives raise additional issues, however:

• Value of assets to be segregated?

• Based on notional amount, mark-to-market value, or something else?

• Should amount to be segregated depend on purpose for which particular

derivative is used?

• Uses of derivatives include seeking higher returns through increased

investment exposures, hedging interest rate, credit, and other risks in

investment portfolios and greater transaction efficiency

44


• SEC guidance on segregation of assets in relation to derivatives is

currently contained in more than 30 no-action letters, which address

questions on an instrument-by-instrument basis

• Market practice has evolved under which, in relation to certain

derivatives, funds segregate the entire notional amount, and in

relation to others, they segregate only the mark-to-market value

• In August, 2011, the SEC, seeking to systematize its approach to

regulating funds’ practices in relation to derivatives, published a

concept release, which requested comment on a wide range of

issues concerning investment companies’ uses of derivatives.

• Proposed Rules follow up on that concept release

45

Proposed SEC Rules – Segregation Requirements

• The Proposed Rules would clarify the amounts and nature of the

assets that funds are required to segregate in connection with

derivatives transactions.

• Offer a middle ground between requiring the segregation of, one the

one hand, the entirety of a transaction’s notional amount and, on the

other, only its current mark-to-market value.

• Would require a fund to identify on its books and records “qualifying

coverage assets,” determined daily, with a value equal to the sum of

the fund’s

• aggregate mark-to-market coverage amounts and

• risk-based coverage amounts.

46


• “Mark-to-market coverage amount” would mean, for each derivatives

transaction, the amount that would be payable by the fund if the fund

were to exit the derivatives transaction at the relevant time

• “Risk-based coverage amount” would mean, for each derivatives

transaction, an amount representing “a reasonable estimate of the

potential amount payable by the fund if the fund were to exit the

derivatives transaction under stressed conditions”

• In calculating both “mark-to-market coverage amounts” and “risk-

based coverage amounts,” a fund could net transactions under the

same netting agreement, thus reducing the amount of assets

required to be segregated.

47


• In addition, both “mark-to-market coverage amounts” and “risk-based

coverage amounts” could be reduced by the amount of margin

pledged by the fund to its counterparty in accordance with Section 17

of the Act

• The “mark-to-market coverage amount” would be reduced by the

value of any variation margin pledged by the fund

• The risk-based coverage amount would be reduced by the value of

any initial margin pledged by the fund

48


• The Proposed Rules would require that the assets identified on a

fund’s books and records consist of “qualifying coverage assets”

• For derivatives, such assets would consist of cash and cash

equivalents, or the particular asset that may be deliverable under a

derivatives transaction.

• The other aspects of the SEC’s Proposed Rules, regarding portfolio

limitations and risk management programs, are more unexpected

than the proposed asset segregation requirements

49

Proposed SEC Rules – Portfolio Limitations

• Proposed Rules would limit the notional amounts of derivatives that

funds could transact.

• Portfolio Limitations are a “relatively blunt measurement,” because

derivatives can be put to many uses, and their risk profiles can vary

dramatically

• SEC is interested in finding a reasonably practicable test, even if it

may not be the most refined possible test

• In order to transact derivatives, a fund would be required to conform

to one of two portfolio limitations, each intended to prevent a fund

from becoming excessively leveraged or speculative.

• Board approval required for the portfolio limitation under which

the fund would operate.

50


• The first portfolio limitation would be based on a fund’s “exposure,” a

term defined to include, but not be limited to, the notional amounts of

a fund’s derivatives.

• The first portfolio limitation would require that a fund’s aggregate

“exposure” not exceed 150% of the value of the fund’s net assets.

• “Exposure” for these purposes would equal the sum of

• the notional amounts of a fund’s derivatives (subject to netting for

directly offsetting derivatives)

• the fund’s aggregate obligations, whether conditional or

unconditional, under financial commitment transactions (such as

reverse repurchase agreements, firm commitment agreements

and standby commitment agreements) and

• aggregate indebtedness under other senior securities

transactions

51


• The limitation at 150% is based on the SEC’s view that exposure

levels higher than that level “could be used to take on additional

speculative investment exposures that go beyond what would be

expected to allow for hedging arrangements.”

• Further, limiting exposure to 150% of net assets would allow a fund

“to obtain a level of indirect market exposure solely through

derivatives transactions that could approximate the level of market

exposure that would be possible through securities investments

augmented by borrowings as permitted under section 18.”

52


• The second, “risk-based,” portfolio limitation would permit greater “exposure,”

up to 300% of a fund’s net asset value, but would also require that a fund’s

derivatives transactions decrease the fund’s overall market risk, as measured

by “Value-at risk” or “VaR”

• Proposed Rules VaR as “an estimate of potential losses on an instrument or

portfolio, expressed as a positive amount in U.S. dollars, over a specified

time horizon and at a given confidence interval.”

• For a fund to comply with this second limitation, its “full portfolio VaR” – that,

is, the VaR of the fund’s entire portfolio, including derivatives – would need to

be less than the fund’s “securities VaR,” the VaR of the fund’s portfolio

excluding any derivatives transactions.

• Requirements for VaR models: must take into account all relevant risk

factors, must have minimum 99% confidence interval, must have a time

horizon of not less than 10 and not more than 20 trading days and, if using

historical simulation, a minimum of three years of historical data

53

Proposed SEC Rules – Risk Management Programs

• Under the Proposed Rules, many funds using derivatives would be required

to adopt and implement a written derivatives risk management program.

• The requirement to adopt such a program would apply to any fund that either

• entered into a “complex derivatives transaction” or

• did not implement and comply with a portfolio limitation under which the notional

amount of its derivatives could not exceed 50% of its net asset value.

• For these purposes, a “complex derivatives transaction” is defined as one

under which an amount payable by either party upon settlement, maturity or

exercise

• is dependent on the value of the underlying reference asset at multiple points in

time during the term of the transaction (e.g., an Asian option or barrier option) or

• is a non-linear function of the value of the underlying reference asset, other than

due to optionality arising from a single strike price (e.g., a variance swap).

54


• Such programs must be reasonably designed to:

• assess the risks associated with the fund’s derivatives transactions, including an

evaluation of potential leverage, market, counterparty, liquidity, and operational

risks and any other relevant risks considered relevant;

• manage the risks associated with the fund’s derivatives transactions including by:

• monitoring whether the fund’s use of derivatives transactions is consistent

with any investment guidelines established by the fund or its investment

adviser, the portfolio limitation applicable to the fund, and disclosure to

investors; and

• informing persons responsible for portfolio management of the fund or the

fund’s board of directors, as appropriate, regarding material risks arising from

the fund’s derivatives transactions; and

• Requirement to segregate the functions associated with the program

from the fund’s portfolio management

• Requirement that program be reviewed and updated at least annually

55

Proposed SEC Rules – Risk Management Programs

• Under the Proposed Rules, a fund’s board of directors, including a

majority of directors who are not interested persons of the fund, must:

• approve the program and any material changes to it;

• approve the designation of an employee or officer of the fund or

the fund’s investment adviser (who may not be a portfolio

manager of the fund) responsible to administer the program; and

• review, at least quarterly, a written report prepared by person

designated to administer the program that describes the

adequacy of the fund’s program and the effectiveness of its

implementation

56

Proposed SEC Rules – Record Retention

• Under the Proposed Rule, a fund would be required to maintain,

generally for a period of at least five years, written records relating to,

among other things:

• the policies and procedures adopted by the fund.

• each determination made by the fund’s board of directors with respect to

the portfolio limitation applicable to the fund;

• the mark-to-market coverage amount and the risk-based coverage

amount for each derivatives transaction entered into by the fund, and the

related qualifying coverage assets maintained by the fund, as determined

on each business day;

• the fund’s compliance, after entering into any derivatives transaction, with

the portfolio limitation applicable to the fund, reflecting the fund’s

aggregate exposure, the value of the fund’s net assets and, if applicable,

the fund’s full portfolio VaR and securities VaR.

57

Proposed SEC Rules – Record Retention

• In addition, funds that are required to adopt a derivatives risk

management program must also maintain, generally for a period of at

least five years, copies of:

• the policies and procedures adopted by the fund as part of its

derivatives risk management program;

• any materials provided to the board of directors in connection with

its approval of the derivatives risk management program,

including any material changes to the program, and any written

reports provided to the board of directors relating to the program;

and

• records documenting the periodic reviews and updates of the

derivatives risk management program required by the Proposed

Rule

58

ISDA Resolution Stay Protocols

• As of late last year, there are two such protocols:

• ISDA 2014 Resolution Stay Protocol; and

• ISDA 2015 Universal Resolution Stay Protocol

• Primary difference is scope of product coverage – the

new “universal” protocol covers not only transactions

under ISDA Master Agreements, but also securities

financing transactions

• “Securities financing transactions” include repurchase

transactions and securities lending transactions

• New protocol supersedes previous one for parties who

adhered to previous protocol

59


• Protocols are contractual solutions to questions relating to the cross-

border application of special resolution regimes

• Protocols are intended to address issue of banks being “too big to fail”

and to give regulators time to facilitate an orderly resolution of a troubled

bank

• The terms of the protocols are especially topical now because proposed

regulations will be proposed in the near future that will apply to a broader

range of market participants requirements similar to those contained in

the protocols

• Proposed regulations are expected to require regulated institutions to

include in their contracts with unregulated counterparties provisions

similar to those contained in the protocols

• New regulations (like 2015 protocol) are expected to apply to derivatives,

repurchase transactions and securities lending transactions

60


• Both protocols were developed by a group of ISDA

member institutions in coordination with the Financial

Stability Board

• Address the fundamental concern is that a close-out of

derivatives/repo/sec lending transactions by a large

institution could destabilize markets and make resolution

of the institution difficult

• Apart from the broader product coverage of the 2015

protocol, the substance of the two protocols is largely

similar

61


• In the U.S., concerns are addressed by Title II of Dodd-Frank

(“Orderly Liquidation Authority”), which imposes a limited stay on

termination rights against U.S. banks.

• There are similar provisions in other countries to likewise restrict

termination rights against banks

• However, the cross-border application of such special resolution

regimes is not wholly clear

•What if U.S. bank in resolution faces counterparty in another

jurisdiction? Is counterparty bound by Dodd-Frank’s special

resolution provisions?

•Similarly, what if non-U.S. bank faces a counterparty in the U.S?

Is U.S. counterparty bound by the bank’s home country resolution

procedures?

62

ISDA 2015 Universal Resolution Stay Protocol

• Under both protocols, adhering parties opt into accepting

the special resolution regimes that may apply to their

counterparties

• Such resolution regimes typically stay or override

certain default rights that would otherwise arise when

a bank enters into insolvency, resolution or similar

proceedings

• In addition, adhering parties opt into contractual stays

on certain cross-default rights that would otherwise

apply in the context of insolvency proceedings and that

are similar to some of the types of stays contained in

certain statutory resolution regimes

63


• The Protocol was intended to apply only to the 21 largest institutions

and their affiliates

• At latest count there were 203 adhering parties, mainly large banks

and their affiliates

• Many market participants (e.g., fiduciaries such as asset managers)

would have potential legal issues if they voluntarily gave up or agreed

to delays in exercising their termination rights

• Accordingly, regulators will likely impose the contents of the protocol

on many market participants by regulation in the near future, by

means of requiring banks to add similar provisions to their trading

agreements

64


• When and how will provisions of the protocol be rolled out

to the market beyond the largest banks?

• Regulations are expected soon to be proposed that will,

when finalized, require regulated entities to include in

their contracts with non-regulated entities provisions

similar to those contained in the protocol

• Such regulations have already been proposed in

Germany and the UK

• ISDA has stated that it expects to release a protocol to

facilitate compliance with the expected regulations

• There will likely be two different forms of the protocol, one

for regulated entities and one for buy-side firms

65


• Section 1 – Opt-in to Special Resolution Regimes

• Provides generally that if one adhering party is subject to a special

resolution regime, then the other adhering party may exercise default

rights under a “Covered Agreement” or related credit support

arrangement only to the extent it would be able to do so under such

special resolution regime

• Covered Agreements include both ISDA Master Agreements and

numerous forms of repurchase and securities lending agreements

• Also provides that transfers of Covered Agreements and related credit

support arrangements will be effective to the same extent as such a

transfer would be effective under the relevant special resolution regime

66


• Section 1 – Opt-in to Special Resolution Regimes

• Contains similar provisions that may apply if

• an affiliate of an adhering party (not the adhering party itself)

becomes subject to a special resolution regime or

• a credit support arrangement runs to the benefit of an affiliate of a

party to a Covered Agreement

67


• Definition of “Special Resolution Regime” includes

• identified resolution regimes of France, Germany, Japan, Switzerland,

the UK and the U.S. and

• “Protocol-eligible Regimes,” which are defined to include:

• the resolution regimes of states that are members of the FSB

(examples: Argentina, Russia and Saudi Arabia), but only if such

resolution regimes incorporate certain protections for creditors

• no discrimination based on nationality, location or domicile of

creditors or jurisdiction where they may be paid

• limitations on length and nature of stay that may restrict

creditors’ rights; and

• any other jurisdiction that is the jurisdiction of organization of the

ultimate parent entity within a banking group that has been

designated by the Financial Stability Board as a “global systemically

important bank”

68


• Section 2 – Limitation on Exercise of Default Rights in U.S.

Insolvency Proceedings

• Restricts default rights that would otherwise arise if an affiliate of an

adhering party, not the party itself, becomes subject to insolvency

proceedings

• Intended to support a “single point of entry”-style resolution of a

parent entity of a financial group, a resolution with only the top-tier

parent company entering proceedings

69


• Protocol distinguishes between affiliates that are credit enhancement

providers and affiliates that are not (but are presumably Specified

Entities for purposes of a related ISDA Master Agreement)

• The protocol overrides contractual rights somewhat more narrowly

with respect to a default of a credit enhancement provider of a party

to an ISDA Master Agreement than with respect to a default of a

Specified Entity of a party to an ISDA Master Agreement

70

CFTC’s Proposed Reg. AT

• On November 24, 2015, the CFTC issued proposed rules related to

automated trading on derivatives exchanges, referred to as

Regulation AT.

• The proposed rules, if adopted, would create new requirements for

proprietary trading firms, designated contract markets (“DCMs”)

futures commission merchants (“FCMs”), and other CFTC registrants

using algorithmic trading systems.

• The proposed rules would also require that certain persons register

with the CFTC under a new definition of “floor trader” due to their

algorithmic trading through Direct Electronic Access (as defined in the

proposed rules) to a DCM.

• Proposal includes 164 questions for comment.

• Comment period on the proposed rules closes March 16, 2016.

71

Algorithmic Trading

• CFTC defines Algorithmic Trading broadly under the proposal as

trading in any commodity interest on or subject to the rules of a DCM,

where:

• One or more computer algorithms or systems determines whether to

initiate, modify, or cancel an order, or otherwise makes determinations

with respect to an order, including but not limited to: the product to be

traded; the venue where the order will be placed; the type of order to be

placed; the timing of the order; whether to place the order; the

sequencing of the order in relation to other orders; the price of the order;

the quantity of the order; the partition of the order into smaller

components for submission; the number of orders to be placed; or how

to manage the order after submission; and

• Such order, modification or order cancellation is electronically submitted

for processing on or subject to the rules of a DCM, except for orders

modifications, or cancellations that are manually entered into a front-end

system by a natural person with no further discretion by any computer

system or algorithm, prior to its electronic submission to a DCM.

72

Purpose of Proposed Rules

• The CFTC believes that rules are needed to prevent persons from

using Algorithmic Trading to violate the CEA or CFTC regulations,

including by disrupting the market.

• The proposed rules would require risk controls and other

requirements in order to address the risks of Algorithmic Trading,

including the potential for market disruptions arising from system

malfunctions, other errors, or intentional disruptive conduct.

• Risk controls and other requirements must be adopted at 3 levels:

• Market participants using algorithmic trading systems (AT

persons in the rule);

• Clearing member FCMs with respect to their AT Person

customers; and

• DCMs executing AT person orders.

• Proposal applies to algorithmic trading irrespective of whether it is

high frequency trading; it does not apply to trading on SEFs.

73

Registration Requirement

• Under current CFTC regulations, persons that engage in proprietary

trading (i.e., not on behalf of customers) are not required to register

unless they trade for their own account in or around a trading pit, ring,

post, or other place provided by a DCM, and, in that case, they must

register as a floor trader.

• Proposed Rules would amend the definition of floor trader to include

persons who trade commodity interests at a DCM for their own

account through “Direct Electronic Access.”

• Direct Electronic Access is defined as an arrangement where a

person transmits an order electronically to a DCM, without the order

first being routed through a clearing FCM.

• CFTC requests comment as to whether the floor trader definition

should be expanded to all firms operating algorithmic trading systems

in CFTC-regulated markets that are not otherwise required to register

(not just through direct electronic access).

74

AT Persons

• Proposed rules contain requirements that apply to market participants

that are “AT Persons.”

• AT Person is defined as:

• Any person registered or required to be registered as an FCM,

floor broker, swap dealer, major swap participant, commodity

pool operator, commodity trading advisor, or introducing broker

that engages in Algorithmic Trading, or

• A floor trader that engages in Algorithmic Trading through Direct

Electronic Access.

75

AT Person Requirements

• Risk Controls. AT persons would be required to implement risk

controls on orders submitted through Algorithmic Trading, including

pre-trade risk controls (maximum order message and execution

frequency per unit time, order price and maximum order size

parameters), and order cancellation systems that can disengage

algorithmic trading, cancel selected or all resting orders, and prevent

submission of new orders.

• Development, testing, and monitoring. AT persons would be

required to implement standards for development, testing and

monitoring of algorithmic trading systems, including complete

separation of the environment used for system development and the

one used for production, testing before implementation, real-time

monitoring of such systems, and standards to ensure that systems

comply with CFTC regulations, and must designate and provide

training for algorithmic trading staff responsible for ensuring

compliance.

76


• Source Code Repository. AT persons would be required to

establish and maintain a source code repository that includes the

documenting of strategy and design of proprietary algorithmic trading

software used and any changes implemented, including an audit trail

that shows who made a change, when it was made, and its coding

purpose.

• Repository records must be kept under the CFTC’s

recordkeeping regulation and made available for inspection upon

request by the CFTC or DOJ (for any reason without a

subpoena).

• This requirement has provoked controversy within the industry

due to concerns about the CFTC/DOJ being able to protect

sensitive proprietary information.

• Commissioner Giancarlo raised these concerns at the open

meeting and in his concurring statement.

77


• Compliance Reports. AT persons would be required to annually

prepare and submit to DCMs compliance reports regarding their risk

controls as well as copies of written policies and procedures

developed to comply with testing and other requirements.

• They would also be required to keep books and records

regarding their Algorithmic Trading procedures for inspection by

DCMs.

• Notification Requirement/Use of Self-Trade Prevention Tools. AT

persons would be required to notify applicable clearing member

FCMs and DCMs that the AT person will engage in Algorithmic

Trading, and calibrate or otherwise implement DCM-provided self-

trade prevention tools.

78

Requirements for Clearing Member FCMs

• Risk Controls. Clearing member FCMs would be required to

implement risk controls for Algorithmic Trading orders originating with

AT persons, including pre-trade risk controls applicable to AT

persons.

• Pre-trade risk controls would have to be set the level of each AT

person, or more granular level as each clearing member FCM

may determine.

• Clearing member FCMs would have to implement DCM-provided

risk controls for Direct Electronic Access orders.

• They would also be required to have policies and procedures

reasonably designed to ensure that natural person monitors at

the FCM are promptly alerted when pre-trade risk control

parameters are breached.

79

Requirements for Clearing Member FCMs

• Compliance Reports. Clearing Member FCMs would be required to

annually prepare and submit to DCMs compliance reports that

describe how they comply with maintenance of risk controls on their

AT person customers.

• The report would have to be certified by the CEO or CCO that the

report is accurate and complete to the best of his/her knowledge and

reasonable belief.

• Clearing member FCMs would also be required to keep, and provide

to a DCM upon request, books and records regarding their risk

controls for Algorithmic Trading orders for inspection by DCMs.

80

Requirements for DCMs

• Risk Controls. DCMs would be required to implement risk controls

on orders submitted through Algorithmic Trading (and parallel

controls for manual orders), including maximum order message and

execution frequency per unit time, order price and size parameters,

and order cancellation systems.

• Compliance Reports. DCMs would have to require risk control

compliance reports from AT persons and their clearing member

FCMs.

• DCMs would be required to periodically review compliance

reports, identify outliers and provide instructions for remediation,

as well as review, as necessary, books and records of AT

persons and clearing member FCMs concerning Algorithmic

Trading procedures.

• Test Environments. DCMs would be required to provide test

environments where AT persons can test algorithmic trading systems.

81


• Self-Trade Prevention. DCMs would be required to establish self-

trade prevention tools, and either apply such tools or provide them to

all market participants (not just AT persons) and require their use.

• The rules would define “self-trading” as the matching of orders for

accounts with common beneficial ownership or under common

control.

• DCMs would be required to determine which accounts will be

prohibited from trading with each other, or require market

participants to identify such accounts.

• Exemptions would be provided for order matching for accounts

with common beneficial ownership but initiated by independent

decision makers or for certain orders that comply with a DCM’s

cross-trade, minimum exposure requirements or similar rules.

Prior approval from the DCM would need to be obtained to rely

on these exemptions.

82


• Disclosure Regarding Trade Matching. DCMs would be required

to provide public disclosure regarding certain elements of their

electronic trade matching systems that materially affect order

execution.

• Market Maker and Incentive Programs. DCMs would be required

to provide disclosures of market maker and incentive programs

submitted to the CFTC as rule filings.

• Such disclosures would have to specify all of the products or

services to which they apply, eligibility requirements, and

payment benefits or incentives received (e.g., fee rebates) and

non-financial benefits (e.g., enhanced trading priorities or

preferential access to market data).

• Payments would be prohibited for trades between accounts

under common beneficial ownership.

83

Requirements for RFAs

• The proposal would require registered futures associations to adopt

membership rules, as deemed appropriate by the registered futures

association, relevant to algorithmic trading for each category of

member.

• AT persons would be required to become members of a registered

futures association (currently, the only registered futures association

is the National Futures Association).

84

CFTC Preliminary Report on De Minimis Threshold

• Dodd-Frank directs the CFTC and the SEC jointly to further define,

among other terms, the term “swap dealer” and to exempt from

designation as a swap dealer an entity that engages in a de minimis

quantity of swap dealing

• Pursuant to that statutory requirement, the CFTC and SEC jointly

issued CFTC Regulation 1.3(ggg), which defines the term “swap

dealer” and provides for a de minimis exception

• Under the de minimis exception, a person is not deemed to be a

swap dealer unless its swap dealing activity exceeds an aggregate

gross notional amount threshold

• The level of the de minimis threshold is important to non-dealers who

have a substantial presence in the swaps market but who have not

been required to register as swap dealers and do not wish to be

required to register as swap dealers

85


• In November of last year, the CFTC issued a preliminary report regarding

the swap dealer de minimis exception

• The report addresses the exception and possible changes to it

• We are still in the phase-in period, during which the de minimis threshold

is $8 billion in notional amount (measured over a 12-month period)

• Under Regulation 1.3(ggg)(4), the phase-in period will terminate on

December 31, 2017, and the de minimis threshold will fall to $3 billion in

notional amount, unless the CFTC takes prior action to set a different

termination date or to modify the de minimis exception

• Regulation 1.3(ggg)(4) further provides that nine months after the

publication of a staff report and after giving due consideration to the

report and any associated public comment, the CFTC may either set a

termination date for the phase-in period or issue a notice of proposed

rulemaking to modify the de minimis exception

86


• In the report, the CFTC staff sought comment on many aspects of the

de minimis exception

• If the CFTC takes no action, then the de minimis threshold will fall to

$3 billion

• The preliminary report states that, after the CFTC staff considers the

comments that it receives on the preliminary report, staff will

complete and publish a final report

• Comments are due by January 19, 2016

87

CFTC Preliminary Report Highlights

• The preliminary report does not appear to indicate whether or not the

CFTC is leaning toward terminating the phase-in period or modifying

the de minimis exception

• The extent to which the CFTC appears to view questions regarding

the exception as open appears to mean that there may be a genuine

possibility that the much lower $3 billion post-phase-in period

threshold will not go into effect or will be modified

• Report addresses, among other things:

• the data used in the preparation of the preliminary report and

methodology

• the policies underlying swap dealer registration and regulation

and the de minimis exception

• Possible alternative approaches to the de minimis exception

88


• Originally, the CFTC took the view that a $3 billion notional value

standard for the de minimis exception was appropriate because it

equaled approximately 0.001 percent of the estimated overall

domestic market for all swaps between all counterparties

• However, a higher initial threshold amount was appropriate to

• permit market participants and regulatory agencies to become familiar with the

application of the swap dealer definition and regulatory requirements

• afford the regulatory agencies time to study the swap market as it evolves and to

consider new information about the swap market that becomes available,

including through swap data reporting

• provide potential swap dealers that engage in smaller amounts of activity

additional time to adjust their business practices; and

• address comments suggesting that the de minimis threshold be set higher initially

to provide for efficient use of regulatory resources and that implementation of

swap dealer requirements overall be phased in

89

CFTC Preliminary Report – Data

• The data used in the Preliminary Report was sourced primarily from data

reported to the four registered SDRs

• SDR data is still relatively new, and there is still significant ongoing work to

improve it in various ways

• Data is accordingly of somewhat limited value

• Covered five asset classes – CDS, IRS, commodities, FX and equities

• Issues include:

• Lack of data indicating whether transactions are entered into for dealing purposes

• Lack of legal entity identifiers (LEIs) (14% of reported transactions lacked these

for one or both counterparties)

• Confusion over unique swap identifiers (USIs), which were sometimes reused for

multiple swaps

• Issues in connection with swaps that do not count toward de minimis threshold,

such as certain inter-affiliate swaps

• Notional amounts not always clear

90

CFTC Preliminary Report – Policy Considerations

• General policy goals for swap dealer registration and regulation:

• reduction of systemic risk,

• counterparty protections, and

• market efficiency, orderliness, and transparency.

• Policy goals for de minimis exception :

• careful balancing that considers the regulatory interests that could be undermined

by an unduly broad exception as well as those regulatory interests that may be

promoted by an appropriately limited exception.

• A narrow de minimis exception (i.e., too low a de minimis threshold) would

likely mean:

• that a greater number of counterparties would be required to register as

swap dealers and become subject to the regulatory framework, but

• it could discourage certain market participants, including small and mid-

sized banks, from engaging in swap dealing activity in order to avoid the

burdens associated with swap dealer regulation.

91


• The Preliminary Report also considers whether alternative approaches to the

de minimis exception would more effectively promote the regulatory goals

associated with a de minimis exception.

• Possibility of a higher or lower gross notional de minimis threshold

• Data appears to indicate that an additional 80 or so entities might be

subject to swap dealer registration requirements if the de minimis

threshold drops to $3 billion as currently scheduled, but, at the same

time, that lower threshold would capture only another one or two percent

more activity, measured by notional amount

• Similarly, the de minimis threshold would also need to be raised to a

much higher number in order to capture significant less activity,

measured by notional amount

92


• Possible alternative approaches:

• a notional de minimis threshold specific to each asset class

• a multi-factor approach that would potentially include number of

counterparties and/or number of transactions metrics in the de minimis

exception, in addition to a gross notional dealing threshold • Energy firms have expressed discomfort over this possibility

• a multi-tiered approach where the regulatory requirements associated

with swap dealer registration are commensurate with an entity’s level of

dealing activity

• Potentially Tier 1 and Tier 2 dealers, with Tier 1 being subject to the

full scope of swap dealer regulations and Tier 2 subject to a lesser

set of regulations

• the exclusion of swaps that are traded on a registered or exempted swap

execution facility (“SEF”) or designated contract market (“DCM”), and/or

cleared from an entity’s de minimis calculation

93

Expectations for 2016

• Swap market participants (other than commercial end users) will

devote significant resources next year to compliance with the rules

requiring margin for uncleared swaps, which are scheduled to be

phased into effect starting in September of this year

• Status of capital rules for non-bank swap dealers unclear

• Position limit rules

• Expected to be finalized this year, but highly controversial

• SEC Rules – preparation for SBS dealer registration in 2017?

• Cross-border harmonization

• Cleared swaps (clearinghouse recognition)

• Uncleared – timing for substituted compliance determinations not clear

• Compliance with regulatory requirements parallel to provisions

contained in ISDA 2015 Universal Resolution Stay Protocol

• Additional ISDA protocol(s) expected to address these

94

Questions?

Julian E. Hammar

[email protected]

(202) 887-1679

James E. Schwartz

[email protected]

(212) 336-4327

95

About Morrison & Foerster

• We are Morrison & Foerster—a global firm of exceptional credentials.

Our clients include some of the largest financial institutions,

investment banks, Fortune 100, technology and life sciences

companies. We’ve been included on The American Lawyer’s A-List

for 10 straight years, and Fortune named us one of the “100 Best

Companies to Work For.” Our lawyers are committed to achieving

innovative and business-minded results for our clients, while

preserving the differences that make us stronger. This is MoFo. Visit

us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights

reserved. For more updates, follow Thinkingcapmarkets, our Twitter

feed: www.twitter.com/Thinkingcapmkts.

• Because of the generality of this presentation, the information

provided herein may not be applicable in all situations and should not

be acted upon without specific legal advice based on particular

situations.

1 © 2016 Morrison & Foerster LLP | mofo.com Attorney Advertising

Client Alert January 13, 2016

CFTC Proposes Regulation of Automated Trading By Julian E. Hammar

On November 24, 2015, the Commodity Futures Trading Commission (“CFTC”) approved the issuance of proposed rules to implement a framework of registration, reporting, recordkeeping and other compliance requirements for market participants engaged in algorithmic trading, referred to as Regulation AT. If adopted, the proposed rules would impose requirements on proprietary trading firms, designated contract markets (“DCMs”), clearing member futures commission merchants (“FCMs”) and other CFTC registrants that use algorithmic trading systems. It also proposes to require the registration of certain proprietary traders under a new definition of the term “Floor Trader” due to their algorithmic trading through direct electronic access (as defined in the proposed rules) to a DCM. The proposed rules, which were published in the Federal Register on December 17, 2015, are available here, and are open for public comment (including with respect to 164 questions contained in the release) until March 16, 2016.

DEFINITION OF ALGORITHMIC TRADING

The CFTC defines the term “Algorithmic Trading” broadly under the proposal as trading in any commodity interest (e.g., futures, options or swaps) on or subject to the rules of a DCM, where:

• One or more computer algorithms or systems determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order, including but not limited to: the product to be traded; the venue where the order will be placed; the type of order to be placed; the timing of the order; whether to place the order; the sequencing of the order in relation to other orders; the price of the order; the quantity of the order; the partition of the order into smaller components for submission; the number of orders to be placed; or how to manage the order after submission; and

• Such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM.

The proposed rules would exclude from the definition of algorithmic trading any orders modifications, or cancellations that are manually entered into a front-end system by a natural person with no further discretion by any computer system or algorithm, prior to their electronic submission to a DCM.

PURPOSE OF THE PROPOSED RULES

The CFTC believes that the proposed rules are needed to prevent persons from using Algorithmic Trading to violate the Commodity Exchange Act (“CEA”) or CFTC regulations, including by disrupting the market. The proposed rules would require risk controls and other requirements in order to address the risks of Algorithmic


Client Alert Trading, including the potential for market disruptions arising from system malfunctions, other errors, or intentional disruptive conduct. Under the proposal, risk controls and other requirements must be adopted at three levels:

• Market participants using algorithmic trading systems (AT persons in the proposed rule);

• Clearing member FCMs with respect to their AT Person customers; and

• DCMs executing AT person orders.

The proposed rules would apply whether or not a market participant engages in or facilitates high frequency trading; their requirements would apply to algorithmic trading irrespective of the speed of such trading. The proposal does not apply to trading on swap execution facilities.

REGISTRATION REQUIREMENT

Under current CFTC regulations, persons that engage in proprietary trading (i.e., not on behalf of customers) are not required to register unless they trade for their own account in or around a trading pit, ring, post, or other place provided by a DCM, and, in that case, they must register as a Floor Trader. The proposed rules would amend the definition of the term Floor Trader to include persons who trade commodity interests at a DCM for their own account through “Direct Electronic Access.” Direct Electronic Access is defined as an arrangement where a person transmits an order electronically to a DCM, without the order first being routed through a clearing member FCM of a derivatives clearing organization to which the DCM submits transactions for clearing. The CFTC requests comment as to whether the Floor Trader definition should be expanded to all firms operating algorithmic trading systems in CFTC-regulated markets that are not otherwise required to register (not just through Direct Electronic Access).

REQUIREMENTS FOR AT PERSONS

The proposed rules contain requirements that apply to market participants that are “AT Persons.” An AT Person is defined as:

• Any person registered or required to be registered as an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in Algorithmic Trading, or

• A Floor Trader that engages in Algorithmic Trading through Direct Electronic Access.

Risk Controls. AT persons would be required to implement risk controls on orders submitted through Algorithmic Trading, including pre-trade risk controls (e.g., maximum order message and execution frequency per unit time, order price and maximum order size parameters) and order cancellation systems that can disengage algorithmic trading, cancel selected or all resting orders, and prevent submission of new orders.

Development, Testing, and Monitoring. AT persons would be required to implement standards for the development, testing and monitoring of algorithmic trading systems, including complete separation of the environment used for system development from the one used for production, testing before implementation, real-


Client Alert time monitoring of such systems, and standards to ensure that systems comply with CFTC regulations, and must designate and provide training for algorithmic trading staff responsible for ensuring compliance.

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

Compliance Reports. AT persons would be required to annually prepare and submit to DCMs compliance reports regarding their risk controls, as well as copies of written policies and procedures developed to comply with testing and other requirements. They would also be required to keep books and records regarding their Algorithmic Trading procedures for inspection by DCMs.

Notification Requirement/Use of Self-Trade Prevention Tools. Prior to an AT person’s initial use of Algorithmic Trading to submit an order to a DCM, such AT person would be required to notify applicable clearing member FCMs and DCMs that the AT person will engage in Algorithmic Trading, and calibrate or otherwise implement DCM-provided self-trade prevention tools.

REQUIREMENTS FOR CLEARING MEMBER FCMS

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

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


Client Alert REQUIREMENTS FOR DCMS

Risk Controls. Under the proposed rules, DCMs would be required to implement risk controls on orders submitted through Algorithmic Trading (and parallel controls for manual orders), including maximum order message and execution frequency per unit time, order price and size parameters, and order cancellation systems.

Compliance Reports. DCMs would have to require risk control compliance reports from AT persons and their clearing member FCMs. DCMs would be required to periodically review compliance reports, identify outliers and provide instructions for remediation, as well as review, as necessary, books and records of AT persons and clearing member FCMs concerning Algorithmic Trading procedures.

Test Environments. DCMs would be required to provide test environments where AT persons can test algorithmic trading systems.

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

Disclosure Regarding Electronic Trade Matching Systems. DCMs would be required to provide public disclosure regarding certain elements of their electronic trade matching systems that materially affect order execution, including the ability to cancel, modify, or limit display of orders; the ability to cancel or modify orders; and the transmission of market data and order or trade confirmations to market participants.

Market Maker and Incentive Programs. DCMs would be required to provide disclosures of market maker and incentive programs submitted to the CFTC as rule filings. Such disclosures would have to specify all of the products or services to which they apply, eligibility requirements, and payment benefits or incentives received (e.g., fee rebates), as well as non-financial benefits (e.g., enhanced trading priorities or preferential access to market data). Payments would be prohibited for trades between accounts under common beneficial ownership.

REGISTERED FUTURES ASSOCIATIONS

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


Client Alert Contact:

Julian E. Hammar (202) 887-1679 [email protected]

About Morrison & Foerster:

We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.


Client Alert December 23, 2015

CFTC Adopts Uncleared Swaps Margin Rules By Julian Hammar

On December 16, 2015, the Commodity Futures Trading Commission (“CFTC” or “Commission”) adopted final rules to impose margin requirements on uncleared swaps entered into by swap dealers and major swap participants subject to CFTC regulation, referred to as “Covered Swap Entities” or “CSEs” in the rules. The CFTC also adopted an interim final rule to exclude from the requirements most uncleared swaps that swap entities enter into with commercial end users, financial institutions with $10 billion or less in total assets, and certain other entities consistent with the requirements of the Business Risk Mitigation and Price Stabilization Act of 2015.

The CFTC’s regulations are largely the same as the rules and interim final rule adopted by the Prudential Regulators (the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency) in October 2015 for swap entities subject to their supervision, with a few important differences noted below. The CFTC’s and Prudential Regulators’ rules will significantly impact the economics of the swaps market. Both sets of rules become effective on April 1, 2016, with a compliance schedule discussed below. The CFTC’s final rules are available here, while the Prudential Regulators’ final rules and interim final rule have been published in the Federal Register.1

BACKGROUND

One of the criticisms of the swaps market in the wake of the 2008 financial crisis was that it did not require swaps counterparties to provide margin (that is, collateral) to secure their obligations to each other. In practice, in many cases before and (even more so) after the crisis, parties have provided collateral (“variation margin”) to cover the current (“mark-to-market”) value of their obligations to each other. Though less common, some parties have also provided upfront collateral (“initial margin”) to cover the potential for further changes in mark-to-market value that could occur over some period (such as 5 business days).

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)2 requires the Prudential Regulators, the CFTC and the Securities and Exchange Commission (“SEC”) to draft rules requiring margin for bilateral swaps that will not be cleared at a clearinghouse (cleared swaps, in contrast, are subject to margin requirements imposed by clearinghouses and their members). In fulfillment of the statutory mandate, the CFTC and Prudential Regulators released in the fall of 2014 re-proposed rules for margin requirements for uncleared swap transactions subject to their regulation, which they first proposed in 2011. The re-proposed rules were issued in response to an international framework for uncleared swaps margin stated in a series of papers released by the Basel Committee on Banking Supervision and the Board of the International Organization of 1 See Margin and Capital Requirements for Covered Swap Entities; Final Rule, 80 Fed. Reg. 74,839 (Nov. 30, 2015) and Interim Final Rule,

80 Fed. Reg. 74,915 (Nov. 30, 2015). 2 Pub. L. No. 111-203, 124 Stat. 1376 (2010).


Client Alert Securities Commissions, the last of which was issued in September 2013 (the “BCBS/IOSCO Framework”). For more information on the Prudential Regulators’ and CFTC’s proposed rules, please see our alert here.

FINAL RULES EXECUTIVE SUMMARY

Overview of the final rules

Like the Prudential Regulators’ final rules, the CFTC’s final rules in general would:

• Require Covered Swap Entities3 to bilaterally exchange, subject to a $50 million threshold below which it need not be exchanged, “initial margin” with other swap entities and with a broad range of “financial end users,” whose use and affiliates’ use of uncleared swaps meet a notional amount-based exposure (“material swaps exposure”);

• Mandate that all such initial margin, which is intended to secure potential future exposure or adverse changes in value that may arise during the period of time when a swap is being closed out, must be segregated generally with a third-party custodian (not affiliated with either counterparty) and not subject to re-hypothecation or other use by the custodian;4

• Permit the calculation of initial margin by means of either a model-based method, subject to regulatory approval, or a table-based method provided for in the rules;

• Impose a significantly higher initial margin requirement on uncleared swaps as compared to cleared swaps by requiring that initial margin models use a 10 business day closeout horizon for most uncleared swaps as opposed to a 5 business day horizon for most cleared swaps; and

• Require swap entities to exchange “variation margin” with swap entities and with a broad array of financial end users without regard to the existence of material swaps exposure and without any threshold.

Relief provided from the re-proposals in the final rules

Also like the Prudential Regulators’ rules, the CFTC’s rules provide some relief from the re-proposal in certain areas, as well as some harmonization with the BCBS-IOSCO Framework. Specifically, the Prudential Regulators’ and CFTC’s rules, as discussed in more detail below, would:

• Increase the material swaps exposure amount for financial end users from $3 billion to $8 billion of average daily aggregate notional amount of swaps activity over a three-month period, thereby decreasing the number of entities from and to which Covered Swap Entities must post and collect initial margin and aligning the amount with the BCBS/IOSCO Framework;

3 Under the CFTC’s rules, Covered Swap Entities are swap dealers and major swap participants for which there is no Prudential Regulator,

while under the Prudential Regulators’ rules, Covered Swap Entities include swap dealers, major swap participants, security-based swap dealers and major security-based swap participants that are regulated by a Prudential Regulator.

4 However, the Prudential Regulators and the CFTC clarify that cash collateral may be held in a general deposit account with the custodian if the funds in the account are used to purchase other forms of eligible collateral, such eligible non-cash collateral is segregated, and the purchase of which takes place within a time period reasonably necessary to consummate such purchase after the cash collateral is posted as initial margin. See 17 C.F.R. 23.157(c) and Prudential Regulators Rule __.7(c).


Client Alert • Harmonize dollar amounts for the initial margin threshold and minimum transfer amount with the BCBS-

IOSCO Framework in light of changed exchange rates;

• Revise the definition of affiliate to eliminate a test of affiliation based on “control” in favor of consolidation under accounting rules, which should make certain calculations easier, such as for material swaps exposure, required by the rules;

• Expand the eligible collateral for initial and variation margin by permitting redeemable securities in certain money market mutual funds for initial margin and providing that variation margin collateral, which under the re-proposals could only be in cash, may be in any form that is eligible for initial margin for swaps between CSEs and financial end users;

• Modify treatment of pre- and post-compliance date swaps under “eligible master netting agreements” (agreements meeting certain requirements under which variation margin can be calculated on a net basis and risk offsets recognized for calculating initial margin); and

• Amend the phased-in compliance schedule for the rules in accordance with delay of the schedule announced by BCBS and IOSCO earlier this year by 9 months.

Notable differences between the CFTC’s and Prudential Regulators’ rules

The CFTC’s final rules have a few notable differences from the Prudential Regulators’ rules, including:

• Providing for a broader exemption from swaps between Covered Swap Entities and their affiliates than the more limited exemption provided by the Prudential Regulators, but with an anti-evasion provision;

• Delegating authority to the National Futures Association (“NFA”), the self-regulatory organization in the futures and swaps industry, to approve initial margin models, which could also be approved by the CFTC (the Prudential Regulators would undertake their own approvals);

• Excluding from the financial end user definition treasury affiliates that qualify for an exemption from mandatory clearing that the CFTC has exempted by rule (the Prudential Regulators have stated that they will include this provision if the CFTC acts to exempt such entities, which currently qualify for an exemption under CFTC staff no-action letters, by rule);

• Requiring that the variation margin calculation use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, and other objective criteria (the Prudential Regulators’ rules do not contain this provision); and

• Not addressing cross-border application of the rules, which are being considered by the CFTC in a separate proposal.

Even with the relief provided for in the CFTC’s and the Prudential Regulators’ rules, however, the obligations of the rules represent a significant regulatory burden and cost on the OTC swaps market that did not exist before. It remains to be seen how the swaps market will respond to these requirements.


Client Alert SCOPE OF THE FINAL RULES

Financial end users

Under both the CFTC’s and Prudential Regulators’ rules, a Covered Swap Entity will not be required to collect or post specified amounts of initial or variation margin on swaps with counterparties that are not swap entities or “financial end users.” Such counterparties are described in the final rules as “other counterparties” by the Prudential Regulators and “non-financial end users” by the CFTC. The final rules retain the “financial end user” definition used in the re-proposal (a list of enumerated financial market status types under various U.S. statutes and regulations including banks, broker-dealers, investment companies, insurance companies, commodity pools and ERISA plans),5 which was intended to provide greater clarity than the “financial entity” definition used in the statutory exemption from mandatory clearing in the Commodity Exchange Act (“CEA”). Expressly excluded from the financial end user definition are sovereign entities (central governments or an agency or department thereof), the Bank for International Settlements, multilateral development banks,6 entities exempt from the definition of financial entity under section 2(h)(7)(C)(iii) or (D) of the CEA or section 3C(g)(4) of the Securities Exchange Act of 1934 (“Exchange Act”), and, as noted above, the CFTC’s rules include an exclusion for treasury affiliates that qualify for an exemption from mandatory clearing that the CFTC has exempted by rule (currently exempted by staff no-action letters). The Prudential Regulators and the CFTC declined to exclude structured finance vehicles or covered bond issuers that had been requested by commenters.

Requirements for swaps with non-financial end users

Swaps with entities that are not financial end users are exempt from the margin requirements under both the CFTC’s and the Prudential Regulators’ rules, except under the Prudential Regulators’ rules, a Covered Swap Entity must collect margin (if any) from such non-financial end users as the CSE determines is appropriate in its overall credit risk management of its exposure to the customer.7 CSEs must make this determination for entities that do not qualify for the separate interim final rule (e.g., a commercial end user that is not hedging or mitigating commercial risk), as well as with respect to initial margin for financial end users without material swaps exposure (who are not subject to the rule’s initial margin requirements). The CFTC’s release does not require this determination, and also removes the requirement contained in the CFTC’s re-proposal that CSEs calculate

5 See 17 C.F.R. 23.151 and Prudential Regulators Rule __.2 (definition of financial end user). The Prudential Regulators and the CFTC added

to the financial end user definition a U.S. intermediate holding company established or designated for purposes of compliance with the Federal Reserve Board’s Regulation YY (12 C.F.R. 252.153), and three CFTC-registered entities to the enumerated list: floor brokers, floor traders, and introducing brokers. The CFTC also added business development companies to align its financial end user definition with that of the Prudential Regulators. Both sets of rules include a provision that would cover an entity, person, or arrangement that is, or holds itself out as, as entity, person, or arrangement that raises money from investors, accepts money from clients, or uses its own money primarily for the purpose of investing or trading or facilitating the investing or trading in loans, securities, swaps, funds, or other assets for resale or other disposition, or otherwise trading in loans, securities, swaps, funds, or other assets. See (xi) of the financial end user definition. The final rules also remove the provision contained in the re-proposals that would have included any other entity that the relevant agency determined should be treated as a financial end user.

6 Multilateral development banks are separately defined in the rule to include certain specified entities. 7 See 80 Fed. Reg. at 74,844.


Client Alert hypothetical margin requirements for swaps with non-financial end users, citing the administrative burden and that other CFTC rules should address monitoring of risk exposures for these entities.8

Interim final rule exemption

The CFTC, like the Prudential Regulators, also adopted an interim final rule in accordance with the Business Risk Mitigation and Price Stabilization Act of 2015, which provides that the requirements of the uncleared swaps margin rules do not apply where the counterparty would be eligible for:

• An exemption from mandatory clearing under Section 2(h)(7)(A) of the CEA or Section 3C(g)(1) of the Exchange Act (i.e., a non-financial entity using the swap to hedge or mitigate commercial risk, certain small financial institutions and captive finance companies);

• An exemption under CEA Section 4(c)(1) for cooperative entities that would otherwise be subject to the requirement to clear; or

• The exemption for affiliates under CEA Section 2(h)(7)(D) or Exchange Act Section 3C(g)(4) (i.e., affiliates that act as an agent).9

KEY MODIFICATIONS TO THE RE-PROPOSALS IN THE FINAL RULES

The CFTC’s and the Prudential Regulators’ final rules make a number of modifications to the re-proposals, as noted above, which provide relief in some cases as well as some harmonization with the BCBS/IOSCO Framework. The discussion of these modifications below also highlights differences between the CFTC’s and Prudential Regulators’ rules.

Material swaps exposure

Under both the CFTC’s and the Prudential Regulators’ final rules, the threshold for determining whether a financial end user has “material swaps exposure” has been increased from $3 billion to $8 billion of average daily aggregate notional amount of swaps activity for June, July, and August of the previous calendar year (determined by reference to the swaps activity of the financial end user and its affiliate(s) on business days), which is more closely aligned with the BCBS-IOSCO Framework. This change will reduce the number of entities from which swap entities must post and collect initial margin, which is required under the rules for swaps between swap entities and financial end users with material swaps exposure, and level the playing field between swap entities subject to U.S. rules and those subject to rules of foreign jurisdictions, such as the European Union and Japan, which have more closely followed the BCBS-IOSCO Framework. Both sets of rules also clarify that swaps eligible for an exemption under the interim final rule do not count toward this threshold and that swaps entered into between an entity and its affiliate are counted only once to prevent double counting.

A new provision common to both the CFTC’s and Prudential Regulators’ rules not contained in the re-proposals clarifies the consequences of a change in a counterparty’s status. Under the new provision, if a change would

8 See CFTC Final Rule Release at 48. 9 17 C.F.R. 23.150; Prudential Regulators Interim Final Rule.


Client Alert make the rules stricter, such as when a financial end user becomes a financial end user with material swaps exposure, the stricter rules would apply for new swaps entered into after the change. Where a change would make the rules less strict (such as when the exposure of a financial end user with material swaps exposure falls below the $8 billion threshold), the swap entity may comply with less strict requirements for all outstanding swaps. Accordingly, initial margin, which is not required for swaps with financial end users that do not have material swaps exposure, would no longer be required with respect to all swaps under this provision if a financial end user drops below the $8 billion threshold.10

Changes to other numerical amounts

In addition to the modification to the material swaps exposure amount, both the CFTC’s and the Prudential Regulators’ rules modify other numerical amounts contained in the re-proposals to take into account changed exchange rates that have occurred since the re-proposals were issued. Specifically, the initial margin threshold amount—i.e., the amount under which initial margin need not be collected—has been reduced from $65 million in the re-proposals to $50 million in the final rules due to changed exchange rates.11 Similarly, the minimum transfer amount across initial and variation margin—or the amount below which initial and variation margin need not be exchanged until it is exceeded—has been reduced from $650,000 to $500,000 in the final rules.12

Definition of affiliate

Under both the CFTC’s and the Prudential Regulators’ final rules, the definition of “affiliate” (“margin affiliate” in the CFTC’s rules) has been aligned with established accounting standards rather than relying on the “control” test contained in their re-proposals. The re-proposals contained a low level of control for affiliation to exist—only 25 percent (not 50 percent or more) of the ownership or control, directly or indirectly, of a class of voting securities or total equity. The final rules provide that affiliation exists if a company consolidates the other (or both companies are consolidated with a third company) on financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles, the International Financial Reporting Standards, or other similar standards.13 The change may make it easier for companies to determine whether, for example, a financial end user has “material swaps exposure” (which must be calculated to include the exposures of its affiliates), as well as determine compliance deadlines under the phased-in compliance schedule discussed below. The CFTC did not include in its affiliate definition a provision included in the Prudential Regulators’ definition of the term “affiliate” pursuant to which the relevant Prudential Regulator may determine that a company is an affiliate of another company based on the regulator’s conclusion that either company provides significant support to, or is materially subject to the risk of losses of, the other company.

10 See 17 C.F.R. 23.161(c) and Prudential Regulators Rule __.1(g). 11 See 17 C.F.R. 23.151 and Prudential Regulators Rule __.2 (definition of initial margin threshold amount). 12 See 17 C.F.R. 23.151 and Prudential Regulators Rule __.2 (definition of minimum transfer amount). In addition to these modifications, the

CFTC’s and Prudential Regulators’ rules provide clarification about when margin must be collected, when counterparties are in different time zones or observe different legal holidays. See CFTC Final Rule Release at 54-57 and 80 Fed. Reg. at 74864- 65.

13 See 17 C.F.R. 23.151 (definition of “margin affiliate”) and Prudential Regulators Rule __.2 (definition of affiliate).


Client Alert Expansion of eligible collateral for initial and variation margin

The CFTC’s and Prudential Regulators’ rules also expand the types of eligible collateral for initial and variation margin. Eligible collateral types for initial margin include U.S. Treasury securities, government sponsored enterprise securities, securities issued or guaranteed by the Bank for International Settlements, the European Central Bank, the International Monetary Fund and multilateral development banks, publicly traded debt (other than asset-backed securities), publicly traded equities in certain indices and gold, but not securities issued by the pledgor or its affiliate or banks and similar entities. The final rules also permit collateral (not permitted in the re-proposals) of redeemable securities in certain money market mutual funds that meet specific requirements.14

The CFTC’s and Prudential Regulators’ final rules also provide that variation margin may include major currencies (defined in the final rules)15 in addition to U.S. dollars and the currency of settlement, while the re-proposals would not have permitted major currencies. An 8 percent cross-currency haircut applies if margin is denominated in a currency different from settlement currency, except that variation margin in immediately available cash funds in the major currencies is not subject to the haircut.

Both sets of final rules also permit non-cash collateral eligible to be used for initial margin to serve as variation margin for swaps between a Covered Swap Entity and a financial end user (but not for swaps with other swap entities), while the re-proposals only permitted cash collateral for variation margin for all counterparties.16 This change may be welcomed by certain financial entities, such as insurance companies, that hold significant reserves of bonds and other securities and commented that the restriction to cash-only variation margin would reduce their investment returns.

The CFTC’s rules include a provision, not included in the Prudential Regulators’ rules, that requires that variation margin calculations use methods, procedures, rules, and inputs that, to the maximum extent practicable rely on recently executed transactions, valuations provided by independent third parties, or other objective criteria.17

Approval of initial margin models

The CFTC’s and the Prudential Regulators’ final rules differ in terms of the approval of initial margin models. Both sets of final rules, like the re-proposals, impose stringent regulatory requirements on initial margin models, including written approval of the relevant regulator for use of initial margin models, demonstration on an ongoing basis that the model satisfies all of the requirements under the rules, and prior notice to the relevant regulator before making changes to the model or its assumptions. However, the CFTC’s final rules would provide a 14 See 17 C.F.R. 23.156 and Prudential Regulators Rule __.6. 15 The major currencies are United States Dollar (USD); Canadian Dollar (CAD); Euro (EUR); United Kingdom Pound (GBP); Japanese Yen

(JPY); Swiss Franc (CHF); New Zealand Dollar (NZD); Australian Dollar (AUD); Swedish Kronor (SEK); Danish Kroner (DKK); Norwegian Krone (NOK); and any other currency designated by the CFTC or relevant Prudential Regulator. See 17 C.F.R. 23.151 and Prudential Regulators Rule __.2 (definition of major currency).

16 See 17 C.F.R. 23.156(b)(1)(ii) and Prudential Regulators Rule __.6(b). 17 Both releases clarify, in response to comments that the re-proposals appeared to require calculation of variation margin based on the

market value of the swap calculated from the Covered Swap Entity’s perspective, that the market value used to determine the cumulative mark-to-market change will be mid-market prices, if that is consistent with the agreement of the parties. CFTC Final Rule Release at 114-15, 80 Fed. Reg. at 74,867.


Client Alert registered futures association (the NFA is the only registered futures association) with authority to approve initial margin models in addition to the CFTC.18 The Prudential Regulators’ final rules do not contain a similar provision; all approvals of initial margin models for Covered Swap Entities subject to their supervision will have to be approved by the relevant Prudential Regulator.19 The CFTC notes that it or the NFA will coordinate with the Prudential Regulators in order to avoid duplicative efforts and to provide expedited approval of Prudential Regulator-approved models.20

Eligible master netting agreements

Relief was also provided by the CFTC and the Prudential Regulators from their re-proposals with respect to pre-compliance date and post-compliance date swaps subject to a single eligible master netting agreement (“EMNA”). For swaps subject to an EMNA, variation margin can be calculated on a net basis and risk offsets can be recognized within asset classes for calculating initial margin. Under the re-proposals, although the rules applied only to swaps entered into after the relevant compliance date, transactions subject to an EMNA applicable to pre-compliance date transactions would be subject to margin requirements for all swaps under the EMNA. Accordingly, without the relief provided for in the final rules, counterparties would have had to enter into a separate EMNA for new swaps, which received criticism from commenters who argued that this would reduce netting sets and thus increase systemic risk.

Both sets of final rules permit counterparties to document pre- and post-compliance date swaps as separate portfolios for netting purposes under the same EMNA covered by separate credit support annexes.21 Accordingly, netting portfolios that contain only uncleared swaps entered into before the applicable compliance date are not subject to the final rules. EMNAs, as provided under the re-proposals, are subject to a requirement that a swap entity conduct sufficient legal review to conclude with a well-founded basis that, among other things, the contract would be found legal, binding, and enforceable under the law of the relevant jurisdiction. Although unqualified legal opinions are not required, the legal review must be in writing.22 Also with regard to EMNAs, the definition of EMNA is amended in the final rules to provide that impermissible “walk away” clauses do not include clauses that only suspend payment obligations when a counterparty defaults.23 A provision included in the Prudential Regulators’ final rules that, if a netting agreement does not qualify as an EMNA, the Covered Swap Entity must collect variation margin on a gross basis but may post on a net basis, is not contained in the CFTC’s final rules.

18 See 17 C.F.R. 23.154(b). 19 See Prudential Regulators Rule __.8(c). 20 See CFTC Final Rule Release at 74. 21 See CFTC Final Rule Release at 59-60 and 80 Fed. Reg. at 74,868. 22 See generally CFTC Final Rule Release at 79-80 and 80 Fed. Reg. at 74,862. A similar legal review requirement applies to custodial

agreements with third party custodians for initial margin. The CFTC and Prudential Regulators provide guidance that, for that purpose, the relevant jurisdictions include that of the custodian as well as that of the Covered Swap Entity’s counterparty. See CFTC Final Rule Release at 139 and 80 Fed. Reg. at 74,875.

23 In this regard, the definition of EMNA has been modified to align it with the definition of qualifying master netting agreement in the risk-based capital rules that was modified earlier this year. See 80 Fed. Reg. at 74861-62.


Client Alert Inter-affiliate swaps

Neither the CFTC’s nor the Prudential Regulators’ re-proposals contained an exemption from the margin requirements for swaps between a Covered Swap Entity and its affiliates. As mentioned above, the Prudential Regulators’ and the CFTC’s final rules differ on the treatment of such inter-affiliate swaps.

Under the Prudential Regulators’ final rules, the margin requirements generally apply to swaps between a Covered Swap Entity and its affiliates (unless otherwise exempt), except that a Covered Swap Entity is not required to post initial margin to an affiliated counterparty.24 The Covered Swap Entity is required to calculate the amount of initial margin that would be required to be posted under the rules to an affiliate (that is a financial end user with material swaps exposure) and provide documentation of such amount on a daily basis. The threshold for collecting initial margin from an affiliate that is a financial entity with material swaps exposure is $20 million (rather than the generally applicable $50 million threshold). The Prudential Regulators’ rules do not provide relief from variation margin, which must be posted to and collected from financial end user affiliates by swap entities. Initial margin in the form of non-cash collateral for swaps between a swap entity and its affiliates may be held by a custodian that is an affiliate of the Covered Swap Entity or by the Covered Swap Entity itself (rather than an unaffiliated third party as required for uncleared swaps with non-affiliates). The Prudential Regulators’ final rule allows a Covered Swap Entity to use a 5 business day close-out time horizon for modelling the initial margin requirement, rather than the generally applicable 10 business day horizon, for swaps that are required to be cleared but which are exempt because of a clearing exemption for inter-affiliate swaps. It should be noted that, if an affiliate of a swap entity is itself a swap entity, then the Prudential Regulators’ rules require that both swap entities must collect margin, and thus there is no relief from the posting requirement.

Under the CFTC’s final rules, a Covered Swap Entity is generally not required to collect initial margin from a margin affiliate (including another swap entity), provided that the CSE meets the following conditions:

• The swaps are subject to a centralized risk management program that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps; and

• The CSE exchanges variation margin with the margin affiliate.25

The CFTC’s final rules provide, however, that a Covered Swap Entity must collect initial margin from non-U.S. affiliates that are financial end users that are not subject to comparable initial margin collection requirements on their own outward-facing swaps with financial end users. In addition, in order to facilitate compliance with the Prudential Regulators’ rules, the CFTC’s rules would require a Covered Swap Entity to post initial margin with a swap entity that is subject to the Prudential Regulators’ rules (and required to collect initial margin from its affiliates). As is the case under the Prudential Regulators’ rules, the CFTC’s rules would require that variation margin be exchanged with respect to swaps between a Covered Swap Entity and its affiliates.

24 See Prudential Regulators Rule __.11. 25 See 17 C.F.R. 23.159.


Client Alert Phased-in compliance schedule

Both the CFTC’s and the Prudential Regulators’ final rules adopt the phase-in schedule announced by BCBS/IOSCO in March 2015, which delays implementation of initial margin and variation margin requirements by nine months compared with the re-proposals, starting in September 1, 2016.26 The compliance schedule is nonetheless aggressive in light of the legal, operational, and regulatory approval requirements imposed by the rules. The final rules provide for phased-in implementation for initial margin depending upon swaps exposure of the Covered Swap Entity and its affiliates and its counterparties and their affiliates starting from September 1, 2016 (for entities with the largest exposure) through September 1, 2020, after which swaps with all financial end users with material swaps exposure will be subject to the initial margin requirements.

The CFTC’s and Prudential Regulators’ final rules also provide for a delayed-implementation schedule with regard to variation margin for Covered Swap Entities belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives is less than $3 trillion for March, April and May 2016, until March 1, 2017. For all other Covered Swap Entities, the compliance date for variation margin is September 1, 2016.

The final rules clarify that, once a CSE and its counterparty (and their affiliates) become subject to the margin requirements under the schedule, they remain subject to the requirements even if they have a change in status due to a reduction in notional exposure (this differs from the rule explained earlier when a financial end user with material swaps exposure changes status and the less strict margin requirements apply). The Prudential Regulators and the CFTC declined to provide guidance in response to commenters’ requests that certain swaps be considered to be entered into before the applicable compliance date.

Cross-border application

The Prudential Regulators’ final rules contain provisions governing the cross-border application of the margin rules, while the CFTC has proposed a separate rulemaking to address cross-border application, which has not yet been finalized.27 The Prudential Regulators’ final rules, as under the re-proposal, exempt foreign swap entities (but not their U.S. branches or agencies) with respect to the foreign non-cleared swaps from the margin requirements. The exemption is not available where the foreign counterparty is, or is guaranteed by, a U.S. entity, a U.S. branch or subsidiary of a foreign bank, or a foreign swap entity that is a subsidiary of a U.S. entity. Substituted compliance (i.e., compliance with non-U.S. rules rather than U.S. rules) may be available for a foreign bank, U.S. branch or agency of a foreign bank, or an entity that is a foreign subsidiary of a depository institution, Edge corporation or agreement corporation. However, substituted compliance would be available only if the Prudential Regulators have made a comparability determination for the jurisdiction the rules of which would apply to the uncleared swap. Moreover, substituted compliance would not be available if the swap is guaranteed by a U.S. entity.

26 See 17 C.F.R. 23.161 and Prudential Regulators Rule __.1(e). 27 See Prudential Regulators Rule __.9. For more information on the CFTC’s proposed rules regarding cross-border application of the

uncleared swaps margin requirements, please see our client alert here.


Client Alert All swap entities (including U.S. entities) under the Prudential Regulators’ rules will be deemed to satisfy the initial margin posting requirement under the final rules if they post the amount of initial margin that each of their counterparties is required to collect under non-U.S. rules, provided that the Prudential Regulators have made a substituted compliance determination with respect to those rules and the swap is not subject to a guarantee from a U.S. entity. The Prudential Regulators’ final rules also provide relief in certain circumstances from the segregation requirements to foreign branches and subsidiaries of U.S. banks and Edge corporations where inherent limitations in the legal or operational infrastructure in a foreign jurisdiction make it impracticable to segregate collateral.28

CONCLUSION

The CFTC’s and Prudential Regulators’ final rules provide some welcome relief to market participants when compared with the re-proposals, and the harmonization efforts with non-U.S. regulators should help to create a more level playing field. Nonetheless, the margining requirements imposed by the rules represent a significant regulatory burden and cost on the OTC swaps market that did not exist before, in particular as it pertains to initial margin, which, due to the segregation and re-hypothecation restrictions, will impose a significant new cost for swap dealers and financial end users with material swaps exposure. Because of the 10 business day close-out requirement for calculating initial margin, this cost will be substantially higher than other derivative products, such as cleared swaps or futures. It remains to be seen how the swaps market will respond to these requirements and whether, as a result of their cost, the use of other derivative products, such as cleared swaps and futures, may be used in place of OTC swaps.

Contact:

Julian E. Hammar (202) 887-1679 [email protected]

David H. Kaufman (212) 468-8237 [email protected]

James Schwartz (212) 336-4327 [email protected]

Chrys A. Carey (202) 887-8770 [email protected]

About Morrison & Foerster:

We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.

28 See Prudential Regulators Rule __.9(f).

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Client Alert August 28, 2015

The SEC’s Registration Rules for Security-Based Swap Dealers

Early this month the U.S. Securities and Exchange Commission (“SEC”) released final rules (the “Registration Rules”) for the registration of security-based swap dealers (“SBSDs”).1 The Registration Rules, released more than three years after the release by the U.S. Commodity Futures Trading Commission (“CFTC”) of its parallel rules for the registration of swap dealers,2 set out the formal requirements for SBSD registration and are instructive for financial institutions that may be required to register as SBSDs when such registration comes to be required.

Timing for Registration and for Related Calculations

The Registration Rules have little immediate effect. Their compliance date, when the SBSD registration requirement will go into effect, will occur only after the occurrence of several events that, taken together, have not yet occurred, cannot occur for a minimum of six months, and seem relatively unlikely to occur until after significantly more than six months have passed.3

Moreover, market participants are not required to register as SBSDs until after their security-based swap activity exceeds certain de minimis thresholds.4 The Registration Rules Release states that, for purposes of complying with registration requirements, entities engaging in security-based swaps activities are not required to begin calculating whether their activities meet or exceed such thresholds until two months prior to the compliance date of the Registration Rules.5

1 Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, 80 Fed. Reg. 48,963 (August 14, 2015) (the “Registration Rules Release”). The Registration Rules Release is available here. Under the Registration Rules, registration requirements are very similar for SBSDs and for major security-based swap participants (“MSBSPs”). For clarity and ease of reading, and in view of the likely rarity of MSBSPs, this client alert generally refers to SBSDs and not to MSBSPs. 2 Registration of Swap Dealers and Major Swap Participants, 77 Fed. Reg. 2613 (January 19, 2012). Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act gives the CFTC jurisdiction over “swaps” and “swap dealers” and the SEC jurisdiction over “security-based swaps” and “security-based swap dealers.” 3 Specifically, the compliance date will occur on the later of: (i) six months after the date of publication in the Federal Register of a final rule release adopting rules establishing capital, margin and segregation requirements for SBSDs; (ii) the compliance date of final rules establishing recordkeeping and reporting requirements for SBSDs; (iii) the compliance date of final rules establishing business conduct requirements for SBSDs; or (iv) the compliance date for final rules establishing a process for a registered SBSD to make an application to the SEC to allow an associated person who is subject to a statutory disqualification to effect or be involved in effecting security-based swaps on the SBSD’s behalf. Registration Rules Release at 48,964. 4 See generally Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30,596, 30,756 (May 23, 2012). 5 Registration Rules Release at 48,964.


Conditional Registration

An applicant will be conditionally registered if it timely completes and submits (i) the primary application form applicable to it, as described below, and (ii) a certification form, also described below.6 The SEC may deny or grant ongoing registration as a SBSD based on the applicant’s application. The SEC will grant ongoing registration if it finds that applicable requirements are satisfied, and may institute proceedings to determine whether ongoing registration should be denied.7 If information contained in an applicant’s registration materials becomes inaccurate, such applicant must correct such materials.8

Primary Application Forms

The Registration Rules provide that an applicant must file one of three primary forms as part of its application for registration.9 The forms are annexed to the Registration Rules and form part of the rulemaking. The three forms are:

• Form SBSE, for entities that are neither registered or registering with the SEC as a broker-dealer nor registered or registering with the CFTC as a swap dealer or major swap participant;

• Form SBSE-A, for entities that are not registered or registering with the SEC as a broker-dealer but that are registered or registering with the CFTC as a swap dealer or major swap participant; and

• Form SBSE-BD, for entities that are registered or registering with the SEC as a broker or dealer.10

The SEC’s decision to use three different primary application forms is intended to recognize that, if an applicant is registered with the SEC or the CFTC, the SEC can obtain access to certain information regarding such applicant.11 As a result, the three forms request different amounts of information, with the Form SBSE-BD, for entities already registered or registering as a broker or dealer with the SEC, appearing to require significantly less information than the other two forms.

Certifications

In addition to a primary application form, an applicant must file a Form SBSE-C, which, like the primary application forms, is annexed to the Registration Rules and forms part of the SEC’s rulemaking. Form SBSE-C contains two separate certifications, one by a senior officer of the applicant and the other by the applicant’s chief compliance officer or his or her designee.

A senior officer of the applicant must certify that such officer has:

• after due inquiry, reasonably determined that the applicant has developed and implemented written policies and procedures reasonably designed to prevent violation of federal securities laws and the rules thereunder; and

• documented the process by which he or she reached such determination.12

6 Registration Rules at § 240.15Fb2-1(d). 7 Registration Rules at § 240.15Fb2-1(e). 8 Registration Rules at § 240.15Fb2-3. 9 Registration Rules at § 240.15Fb2-1(a). 10 Registration Rules Release at 48,989. 11 Registration Rules Release at 48,967. 12 See Registration Rules at § 240.15Fb2-1(b); Form SBSE-C.


For these purposes, the term “senior officer” includes only the most senior executives in an organization, such as an applicant’s chief executive officer, chief financial officer, chief legal officer, chief compliance officer, president, or other person at a similar level. In addition, the “senior officer” making the certification must have the legal authority to bind the applicant.13 The development of the written policies and procedures referenced in this certification will likely be among the most time-consuming of the tasks required to register as an SBSD.

Further, the applicant must certify, by its chief compliance officer or his or her designee, that the applicant:

• neither knows, nor in the exercise of reasonable care should have known, that any associated person14 who effects or is involved in effecting security-based swaps on its behalf is subject to a statutory disqualification,15 unless otherwise specifically provided by SEC rule, regulation or order;16 and

• has performed background checks on all of its associated persons who are natural persons17 and who effect or are involved in effecting security-based swaps on its behalf.18

The Registration Rules expressly require the applicant’s chief compliance officer, or his or her designee, to review and sign the questionnaire or application for employment executed by each associated person who is a natural person and who effects or is involved in effecting security based swaps on behalf of such applicant.19 The questionnaire or application must serve as a basis for a background check of the associated person to verify that such person is not subject to statutory disqualification.20

Nonresident SBSDs

Additional requirements apply to “nonresident security-based swap dealers,” which are defined to include (i) in the case of a corporation, one incorporated in or having its principal place of business in any place not in the United States and (ii) in the case of a partnership or other unincorporated organization or association, one having its principal place of business in any place not in the United States.21

13 Registration Rules Release at 48,968, note 29. 14 For these purposes, an “associated person” of a SBSD means (i) any partner, officer, director or branch manager of the SBSD (or any person occupying a similar status or performing similar functions); (ii) any person directly or indirectly controlling, controlled by or under common control with, the SBSD; or (iii) any employee of the SBSD, provided that the term does not include any person whose functions are solely clerical or ministerial. Registration Rules Release at 48,974 and note 88; Section 3(a)(70) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78c(a)(70). 15 Generally for these purposes a person is subject to “statutory disqualification” if such person has been subject to any of the actions, decrees, orders or judgments described in paragraphs (A)-(F) of Section 3(a)(39) of the Exchange Act, 15 U.S.C. §78c(a)(39). See Registration Rules at § 240.15Fb2–1(e) and § 240.15Fb6–1; Form SBSE-C. 16 When the SEC issued the final Registration Rules, it also voted to publish in the Federal Register proposed rules that would permit a SBSD to make an application to permit a statutorily disqualified person (including a natural person) to effect or be involved in effecting security-based swaps. See Applications by Security-Based Swap Dealers or Major Security-Based Swap Participants for Statutorily Disqualified Associated Persons to Effect or Be Involved in Effecting Security-Based Swaps; Proposed Rule, 80 Fed. Reg. 51,683 (August 25, 2015), available here. The comment period for these proposed rules closes on October 26, 2015. 17 With respect to non-natural persons, when an entity files an application to register as an SBSD, such entity may permit a non-natural person that is associated with such entity that is subject to statutory disqualification to effect or be involved in effecting security-based swaps on its behalf, provided that the statutory disqualification(s) occurred prior to the compliance date of the Registration Rules, and provided that the entity identifies each such associated person on the applicable application form. Registration Rules at § 240.15Fb6-1. 18 Registration Rules at § 240.15Fb6-2; Form SBSE-C. 19 The Registration Rules Release clarifies that a person is “involved in effecting” security-based swaps if the person generally is engaged in functions necessary to facilitate the SBSD’s security-based swap business, including, but not limited to, the following activities: (1) drafting and negotiating master agreements and confirmations; (2) recommending security-based swap transactions to counterparties; (3) being involved in executing security-based swap transactions on a trading desk; (4) pricing security-based swap positions; (5) managing collateral for the SBSD; and (6) directly supervising persons engaged in the activities described in items (1) through (5) above. See Registration Rules Release at 48,976. 20 Registration Rules at § 240.15Fb6-2(b). 21 Registration Rules at § 240.15Fb2-4(a).


Each nonresident SBSD must:

• appoint an agent for service of process in the U.S.;22

• certify that it can and will provide the SEC with prompt access to its books and records and will submit to onsite inspection and examination by the SEC;23 and

• provide an opinion of counsel to the effect that it 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.24

A nonresident SBSD must provide a re-certification within 90 days after any changes in the legal or regulatory framework that would impact a nonresident SBSD’s ability to provide the SEC with prompt access to its books and records. Such re-certification must be accompanied by a revised opinion of counsel describing how, as a matter of law, the nonresident SBSD will continue to meet its obligations to provide the SEC with prompt access to its books and records and to be subject to SEC inspection and examination under the new regulatory regime.25

Author James E. Schwartz New York +1 (212) 336-4327 [email protected] Contacts Anna T. Pinedo New York +1 (212) 468-8179 [email protected]

Julian E. Hammar Washington D.C. +1 (202) 887-1679 [email protected]

David H. Kaufman New York +1 (212) 468-8237 [email protected]

Barbara R. Mendelson New York +1 (212) 468-8118 [email protected]

About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life sciences companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2015 Morrison & Foerster LLP. All rights reserved.

For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. 22 Registration Rules at § 240.15Fb2-4(b). 23 Registration Rules at § 240.15Fb2-4(c)(1)(i). 24 Registration Rules at § 240.15Fb2-4(c)(1)(ii). 25 Registration Rules at § 240.15Fb2-4(c)(2).

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