dodd frank otc derivatives

8/7/2019 Dodd Frank OTC Derivatives

http://slidepdf.com/reader/full/dodd-frank-otc-derivatives 1/19

Rajeev Jha

Capgemini US LLC

4/5/2011

OTC Derivatives: Dodd Frank Act



Table of Contents

1. Executive Summary ................................................................................................................................. 3 2. Derivatives.............................................................................................................................................. 4

2.1. OTC Derivatives.................................................................................................................................. 4 2.1.1. OTC Derivatives – Trade Flow ......................................................................................................... 4 2.1.1.1. Trade Flow – Details........................................................................................................................ 5 2.2. Exchange Traded Derivatives ............................................................................................................... 6 2.2.1. Exchange Traded Derivatives – Trade Flow ....................................................................................... 7 2.2.1.1. Trade Flow - Details ........................................................................................................................ 8 3. Dodd Frank Act – Title VII....................................................................................................................... 9 3.1. Provisions of Title VII.......................................................................................................................... 9 3.1.1. Market Participants .......................................................................................................................... 9 3.1.2. Roles of Supervisors ...................................................................................................................... 10 3.1.3. Derivatives Market Structure .......................................................................................................... 11 3.1.4. Clearing ........................................................................................................................................ 12 3.1.5. Trading ......................................................................................................................................... 12 3.1.6. Capital & Margining Requirements ................................................................................................. 13 3.1.7. Reporting & Recordkeeping ........................................................................................................... 13 3.1.8. CFTC / SEC Rulemaking Process ................................................................................................... 14 3.2. OTC Derivatives Trading - Under DFA Guidelines .............................................................................. 15 3.2.1. OTC Derivatives – DFA Proposed Trade Flow................................................................................. 15 3.2.1.1. Trade Flow – Details...................................................................................................................... 16 4. Evaluation of Proposed DFA Reforms: .................................................................................................... 17 4.1. Market Participants: ........................................................................................................................... 17 4.1.1. Swap Dealers: ............................................................................................................................... 17 4.1.2. Major Swap Participants (MSPs):.................................................................................................... 17 4.1.3. Commercial End Users:.................................................................................................................. 18 4.2. Regulatory Rulemaking:..................................................................................................................... 18

5. Glossaries: ............................................................................................................................................ 19



1. Executive Summary

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-

Frank Act”) was signed into law by U.S. President Barack Obama. It was designed to make order of

the cascading regulatory chaos that ensued in 2008 when mammoth banks and some unregulated

financial firms collapsed, and public funds were used to save them.

The law touches on nearly every facet of the financial sector. The goals of this legislation are to

achieve following objectives:

Establish a new council of "systemic risk" regulators to monitor growing risks in the financial

system, with the goal of preventing companies from becoming too big to fail and stopping

asset from forming, such as the one that led to the housing crisis.

Create a new consumer protection division within the Federal Reserve charged with writing and

enforcing new rules that target abusive practices in businesses such as mortgage lending

and credit card issuance.

Empower the Federal Reserve to supervise the largest, most complex financial companies to

ensure that the government understands the risks and complexities of firms that could pose a risk

to the broader economy.

Allow the government in extreme cases to seize and liquidate a failing financial company in a

way that protects taxpayers from future bailouts.

Give regulators new powers to oversee the giant derivatives market, increasing transparency by

forcing most contracts to be traded through third-parties instead of only between banks and their

customers. Derivatives, which are complex financial instruments, are often used

to hedge risk. Speculative trading in the contracts led to losses at many banks in the 2008 crisis.

The 2,300-page bill which has 16 Titles is the most extensive overhaul for the U.S. financial

system since the 1930s. The objective of this paper is to analyze the impact of Title VII on OTC

derivatives trading.



2. Derivatives

A derivative is a risk transfer agreement, the value of which is derived from the value of anunderlying asset. The underlying asset could be an interest rate, a physical commodity, a company’sequity shares, an equity index, a currency, or virtually any other tradable instrument upon whichparties can agree.In broad terms, there are two groups of derivative contracts, which are distinguished by the way theyare traded in the market. The first is over-the-counter (OTC) derivatives, which are customized,bilateral agreements that transfer risk from one party to the other. OTC derivatives, which aresometimes called swap agreements or swaps, are negotiated privately between the two parties andthen booked directly with each other. The second category consists of standardized, exchange-tradedderivatives, which known generically as listed derivatives or futures. In contrast with OTCderivatives, listed derivatives are executed over a centralized trading venue known as an exchangeand then booked with a central counterparty known as a clearing house.

2.1. OTC Derivatives

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)

directly between two parties, without going through an exchange or other intermediary. Productssuch as swaps, forward rate agreements, and exotic options are almost always traded in this way.These derivatives are not traded on an exchange, so there is no central counter-party. Therefore,they are subject to counter-party risk, like an ordinary contract, since each counter-parties relieson the other to perform.

The OTC derivative market is the largest market for derivatives, and is largely unregulated withrespect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amountsare difficult because trades can occur in private, without activity being visible on any exchange.According to the Bank for International Settlements, the total outstanding notional amount isUS$684 trillion (as of June 2008 ). Of this total notional amount, 67% are interest rate contracts,8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commoditycontracts and 13% are other types of contracts.

Characteristics of OTC Derivatives are as follows:

• Trades negotiated over-the-counter• Customized contracts are broken down by trading desk into tradable risks and hedged in

liquid markets• Traded between dealers as principals• Dealer is normally counterparty to all trades• Margin (collateral) often exchanged but subject to negotiation between counterparties

2.1.1. OTC Derivatives – Trade Flow

Following diagram illustrates the most common way that OTC Derivatives are traded andcleared.



Page 1

OTC Derivatives – Trade Flow

AgreementTerms

Manual

Confirmation

Data Repositories

Swap Dealer Counterparty

Trading

ElectronicConfirmation

Market Wire

Reporting Reporting

Clearing House

Clearing

12

3

45

6

7

2.1.1.1. Trade Flow – Details

The counterparties to the trade enter into a bilateral trade agreement, the details

of which can be conveyed either manually or electronically.

TF# Trade FlowFunction

Descriptions

Dealer A dealer is a person or organization who “make a market”by maintaining bid and offer quotes to other marketparticipants.

Counterparty Counterparty is a legal and financial term. It means a partyto a contract. Counterparty is usually the entity with whomone negotiates on a given agreement, and the term can referto either party or both, depending on context.

Agreement Terms Agreement Terms specify the delivery and payment termsof underling assets.



ManualConfirmation

Manual confirmation is a direct communication betweenthe counterparties' operations departments.

ElectronicConfirmation

Electronic confirmations are often routed through a tradeprocessing facility (eg MarkitSERV) where the trade detailsare confirmed and the formal clearing of the trade isconducted.

Clearing House A clearing house is a financial institution thatprovides clearing and settlement services for financial andcommodities derivatives and securities transactions. Aclearing house stands between two clearing firms (alsoknown as member firms or clearing participants) and itspurpose is to reduce the risk of one (or more) clearing firmfailing to honor its trade settlement obligations.In OTC Derivatives, trade clearing through Clearing

House is an optional process.

Data Repositories Data Repositories retains the trade information of OTCDerivatives. It is administered by a clearing facility or bythe counterparties themselves depending on how the trade iscleared. In OTC Derivatives, the information in Data

Repositories is not available publically.

2.2. Exchange Traded Derivatives

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via

specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where

individual’s trade standardized contracts that have been defined by the exchange. According to

BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during

Q4 2008. Some types of derivative instruments also may trade on traditional exchanges. For

instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed

on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Like

other derivatives, these publicly traded derivatives provide investors access to risk/reward and

volatility characteristics that, while related to an underlying commodity, nonetheless are

distinctive.

Characteristics of Exchange Traded Derivatives are as follows:

• Trades executed on organized exchanges• Trades limited to standardized contracts• All trades are booked with exchange’s clearinghouse, which is counterparty to all trades• Mandatory margin requirements• Initial margin• Variation margin• Daily settlement (mark to market) and margin calls



2.2.1. Exchange Traded Derivatives – Trade Flow

In Exchange Traded Derivatives, rather than a bilateral agreement, the counterparties

convey their bids and offers to an exchange where the trade is consummated. Trade

information is then sent to the exchange associated clearinghouse where it is cleared.

Once cleared the clearinghouse stands between the counter parties guaranteeing both

sides of the trade. Because of that fiduciary arrangement, access to a clearinghouse isrestricted to clearing members who have satisfied particular financial requirements.

Following diagram illustrates the most common way that Exchange Traded Derivativesare traded and cleared.

Page 1

Exchange Traded Derivatives – Trade Flow

Dealer Counterparty

Trading Trading

Exchange

Clearing

Reporting

Clearing Member

Clearing

Clearing House

1 2

3

4

5

6

Data

Repositories



2.2.1.1. Trade Flow - Details TF# Trade Flow

FunctionDescriptions

Dealer A dealer is a person or organization who “make a market”by maintaining bid and offer quotes to other market

participants.Counterparty Counterparty is a legal and financial term. It means a party

to a contract. Counterparty is usually the entity with whomone negotiates on a given agreement, and the term can referto either party or both, depending on context.

Exchange A futures exchange or derivatives exchange is a centralfinancial exchange where people can tradestandardized futures contracts; that is, a contract to buyspecific quantities of a commodity or financial instrument ata specified price with delivery set at a specified time in thefuture.

Clearing Member Clearing Membership is required for a Counterparty to avail

the facility of a Clearing house. Therefore a non-clearinghouse member wishing to trade on an exchange must havean arrangement with a clearinghouse member to representtheir trades to the clearinghouse.

Clearing House A clearing house is a financial institution thatprovides clearing and settlement services for financial andcommodities derivatives and securities transactions. Aclearing house stands between two clearing firms (alsoknown as member firms or clearing participants) and itspurpose is to reduce the risk of one (or more) clearing firmfailing to honor its trade settlement obligations. A clearinghouse reduces the settlement risks by netting offsetting

transactions between multiple counterparties, byrequiring collateral deposits (a.k.a. margin deposits), byproviding independent valuation of trades and collateral, bymonitoring the credit worthiness of the clearing firms, andin many cases, by providing a guarantee fund that can beused to cover losses that exceed a defaulting clearing firm'scollateral on deposit.

Data Repositories Data Repositories retains the trade information of ExchangeTraded Derivatives. It is administered by a clearing house. The information in Data Repositories is available publically.



3. Dodd Frank Act – Title VII

The OTC derivatives market has been largely unregulated, which critics say permitted significant

risks to build within the financial services industry virtually unchecked. In the wake of the financial

crisis in 2008, regulation of derivatives became a primary focus of financial regulatory reform. Title

VII of the Dodd-Frank Act, entitled the Wall Street Transparency and Accountability Act of 2010,

establishes a new framework for regulatory and supervisory oversight of the over-the-counter(“OTC”) derivatives market, which is estimated at more than $600 trillion.

The new regulatory framework described in Title VII requires achieving following objectives:

• The Commodity Futures Trading Commission (“CFTC”) and the Securities and ExchangeCommission (“SEC”) to share regulatory and supervisory authority for OTC derivatives (i.e.,swaps and security-based swaps, respectively – hereinafter “swaps”) and to participate jointlyin the rule-making process.

• Mandatory clearing for swaps accepted by a clearing entity and designated by the CFTC andSEC as clearable.

• Mandatory execution of cleared swaps on a regulated exchange or swap execution facility

(“SEF”).• Mandatory reporting of cleared and non cleared swaps to a trade repository or the CFTC or

SEC.

• Capital and margin requirements with higher requirements to be imposed on un-clearedswaps.

• Prohibitions on certain swap activities for insured depository institutions.

• Public access to swap transaction volume and pricing data.

• The CFTC and SEC are required to promulgate final rules implementing the provisions of Title VII within 360 days of enactment.

3.1. Provisions of Title VII

Highlights of the major provisions of Title VII are discussed below.

3.1.1. Market Participants

Virtually all derivatives market participants are impacted by the legislation, though thedegree of impact depends on how an individual firm is classified. Different rules apply todifferent market participants: swap dealers, major swap participants and commercial end-users.

A “Swap Dealer” is defined as any person whoHolds itself out as a dealer in swaps;Makes a market in swaps;

Regularly engages in the purchase or sale of swaps in the ordinary course of business;

A “Major Swap Participant” (“MSP”) is defined as anyone that maintains a substantialnet position in swaps (excluding positions held for hedging or mitigating commercialrisk) or whose positions create substantial counterparty exposure that could have seriousadverse effects on the financial stability of the U.S. banking system or financial markets.As with swap dealers, a person may be designated as an MSP for one or more categoriesof swaps without being classified as an MSP for all classes of swaps.



“Commercial End Users” are businesses that use derivatives to hedge “commercialrisk,” generally risk from producing or consuming commodities. Commercial end-userswould be exempt from the clearing requirement.

The regulators have significant authority to determine if an end-user is an MSP. Entities

that have a significant swap book and are not commercial hedgers, such as hedge funds,would likely be deemed MSPs. In addition, some large commercial producers, such asmajor oil producers, would likely be deemed MSPs.

3.1.2. Roles of Supervisors

Under the new law, the Federal regulatory supervisors have expanded powers over thederivatives business. The law provides the CFTC and SEC with extensive new authorityand imposes significant requirements on these agencies to regulate the OTC derivativesmarket, products and market participants. The regulatory agencies determine whichmarket participants are subject to the legislation.

Under Title VII, the CFTC has authority over swaps, swap dealers and major swapparticipants, swap data repositories, derivative clearing organizations with regard toswaps, persons associated with a swap dealer or major swap participant, eligible contractparticipants, and swap execution facilities. The SEC has authority over security-basedswaps, security-based swap dealers and major security-based swap participants, security-based swap data repositories, clearing agencies with regard to security-based swaps,persons associated with a security-based swap dealer or major security-based swapparticipant, eligible contract participants with regard to security-based swaps, andsecurity-based swap execution facilities.

Title VII further requires the CFTC and SEC to engage in multiple rulemakings and otherregulatory actions related to derivatives. In advance of rulemakings, the agencies are

required to consult with one another and the Federal prudential regulators (the FederalReserve Board (“Fed”), Office of the Comptroller of the Currency, Federal DepositInsurance Corporation (“FDIC”), Farm Credit Administration, and Federal HousingFinance Agency, as appropriate) to ensure consistency and comparability to the extentpossible. Functionally or economically similar products or entities must be treated in asimilar manner by each of the agencies. Where one agency believes the rules of the othermay pose conflicts, they are permitted to challenge the rule in the U.S. Court of Appealsfor the District of Columbia.

The CFTC and SEC are required to jointly write rules, in consultation with the Fed, toaddress:

Definitions for “swap,” “security-based swap,” “swap dealer,” “security-based

swap dealer,” “major swap participant,” “major security-based swap participant,”“eligible contract participant,” and “security-based swap agreement.”

Books and records to be maintained for security-based swap agreement bypersons recognized as swap data repositories.

Within 180 days of enactment, the CFTC and SEC are to adopt rules to mitigate conflictsof interest at clearinghouses, clearing agencies, exchanges, and swap execution facilities



in regards to bank holding companies with total consolidated assets in excess of $50billion, nonbank financial companies supervised by the Fed, and their affiliates. The rulesadopted may include numerical limits on the control of, or the voting rights of, theseentities.

Title VII gives regulators the ability to limit swap positions held by a derivatives trader or

class of traders. The CFTC imposes aggregate position limits for contracts traded onexchanges, swap execution facilities, non-U.S. boards of trades and swaps that are notcentrally executed. The SEC would be given authority to impose position limits onsecurity-based swaps, including aggregate position limits on security-based swaps andany underlying security or loan that the security-based swap references. The CFTC andthe SEC have further authority to prohibit participation in swaps activity in a foreigncountry that undermines the stability of the US financial market system.In general, the rules required under Title VII must be promulgated in final form no more

than 360 days after the date of enactment unless otherwise specified. (See “CFTC/SEC

Rulemaking Process”).

3.1.3. Derivatives Market Structure

Under the new law, banks can continue to trade most OTC derivatives in-house.Permissible swap and security-based swap transactions include interest rates, foreignexchange, cleared credit default swaps (“CDS”) on investment grade entities, gold andsilver swap transactions, and swaps transactions that hedge a bank’s own risk.

However, under Section 716– the “push-out” provision – swap dealers and MSPs areprohibited from receiving Federal assistance (including access to the Fed discountwindow and FDIC deposit insurance) if they conduct other types of swaps transactionswithin a depository banking institution. This effectively prohibits insured depositoryinstitutions from conducting certain derivatives activities and requires them to “push-out”

the non-permissible swaps activities into a separately capitalized bank holding companyaffiliate. These non-permissible swaps activities include: all commodity, energy andmetals, agriculture, CDS on non-investment grade entities, equities, and uncleared CDS.

A transition period of up to 24 months is available to banks that are required to ceasenon-permissible swaps activities or divest themselves of their swaps activity in order toavoid the prohibition against Federal assistance. The appropriate Federal bankingregulator shall consider the potential impact of divestiture or cessation of activities whenestablishing the transition period. An extension of up to one year may be added to thetransition period following consultation with the CFTC and SEC. The prohibition againstFederal assistance applies only to swaps entered into by an insured institution after theend of the transition period and the prohibition will be effective two years following the

effective date of the legislation.

Derivatives clearing organization, clearing agencies and swap execution facilities mustregister with the CFTC or SEC or both and meet certain requirements including, amongother things, designating a chief compliance officer, adhering to core principals; andreporting requirements.

The CFTC and SEC must issue rules no later than 1 year after enactment requiring swapdealers and MSPs to register with the CFTC or SEC or both. Registered swap dealers and



MSPs are required to meet certain minimum capital and minimum initial and variationmargin requirements as well as business conduct standards and reporting requirements.

3.1.4. Clearing

The legislation mandates clearing of standardized OTC derivatives. The law explicitlyrequires that swap dealers and MSPs use a clearinghouse for standardized or “clearable”derivatives transactions. Under the law, the CFTC and SEC are required to promulgaterules and regulations to provide for the mandatory clearing of such swaps.A swap that is accepted by a derivatives clearing organization (“DCO”) or clearing

agency for clearing and that the CFTC or SEC has designated as clearable must be

cleared. All swaps subject to the clearing requirement must be executed on a designated

contract market, an swap execution facility or an exchange.

Central clearing is initially limited to a few “plain vanilla” swap products. On an ongoingbasis, regulators will review each swap, or any group, category, type, or class of swaps tomake a determination as to whether the swap or group, category, type, or class of swaps

should be required to be cleared.Foreign exchange swaps and forwards are treated as swaps under the law and thereforeare subject to the clearing requirement, unless the U.S. Secretary of the Treasurydetermines otherwise. Note: Foreign exchange swaps and forwards were exempt from theclearing requirement in prior drafts of legislation.

Exceptions to the clearing requirements are provided for:

Commercial end-users, such as farmers, airlines and manufacturers, providedthey explain to regulators how they are meeting their financial obligations withentering into un-cleared swaps.

Affiliates of commercial end users if the affiliate uses swaps to mitigate thecommercial risk of the commercial entity or other affiliate that is not a financialentity.

Except for affiliates that are swap dealers, MSPs, investment companies,commodity pools or bank holding companies with more than $50 billionin consolidated assets. A two-year transition applies.

Swaps entered into before the date of enactment and swaps entered into beforethe application date of the clearing requirement, provided they are reported to aswap data repository or the CFTC or SEC, as appropriate.

Certain depository institutions, farm credit institutions and credit unions with

total assets of $10 billion or less (except for those whose primary business is toprovide financing related to the activities of its parent or holding companyaffiliate) if determined by the CFTC and SEC to be exempt through arulemaking.

3.1.5. Trading

All swaps subject to the clearing requirement must be executed on a regulated exchangeor a swap execution facility. A swap execution facility is defined as “a trading system or



platform in which multiple participants have the ability to execute or trade swaps byaccepting bids and offers made by multiple participants…” It is unclear at this timeexactly what constitutes, and what types of trading platforms may qualify as a swapexecution facility.Section 619 under Title VI of the Dodd-Frank Act prohibits and limits the ability of banking entities from engaging in certain activities (the “Volcker Rule”). These

provisions include prohibitions on “proprietary trading” and investing more than 3percent of the bank’s Tier 1 capital in private equity and hedge funds, and from owningmore than a 3 percent stake in any one private equity or hedge fund. The prohibitions onproprietary trading extend to certain derivatives trading activity. Systemically significantnonbank financial companies are not prohibited from engaging in proprietary trading.However, these companies are subject to additional capital requirements and quantitativelimits determined by the regulators.

3.1.6. Capital & Margining Requirements

Under Title VII, swap dealers and MSPs are subject to capital and margin requirements.The law requires initial and variation margin (also referred to as collateral posting) for all

OTC derivatives that are not cleared. Existing swaps are not specifically exempt from themargin requirement. Regulators are also likely to set minimum margin requirements forclearinghouses.Early versions of the legislation specifically exempted commercial end-users frommargin requirements. This exemption is not in the enacted law, though the sponsoringlegislators have indicated that their intent was to provide such an exemption.Section 171 under Title I of the Dodd-Frank Act (the “Collins Amendment”) requiresFederal banking agencies to set leverage and risk-based capital requirements for insureddepositories, depository holding companies and systemically significant non-banks. Suchrequirements must at a minimum address such risks as significant volumes of derivativesactivity or activity in securitized products, financial guarantees and certain other financialinstruments, as well concentrations in assets or market share. Presumably, capital

requirements developed by supervisors for depositary institutions will be consistent withthe soon-to-be-revised Basel Capital guidelines.

3.1.7. Reporting & Recordkeeping

Under Title VII, all swap dealers and MSPs are required to maintain daily trading recordsof swaps. These daily records include recorded communications, such as electronic mail,instant messages and recordings of telephone calls; daily trading records for eachcustomer or counterparty; and a complete audit trail for conducting comprehensive andaccurate trade reconstructions.The law also requires data collection and publication through clearing houses or traderepositories. Each DCO is specifically required to publicly disclose followinginformation:

The terms and conditions of each contract, agreement or transaction cleared andsettled.

Clearing and other fees charged members; Its margin setting methodology; Daily settlement prices, volume and open interest for each contract settled or

cleared.



Repositories have already been launched for credit and interest rate products and theindustry is in the process of building a repository for equity derivatives. All trades thatare cleared and un-cleared will be recorded in these repositories.Transition rules provide that swaps entered into prior to the enactment date that are stilloutstanding as of the enactment date must be reported to a swap data repository or the

CFTC or SEC, as appropriate. Similarly, swaps entered into after the enactment date andprior to the effective date will also be required to be reported. The CFTC and the SEC arerequired to issue an interim final rule regarding these reporting requirements within 90days after enactment.

3.1.8. CFTC / SEC Rulemaking Process

While the Dodd-Frank Act establishes the broad outline of OTC derivatives marketregulation, many questions about its impact and scope remain unanswered and are left tothe CFTC and SEC to determine. These agencies are required to promulgate final rulesno later than 360 days following enactment.In advance of the official rule-writing process, the CFTC has identified 30 topics where

rule-writing is necessary to regulate the swaps markets. The rule-writing areas have beendivided into eight groups:

Comprehensive Regulation of Swap Dealers & Major Swap Participants; Clearing; Trading; Data; Particular Products; Enforcement; Position Limits; Other Titles;

The CFTC indicates that teams of staff within the agency have been assigned to eachrule-writing area and will be involved with the process “from analyzing the statute’srequirements, to broad consultation, to recommending proposed rulemakings topublishing final rules.” The CFTC is currently soliciting public input on each of the areas.Comments may be submitted through the CFTC web site and will not be consideredofficial responses to a specific rulemaking.Similarly, the SEC has also identified broad areas for which it is seeking public input inadvance of rule-writing. With regard to Title VII, these areas include:

Definitions (e.g., “swap,” “security-based swap” and “mixed swap”); Security-based swap dealers and major security-based swap participants; Mandatory clearing of security-based swaps, end-user exception and security-

based swap clearing agencies;

Mandatory exchange trading and swap execution facilities; Governance and conflict of interest controls for clearing agencies, swap

execution facilities and exchanges; Swap data repositories; Real-time reporting; Anti-manipulation protections.



3.2. OTC Derivatives Trading - Under DFA Guidelines

All Standardized swaps will be traded on exchanges or on Swap Execution Facilities (left

undefined in DFA, but will likely include many of the current electronic trading platforms in

addition to new entrants to the market). Once the trade is completed it must be cleared, the same

way that exchange traded derivatives are currently cleared. A clearinghouse could also clear

swaps trades executed on a Swap Execution Facility when such arrangements are established.All un-cleared swaps could be cleared in much the same way as an OTC trade is cleared.

3.2.1. OTC Derivatives – DFA Proposed Trade Flow

Following diagram illustrates the proposed trade flow of OTC Derivatives:

Page 1

OTC Derivatives – Trade Flow (Proposed under DFA)

Swap Dealer Major Swap Participant

Trading Trading

Clearing

Reporting

Clearing Member

Clearing

Clearing House

1

Eligible for

Clearing

Swap Execution Facility

Un - ClearedSwap

Manual

Confirmation

ElectronicConfirmati

No Yes

Swap Data

Repositories

Reporting

Reporting

2

3

4

5

7

6

8



3.2.1.1. Trade Flow – Details

TF# Trade FlowFunction

Descriptions

Swap Dealer A dealer is a person or organization who “makes a market”by maintaining bid and offer quotes to other market

participants.Major SwapParticipant

A “Major Swap Participant” (“MSP”) is defined as anyonethat maintains a substantial net position in swaps or whosepositions create substantial counterparty exposure that couldhave serious adverse effects on the financial stability of theU.S. banking system or financial markets.

Clearing Eligibility Derivative contracts which are unique and created formitigating commercial risks are exempted from centralizedclearing. All other derivatives contract would have to gothrough centralized clearing process.

Un-cleared Swap Un-cleared OTC Contracts are contracts which are exemptefrom centralized clearing processes. These transactions will

receive advantageous treatment, which implies less stringencapital and margining requirements than will be applicableto the outright trading of tailored swaps. These Swaps mayfollow the current OTC Derivatives trade flow.

Swap ExecutionFacilities

A Swap Execution Facilities will be a trading system orplatform in which multiple participants have the ability toexecute or trade swaps by accepting bids and offers made byother participants that are open to multiple participants in thfacility or system, through any means of interstatecommerce. The execution of cleared swap will be mandatoron Swap Execution Facilities.

Clearing Member Clearing Membership is required for a Counterparty to avai

the facility of a Clearing house.

Clearing House A clearing house is a financial institution thatprovides clearing and settlement services for financial andcommodities derivatives and securities transactions. Aclearing house stands between two clearing firms (alsoknown as member firms or clearing participants) and itspurpose is to reduce the risk of one (or more) clearing firmfailing to honor its trade settlement obligations. A clearinghouse reduces the settlement risks by netting offsettingtransactions between multiple counterparties, byrequiring collateral deposits (a.k.a. margin deposits), byproviding independent valuation of trades and collateral, bymonitoring the credit worthiness of the clearing firms, and imany cases, by providing a guarantee fund that can be usedto cover losses that exceed a defaulting clearing firm'scollateral on deposit.

Swap DataRepositories

All Cleared and un-cleared Swaps information will bereported to Swap Data Repositories. Public will be able toaccess the volume and pricing details of all SwapTransactions.



4. Evaluation of Proposed DFA Reforms:

The main market failures in the OTC derivatives market are the buildup of excess leverage, opacityand difficulties of resolution when a large counterparty gets into trouble. Does the Wall StreetTransparency and Accountability part of Dodd Frank Act on financial reforms address these issues?

4.1. Market Participants:

Key provisions of Title VII – including clearing, trading, capital, margining, reporting andrecordkeeping requirements -- are likely to fundamentally alter the OTC derivatives market. Asstated earlier, virtually all derivatives market participants are impacted by the legislation, thoughthe degree of impact will depend on how an individual firm is classified: swap dealer, majorswap participant or commercial end-user. Some potential key strategic impacts to consider foreach of these classifications include:

4.1.1. Swap Dealers:

Increased transparency from the exchange trading/swap execution facility requirement

could reduce dealer profits but could also impact availability and liquidity for certainbespoke and non-standardized contracts.

New entrants may try to capture a piece of the derivatives business that becomesmore standardized and exchange traded.

Increased regulation, potentially decreased profits and the prospects of increasedcompetition from new market entrants may further alter the dealer landscape.

Margining and other requirements could raise the cost of certain swaptransactions. Swap dealers will almost certainly need more capital to supporttheir derivatives businesses.

The structure of major dealers’ swaps businesses may change. Dealers may look to optimize where they book derivatives within their organizational structuresand global office networks. New corporate governance structures will be requiredto oversee the derivatives businesses in the new entities created for activity“pushed out” of the banking entity.

4.1.2. Major Swap Participants (MSPs):

MSPs face many of the same requirements as dealers. Some MSPs may decide toshrink their businesses to avoid dealing with MSP requirements. Others will seeopportunities to expand into an area previously dominated by a handful of

dealers.

In either event, MSPs will need to review their derivatives governance, activities,operational support and related areas to ensure they are structured andfunctioning within appropriate guidelines.



5. Glossaries:

Term Description

SEC The U.S. Securities and Exchange Commission (frequently abbreviated SEC) is

a federal agency which holds primary responsibility for enforcing the federalsecurities laws and regulating the securities industry, the nation's stock andoptions exchanges, and other electronic securities markets in the United States.

CFTC The U.S. Commodity Futures Trading Commission (CFTC) is an independentagency of the United States government that regulates futures and optionmarkets.

FDIC The Federal Deposit Insurance Corporation (FDIC) is a United Statesgovernment corporation, which guarantees the safety of deposits in memberbanks, currently up to $250,000 per depositor per bank.

BIS The Bank for International Settlements (BIS) is an intergovernmentalorganization of central banks which "fosters international monetary andfinancial cooperation and serves as a bank for central banks..

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