foley deloitte presentation · this presentation focuses on swaps and the cea derivatives...

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Agenda

Overview of Regulatory Framework for DerivativesOverview of Trade Execution & On-BoardingOverview of Clearing and Protection of Customer FundsClearing: When is it Required, What are the Choices and Who Gets to Make Them?Basic Credit Considerations for SwapsPotential Business ImplicationsCounterparty Considerations


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Part I

Overview of Regulatory Framework for Derivatives:– Statutes & Regulators – Derivatives Products – Market Facilities– Market Participants

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Statutes & RegulatorsStatute: Commodity Exchange Act (CEA):

– Derivatives covered: futures / options on futures, commodity options,** security futures /options on security futures,* swaps, mixed swaps,* retail forex, retail commodity, leverage, hybrid securities* / banking products (unless covered by exemption).

– *Regulated jointly with SEC. **Commodity options now regulated as swaps.Regulators:

– Primary Federal Agency: Commodity Futures Trading Commission (CFTC)– Prudential Regulators: Federal Reserve Board, Office of the Comptroller of the Currency,

Federal Deposit Insurance Corporation, Farm Credit Administration and Federal Housing Finance Agency.

Regulate banks and other entities under their prudential regulation that are swap dealers, security-based swap dealers, major swap participants and major security-based swap participants in certain areas, e.g., margin for uncleared swaps and capital requirements.

– Self-Regulatory Organizations (SROs):National Futures Association (NFA)Futures exchangesClearinghouses


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Statutes & RegulatorsStatutes: Securities Exchange Act of 1934 (Exchange Act) & other federal securities laws:

– Derivatives covered: options on securities and securities indices, security futures and options on security futures,* security-based swaps, mixed swaps,* hybrid securities.**

– * Regulated jointly with CFTC. ** Regulated jointly with CFTC unless covered by exemption from CEA, in which case regulated by SEC only.

Regulators:– Primary Federal Agency: Securities and Exchange Commission (SEC)– Prudential Regulators: Same as under CEA.

Regulate banks and other entities under their prudential regulation that are swap dealers, security-based swap dealers, major swap participants and major security-based swap participants in certain areas, e.g., margin for uncleared swaps and capital requirements.

– Self-Regulatory Organizations (SROs): Financial Industry Regulatory Authority (FINRA)National securities exchangesClearing agencies

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The Wall Street Transparency and Accountability ActTitle VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Amended CEA and Exchange Act to provide for comprehensive regulation of over-the-counter (OTC) derivatives, i.e., swaps and security-based swaps.CFTC regulates swaps, such as:

– Interest rates, foreign currencies and swaps on a broad-based index of securities, including credit default swaps (CDS) on a broad-based index of reference obligations or issuers (> 9 plus other conditions); and

– Swaps on physical commodities.

SEC regulates security-based swaps, i.e., swaps on an individual security or narrow-based index of securities, such as:

– Single-name CDS and CDS on a narrow-index of reference obligations or issuers (≤ 9 plus other conditions).

CFTC and SEC jointly regulate mixed swaps, i.e., security-based swaps with a “commodity” component. This presentation focuses on swaps and the CEA derivatives regulatory framework.


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CEA Derivatives ClassificationsCorresponding to Differences in Regulation

Futures on commodities and options on futures (collectively, futures) – Futures are “contracts of sale of a commodity for future delivery,” but deferred delivery

commercial merchandizing contracts are excluded.– Commodity is broadly defined.– Exchange-trading requirement; trades must be cleared.

Swaps and mixed swaps– Broad definition of swap.– Shorthand for derivatives commonly traded on a bi-lateral, OTC basis.

Options on commodities– Subject to CFTC plenary authority to regulate.– Covered by swap definition; CFTC will regulate as swaps, but exempts trade options from

almost all swaps regulation.

Other: Retail forex (e.g., rolling spot), retail commodity, leverage contracts, hybrid securities, security futures and options on security futures.

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Market Facilities: TradingFutures exchanges, called designated contract markets (DCMs)

– Centralized, competitive auction markets; limited trading off facility pursuant to trade rules.– May list futures and swaps; all trades must be cleared.– Examples: Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile

Exchange, ICE Futures U.S.– No requirement that participants be eligible contract participants.

Swap execution facilities (SEFs)– May only list swaps. – Platforms for displaying trading interest; function is to provide price transparency.– No centralized competitive market requirements.– Participants must be eligible contract participants.

OTC trading of swaps will also still continue; futures must be traded on or pursuant to the rules of a futures exchange.


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Market Facilities: Clearing and Swaps Trade Reporting

Clearing:– Clearinghouses, called derivatives clearing organizations (DCOs)

May clear futures and swaps.General regulatory requirements the same for futures and swaps, but with some important differences.

– A clearinghouse may also clear swaps pursuant to CFTC exemption from DCO registration.

– Examples: Chicago Mercantile Exchange (CME), London Clearing House (LCH), ICE Clear U.S. and ICE Clear Credit.

Swap Trade Reporting:– Swap Data Repositories (SDRs).– CFTC, if no SDR exists to accept reports of trades for a type of swap.

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Market Professionals CEA Baseline Registration Categories

Futures Commission Merchant (FCM) –– Executes and/or clears transactions in futures and/or swaps.– May carry customer accounts; may receive and hold customer funds.– Carrying v. non-carrying; clearing v. non-clearing.

Introducing Broker (IB) –– May solicit customers/orders for futures and/or swaps but may not carry

customer accounts or hold customer funds.– Introduces customers to one or more FCMs.

Commodity Trading Advisor (CTA) –– Trading advisor for futures and/or swaps.

Commodity Pool Operator (CPO) –– Operator of a pooled investment vehicle that trades futures and/or swaps.


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Market Professionals New CEA Registration Categories - Swap Dealers

CEA and CFTC Rule 1.3(ggg) baseline definition includes 4 separate subjective tests. A Swap Dealer is a person that:

– holds itself out as a dealer in swaps; or– makes a market in swaps; or– regularly enters into swaps for its own account in the ordinary course of business; or– engages in activities causing the person to be commonly known as a dealer or market

maker in swaps.

Definition excludes a person that enters into swaps but not as part of a regular business.CFTC adopting release provides interpretive guidance.CFTC definition includes bright line exclusions of certain transactions from analysis, e.g., transactions between majority-owned affiliates and physical hedge transactions.

– Trade options also excluded from the analysis by operation of the trade option exemption.

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Market Professionals New CEA Registration Categories - Swap Dealers

De minimis exclusion is available if:– Over the prior 12 months (rolling basis),* – The person’s transactions constituting swap dealing and/or those of its control affiliates, – Do not exceed $8B ($25M in trades with special entities) in aggregate gross notional amount (calculated

taking into account any leverage features under the terms of a trade).

*De minimis exclusion provides a reset opportunity because counting of positions starts on the effective date of the swap definition rule (once adopted).

– Effective date of swap definition rule is expected to be 60 days after publication in the Federal Register.– Exclusion effectively postpones the deadline for filing a swap dealer registration application since that

deadline is the effective date of the swap definition rule.

But a swap counterparty should assess its status using historical data to identify if it could, absent prospective changes to its swaps trading, be deemed a dealer and outside the de minimis exclusion.If initially not a swap dealer, a counterparty has an ongoing obligation to monitor swap trading activities to determine if it has moved into the definition.


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Market Professionals New CEA Registration Categories – Major Swap Participants

Swap Dealers are excluded from the definition.CEA and CFTC Rule 1.3(hhh) definitions include 3 separate tests, generally intended to capture firms whose positions raise systemic risk concerns in the event of their default.

– Only first of the three tests excludes (i) positions held for “hedging or mitigating commercial risk,” and (ii) positions maintained by an employee benefit plan as defined in §§ 3(3) or (32) of ERISA for the “primary purpose of hedging or mitigating any risk directly associated with the operation of the plan.”

The tests are technical and complex, and involve quantification of a person’s “aggregate uncollateralized outward exposure” and “aggregate potential outward exposure” under its open swaps positions to determine if they exceed prescribed thresholds. CFTC has stated it expects only a few firms will be covered in each of the major swap categories (rates, credit, equity and other).Non-Swap Dealers nonetheless will have to undertake this separate analysis, as an initial matter and periodically thereafter. A party could be covered by virtue of guaranteeing performance of counterparties under their swaps transactions, even if the guarantor does not itself enter into swaps.

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Market Participant Classifications of Regulatory Significance, But No CFTC Registration Required

Eligible Contract Participant (ECP)– Status required to trade swaps on a SEF or bi-laterally.– Dodd-Frank amended the CEA definition.– CFTC Rule 1.3(m) further defines the term.

End-User– Enjoys special rights not available to swap dealers or major swap participants, but may also have to be a

non-Financial Entity for certain benefits.

Financial Entity– May not rely upon end-user exception from mandatory clearing and trading requirements for swaps; also

relevant in other contexts (e.g., defining a major swap participant and major security-based swap participant; allocating swap data reporting responsibility between counterparties).

– Definition covers swap dealers, major swap participants, security-based swap dealers, major security-based swap participants, commodity pools (as defined in § 1a(10) of the CEA), private funds (as defined in § 202(a) of the Investment Advisers Act of 1940), employee benefit plans as defined in ¶¶ (3) and (32) of § 3 of ERISA), and persons predominantly engaged in activities that are in the business of banking or financial in nature (as defined in § 4(k) of the Bank Holding Company Act of 1956).


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Market Participant Classifications of Regulatory Significance, But No Registration Required

Special Entity– Receives special protections when facing a swap dealer or major swap participant.– Definition covers:

A Federal agency; A State, State agency, city, county, municipality, other political subdivision of a State, or an instrumentality, department or a corporation of or established by a State or political subdivision of a State; An employee benefit plan subject to Title I of ERISA; A governmental plan, as defined in § 3 of ERISA; An endowment, including an endowment that is an organization described in § 501(c)(3) of the Internal Revenue Code of 1986; or An employee benefit plan defined in § 3 of ERISA not otherwise defined as a Special Entity, that elects to be a Special Entity by notifying a swap dealer or major swap participant of its election prior to entering into a swap with a particular swap dealer or major swap participant.

Hedgers– Multiple definitions of hedging for different regulatory purposes, e.g., exemption from position limits or

exclusion of hedge positions from swap dealer analysis.

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DFA Amendments: CEA Regulatory Oversight Snap Shot

Commodity Futures Trading Commission (CFTC)

Exchanges and Swap Execution

Facilities

Clearinghouses Swap Data Repositories

National Futures Association (NFA)

Members / Participants

Clearing Members /Participants

Registered Industry Professionals

Market Participants


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Part II

Overview of Trade Execution & On-Boarding

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Execution Arrangement Comparison: Materials Prepared by FIA & ISDA


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Part III

Overview of Clearing and Protection of Customer Funds


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What is a Clearinghouse, or Derivatives Clearing Organization (DCO)?

As defined in CEA § 1a, a DCO is:– “…a clearinghouse, clearing association, clearing corporation or similar entity, facility, system, or

organization that, with respect to an agreement, contract, or transaction—(i) enables each party to the agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the derivatives clearing organization for the credit of the parties;(ii) arranges or provides, on a multilateral basis, for the settlement or netting of obligations resulting from such agreements, contracts, or transactions executed by participants in the derivatives clearing organization; or(iii) otherwise provides clearing services or arrangements that mutualize or transfer among participants in the derivatives clearing organization the credit risk arising from such agreements, contracts, or transactions executed by the participants.”

A DCO is subject to detailed regulation under CEA core principles set out in Section 5b, CFTC Part 38 Rules and other CFTC rules, in areas ranging from risk management and default management, financial resources, settlement procedures, treatment of funds, eligibility of products to clear, clearing membership standards and legal risk considerations.

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Clearinghouse Operations and Risk Management

Clearinghouse as central counterparty (CCP) and the clearinghouse guarantee.

– Upon acceptance of a trade for clearing, through a process referred to as novation, the clearinghouse becomes substituted as the buyer to the clearing member seller and the seller to the clearing member buyer.

– The clearinghouse has a “flat” position.– The clearinghouse’s obligations and guarantee extend only to

the clearing members and not to their underlying customers.


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Clearinghouse Operations and Risk ManagementA clearing member must be registered with the CFTC as an FCM to clear trades in futures or swaps for customers. A clearing member FCM has separate “house” and “customer” clearing accounts at the clearinghouse.

– Customer positions are recorded in the customer account on an omnibus basis; may change for cleared swaps under CFTC cleared swaps customer funds segregation rules.

– Trades of affiliates are cleared in the house account, along with the clearing member’s own trades, also on an omnibus basis.

– The FCM acts as “agent” for customer trades and as “principal” for house trades.

The clearinghouse holds customer funds in segregated, commingled accounts at one or more custodian banks or trust companies.

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Clearinghouse Operations and Risk Management

Daily settlement cyclesPosition Netting / CompressionInitial Margin

– Margin requirements at two levels: Clearinghouse collection of margin from clearing membersFCM collection of margin from customers

– Margin methodology

Variation Margin (Mark-to-Market Adjustments)Guarantee Funds: funded by clearing members


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Clearinghouse Default ManagementTransfer (port) customer positions and funds to one or more other clearing members.Liquidation of positions.Coordination across clearinghouses to manage default of common clearing member.Covering losses – Applying the financial resources waterfall:

– Defaulting clearing member’s margin deposits.– For cleared swaps, CFTC limits on recourse by clearinghouse against customer funds

deposited by the defaulting clearing member (more on this below).– Clearinghouse may apply excess funds in the clearing member’s house account to satisfy

amounts owed in the customer account, but not vice versa.

Defaulting clearing member’s deposit to the guarantee fund. Recourse to any other assets of the defaulting clearing member held by the clearinghouse.Financial resources or reserves of the clearinghouse.

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Clearinghouse Default Management: Mutualizing the Risk

Guarantee fund deposits of non-defaulting clearing members and/or clearinghouse assessment authority; other (less favored) mechanisms. Worst case scenario: Clearinghouse insolvency

– Clearinghouse as “commodity broker” under Subchapter IV of Chapter 7 of the Bankruptcy Code and CFTC Part 190 Rules, if U.S. based.

– However, foreign insolvency laws will likely apply to CFTC-regulated DCOs located in foreign jurisdictions. (There are several.)

– Potential access to Fed window if the DCO is designated as systemically important.


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Other Clearing ConsiderationsClearing “silos” within a clearinghouse and measures to insulate one silo from consequences of a default in another silo.Cross-border/multi-jurisdiction issues for clearinghouses subject to multiple regulators, multiple legal enforceability (governinglaw) regimes and/or non-U.S. bankruptcy regime.Regulation of clearinghouse risk management.Clearing membership requirements:

– Net capital requirements.– Financial reporting and monitoring. – Customer funds segregation reporting and monitoring.

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Clearing Intermediaries for Futures & Swaps: FCMs

To provide market users with intermediated access to a clearinghouse for exchange-listed futures and options on futures and for swaps transactions, a firm must be registered with the CFTC as an FCM and a member of NFA.To clear trades directly on a clearinghouse, it must be a member of that clearinghouse, otherwise it must clear trades through a clearingmember FCM, either on an omnibus basis (more common) or a fully-disclosed basis.An FCM is subject to regulation in a number of areas, including net capital requirements, financial reporting and segregation requirements with respect to holding customer funds.


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Protection of Customer Funds: FuturesFCM is obligated to hold futures customer funds on a segregated basis. Unlawful under the CEA for any person receiving customer funds from an FCM which are to be held on a segregated basis, such as a clearinghouse, custodian bank or another FCM, to treat those funds as belonging to anyone other than the depositing FCM’s customers.The CFTC has detailed segregation rules (principally Rules 1.20 - 1.31).An FCM must hold in segregation, at a minimum, an amount that covers its liabilities to its futures customers, i.e., sum of its customers’positive account balances.

– Customer debit balances do not reduce amount to be held in segregation.– Implied “top up” obligation to cover futures customer account debit

balances.

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Protection of Customer Funds: Cleared Swaps -Transitional Basis

Prior to Dodd-Frank, the CEA did not impose any customer funds segregation requirements with respect to cleared OTC derivatives.The CFTC does not currently impose segregation requirements.FCMs and clearinghouses, though, are typically required to hold customer funds on a segregated basis pursuant to:

– Clearinghouse segregation rules modeled after the CFTC’s segregation rules for futures; or

– A CFTC “4d order” permitting OTC derivatives to be held in futures accounts; or

– Exchange or clearinghouse rules that deem an OTC transaction to be exchanged for a futures contract upon acceptance for clearing.


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Protection of Customer Funds: Cleared Swaps -Under Dodd-Frank Framework

DFA added provisions to the CEA for segregation of cleared swaps customer funds that follow closely (but not exactly) the existing CEA provisions for segregation of futures customer funds.

CFTC Part 22 Rules impose a segregation approach that differs in important respects from futures segregation, referred to as Legal Segregation with Operational Commingling, or “LSOC.”

– In the event that a clearing member defaults due to the default of an underlying swaps customer, the clearinghouse would essentially have to treat the defaulting swaps customer as a separate account, as a means to isolate the losses of that customer.

– The clearinghouse would not have any recourse to the funds of the non-defaulting customers of the defaulting clearing member to cover the losses of the defaulting customer.

Part 22 Rules deferred compliance date: November 8, 2012.

Part 22 Rules do not provide absolute protection against fellow customer default risk due to timing of clearing settlement cycles and do not protect customers against loss of segregated funds due to other causes.

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Customer Funds Protection: Bankruptcy Considerations

FCMs are liquidated as “commodity brokers” under subchapter IV of chapter 7 of the Bankruptcy Code, if U.S. based. Chapter 11 unavailable.

– Special risk considerations for FCMs providing customers with access to non-U.S. futures markets through affiliated foreign brokers.

– For an FCM organized under the laws of a foreign jurisdiction, it cannot be assumed that the foregoing provisions would apply. As a practical matter, FCM clearing members will be organized in the U.S.

CFTC Part 190 Rules, adopted pursuant to statutory authority, define pools of “customer property” in a commodity broker liquidation.

– Separate classes for futures segregated funds and cleared swaps segregated funds, as well as for funds for foreign futures trading and delivery property.

– In event of a shortfall, pro-rata distribution by class of customer property.


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Customer Funds Protection: Bankruptcy Considerations

No SIPC insurance coverage for any shortfall in funds to cover futures or cleared swaps customers’ account balances.The 10 largest FCMs, in terms of amount of futures customer segregated funds held, are dually-registered as FCMs and broker-dealers.Bankruptcy liquidation of such a firm triggers both SIPA and commodity broker liquidation provisions.Potential overlay of FDIC orderly liquidation authority if it isdetermined (among other things) that the clearing member’s failure poses significant financial risk to U.S. financial stability.

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Part IV

Clearing: When is it Required, What are the Choices and Who Gets to Make Them?


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Mandatory Clearing & Trading Requirements for Swaps

Mandatory Clearing– The CFTC is authorized to designate types or classes of OTC derivatives, i.e., swaps, that

must be cleared. – If a transaction is in a type of swap that is subject to a CFTC mandatory clearing

determination, it must be submitted to a clearing organization that is registered with the CFTC as a DCO or that is operating pursuant to an exemption from DCO registration from the CFTC.

– If the transaction is traded on a DCM, even if not subject to a mandatory clearing determination, it must nonetheless be cleared.

Mandatory Trading– A swap of a type covered by a mandatory clearing determination must also be executed on a

CFTC-regulated futures exchange, i.e., a DCM or SEF, if one lists the instrument for trading.– To trade swaps on an OTC basis or on a SEF (but not on a DCM), a party must be an eligible

contract participant.

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End-User Exception from Mandatory Clearing & Trading Requirements for Swaps

Under CFTC proposed Rule 39.6, the exception is available if:

– The counterparty electing to use the exception (the “electing counterparty”) is not a financial entity;

– The electing counterparty is using the swap to hedge or mitigate commercial risk; and

– The electing counterparty provides or causes to provide to an SDR or, if none is available, to the CFTC, information required by the proposed rule, including how it generally meets its financial obligations under its non-cleared swap transactions.


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Mandatory Determination Process

CFTC Rule 39.5 sets out the review procedures the CFTC will follow for determining which types of swaps should be subject to mandatory clearing, along with stay procedures for reconsidering a prior determination.Although the rule took effect on September 26, 2011, the CFTC has not, to date, made any such determinations, and it is not expected to do so until after it has adopted a swap definition rule.

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Non-Mandatory Availability of ClearingA DCO may provide clearing for types of swaps that are not subject to mandatory clearing.

– CFTC will separately consider whether a DCO generally meets the standards to be eligible to clear a particular type of swap on a non-mandatory basis.

Swaps clearing exists today and pre-dates Dodd-Frank. – Several DCOs offer clearing for interest rate swaps, CDS and energy and ag-

related swaps, e.g., CME, LCH, ICE Clear Credit. – Unlikely that all swaps for which clearing is currently available will be subject to

mandatory clearing (at least not in the foreseeable future).– Chairman Gensler has indicated that interest rate and credit swaps will be part of

the CFTC’s initial round of mandatory determinations.


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Open Access to Clearing and Cross-Market Fungibility

A DCO must provide for non-discriminatory clearing of OTC swaps and swaps executed on or through the rules of an unaffiliated DCM or SEF. In addition, it must treat swaps submitted to it that have the same terms and conditions as economically equivalent and subject to offset against one another within the DCO. Thus, a cleared swap position may be established in one available trading venue and liquidated in another.

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Clearing Choice When Mandatory Clearing Applies

If the end-user exception is available, the end-user that qualifies for exception decides whether to invoke it.If a choice of clearing is available, and one party to the transaction is a swap dealer or major swap participant, but the other party is not a swap dealer, security-based swap dealer, major swap participant or major security-based swap participant, i.e., it is the end-user party, the end user party gets to choose where to clear the trade.If a choice of clearing is available, and the parties have the same status, they have to agree where to clear the trade.


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Clearing Choice When Not Mandated

If clearing is not mandated but is available, if one party to the transaction is a swap dealer or major swap participant, but the other party is not a swap dealer, security-based swap dealer, major swap participant or major security-based swap participant, i.e., it is the end-user party, the end user party may nonetheless require the trade to be cleared.

– The end-user also gets to decide where to clear the trade, if a choice is available.

If the parties have the same status, they have to agree upon whether and, if a choice is available, where to clear the trade.

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Part V

Basic Credit Considerations for Swaps


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Credit ConsiderationsWhen choice to clear or not clear is available:

– Comparison of protection of funds under credit support documents(uncleared) to protections under regulatory framework for cleared swaps (cleared).

Is collateral posted with the counterparty held in safekeeping or not?If no, clearing may provide greater protection but if yes clearing may not.

– Due diligence / credit risk analysis of counterparty and (if applicable) custodian holding collateral in safekeeping (uncleared) v. due diligence of FCM and DCO (cleared).

– Comparative analysis of bankruptcy issues and protections.

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Credit ConsiderationsCleared transactions

– Selecting the FCMCapital requirements; excess net capital.Customer funds held in segregation; excess funds held in segregationOrganized in U.S. or foreign jurisdiction: protections in the event of the FCM’sbankruptcy under U.S. law v. foreign insolvency law.

– Selecting the DCO when a choice is availableFinancial resources, treatment of funds, default management procedures, etc.Whether organized in U.S. or foreign jurisdiction; comparison of protections in the event of the DCO’s bankruptcy under U.S. law v. foreign insolvency law.

– Credit exposure issues during window between execution of a swap transaction and acceptance of the transaction by a DCO for clearing or if transaction is not accepted for clearing.


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Part VI

Potential Business Implications

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Key Category 2012

Dodd-Frank Act (DFA) First Year Anniversary

2013 2014

1/177/21

2011

DFA Milestones

RegistrationEntity Definitions Products Definitions

Business Conduct and Conflict of Interest

Anti-Manipulation Disruptive Trading Practices

Whistleblowers Business Conduct Standards (Counterparties)

Business Conduct Standards (Internal)

Recordkeeping and Reporting

Large Swaps Trader Reporting

Real-Time Reporting

Recordkeeping and Reporting RequirementsSwap Data Repositories Registration

Indicative high-level implementation timeline and potential IT implications

Central Clearing, Collateral and Margin

Capital & Margin for Non-Banks

End-User Exception

Segregation & Bankruptcy for Cleared and Uncleared Swaps

Mandatory Clearing Clearing documentation and clearing member risk manageme

Position Limits

Agricultural Swaps

Governance on Ownership & Control

Position Limits, incl. Bona Fide Hedging

Electronic Trading SEF Registration Requirements

Registration

1

DCO Core Principles

Final DateKey: Assumed Compliance Date Milestone within Rule

2 3 4 5

1 2 3 4

1 2 3 4

1 2 3 4 5

1 2 3

1 2 3

1 2

1

Today

Source: Deloitte Development LLP


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Revenues from OTC derivatives may experience a significant drop, primarily driven by the margin compression in centrally cleared products.

Potential impacts on OTC revenues from central clearing

Exchange trading

Exchange trading of OTC derivatives may lead to narrower bid-ask spreads:

•When dividend swaps started trading on the Eurex exchange in July 2008, bid/ask spreads declined by ~75%

Increased transparency

Increased transparency and trade reporting may further reduce bid/ask spreads:

•U.S. corporate bonds saw 8% - 30% compression after trade reporting and compliance engine

Cost-volume correlation

Reduction in trading-price levels may lead to growth in trading volumes:

•ICAP projects 175% volume increase for a 50% cost decrease

Industry revenue impact2Margin compression1

Non-OTC62

OTC33

Non-OTC62

OTC21.2

95

83.2

From margin compression

~35%

Total revenues($ bn)

Revenues after margin compression ($ bn)

Source:1 JPM Report - Investment Banking wallet outlook (September 2010), ICAP Post Trade

Risk and Information Investor Day (September 2010) 2 Citi Investment Research & Analysis Research Report (April 2010): Excludes ~$55B

of revenues from FX products that are likely to be excluded from the new rules governing derivatives

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The OTC derivatives market is entering a new era of commoditized products and fiercer competition with potentially a significant first mover advantage.

Early mover advantage

Early mover advantage

• In highly commoditized environments, larger investment banks will likely be more profitable, which may create a “virtuous cycle” with higher trade volumes leading to better economies of scale

• The ‘first mover advantage’ can be significant in the universe of centralized clearing

• It may require substantial capital and technological investments

Changing market landscape• Smaller broker-dealers seemed to be at a disadvantage and may be as riskier

counterparties

• Central clearing may give these smaller broker-dealers the opportunity to compete head-to-head with their larger counterparts

• Many leading players have already made significant commitments towards developing centralized OTC clearing capabilities

• The challenge for many broker-dealers now is to stay ahead of the regulatory curve

Better economies

of scale

Competitive pricing

Higher trade volumes


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Buy-side entities should consider several important choices as they build out their strategy to address the new regulations.

Buy-side entities strategic choices

Choosing the desirable

investment

While the regulations mandate central clearing of standardized derivative contracts, not all derivatives will have to be centrally cleared. There are three investment options for end-users to consider:

Choose bespoke OTC derivative contracts; penalties through higher collateral requirements may make this more expensive than earlierChoose a standardized derivative to be centrally cleared; may pose significant operational

challenges and may reduce the effectiveness of the hedge (previously customized OTC)Choose not to hedge using derivatives; may increase exposure to market and business risks

Choosing the desirable clearing-

house / Central Counterparty

(CCP)

Selection of a Central Counterparty (CCP) is now an economic field that must be agreed upon at the time of execution. The choice of CCP may or may not impact pricing, but there are several considerations as buy-side firms make this choice:Products cleared (IRS, credit default swaps (CDS), etc.)Restrictions on eligible collateralSegregation of initial marginConnectivity to middleware and other industry utilitiesDefault and risk managementOperational readiness and ability to leverage existing infrastructure

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Buy-side entities should consider several important choices as they build out their strategy to address the new regulations.

Choosing the desirable

clearing broker/ FCM

While many top-tier banks have stated intentions of becoming Futures Commission Merchants (FCMs), only a few dominant players may be ready on time and with broad clearing offerings. Considerations for buy-side firms as they choose their FCM:Ability to leverage existing relationship as the executing broker for pricingCredit worthiness and industry reputationOperational readiness:

-Investment in technology-Connectivity to clearing houses, executing brokers, and clients-Ability to leverage existing infrastructure-Knowledge of operational staff and ability to advise clientsQuality of services offered – seamless on-boarding and transition management, enhanced client

service, etc.Breadth of services offered – collateral management, reporting, cross-product netting, etc.

Buy-side entities may need to make important, strategic choices


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If you’re a broker/dealer, the legislation may be good for you (mostly), but the mechanics of how you can get connected and actually clear (and what it will cost) may be of concern.

Potential impacts on sell-side operations

Sell-side priorities

• “Help me with collateral requirements by providing services and know-how”

• “Improve and not tie-up all my cash”

• “Be a source of advice on how I need to sort my internal processes and systems”

• “Don’t price me out of access”• “Assist in removal of counterparty risk,

protecting against a default”

• “Hold margins for positions in a segregated account at the clearing house to minimize default impact”

1

2

3Transitionseamlessly

“Help me achieve a regulatory conformant solution with no bumps along the way”

“Make sure control environment is high and transaction processing is detailed and,problem-free”

Imperfections in the model for buy-side firms

Some buy-side firms are worried about potential high costs of access to CCPs

Potential for netting will likely be limited for many due to trading profiles

CCP product scope means only limited set of trades may be cleared, removing them from Credit Support Annex (ISDA,CSA)

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Potential sell-side opportunities

Considerations

• Only a few dominant players may eventually prevail and trading volumes for these players may increase

• Currently, many banks are not charging their top tier clients a fee for clearing. Tiered pricing based on client segmentation is expected to become the norm

• Pricing terms may differ between “bundled execution and clearing” and “third-party clearing”

• Reduction in risk exposure within a regulated market might cause a boost in trading activity

Banks may be able to provide enhanced collateral management services for a fee

Dominant banks may boost their market share, increasing both execution and clearing revenues

Demand for third-party clearing services may allow clearing brokers to charge additional fees

Source: Morgan Stanley Research Report (2010) derivatives


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Banks could build and offer their clients differentiated collateral management capabilities, but several uncertainties exist.

Potential opportunities for collateral management

Fees charged for enhanced collateral

management services

• Convenience margin fees - Banks could issue a single, aggregated margin call across all CCPs to the client, and then split the received collateral for a fee

• Collateral substitution fees - Banks could accept ineligible CCP collateral and then substitute it with eligible CCP collateral for a fee

• Netting fees - Banks could potentially net the client’s CCP exposure and bilateral exposure for a fee

• Fees for providing “timely collateral posting” services

Buy-side collateral managementoutsourcing

• Increasing complexity of collateral management may force smaller buy-side firms to look at cost-effective solutions

• Broker dealers could enter into this space by providing end-to-end collateral management capabilities to buy-side firms

Re-hypothecating collateralmarkup

• Banks may increase collateral requirements (on top of CCP requirements) based on demand versus supply and client creditworthiness

• Re-hypothecation using advanced collateral optimization systems could generate additional opportunities

Building a world-class collateral management service offering while detailed regulations are still being finalized can present significant challenges

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Acronyms Defined

OTC: Over the counterDCO: Derivatives Clearing OrganizationSEF: Swap Execution FacilityCCP: Central Counterparty Clearing House


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Part VII

Counterparty Considerations

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OverviewCounterparty Classifications: Swap Dealers (SD), Major Swap Participants (MSP) and End UsersLegal Entity Considerations

Agenda


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Overview

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*Exception: The Federal Reserve Board and other US banking agencies have jurisdiction over the capital and margin requirements over foreign and domestic banks that register with the CFTC and SEC as SDs.

Overview of Title VII — Jurisdiction Generally*

Mixed Swaps

CFTC andSEC

Swaps

CFTC

Security-BasedSwaps

SEC


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Clearing, Trade Reporting and Exchange TradingAll swaps that are accepted for clearing must be cleared unless:

– One of the counterparties is not a financial entity;– It is using swaps to hedge or mitigate commercial risk; AND– It notifies the CFTC/SEC how it meets its financial obligations

related to uncleared swaps. – Public companies need board committee approval to enter into

uncleared swapsAll swaps accepted for clearing must be exchange traded unless not accepted by an exchange for tradingAll uncleared swaps must be reported to registered swap data repository or the CFTC/SEC if no repository will accept it

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Counterparty Classifications: Swap Dealers, Major Swap Participants and

End Users


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Statutory Definitions

Registration of Swap Dealers and Major Swap Participants

Swap Dealer

A SD would be any person who, as part of a regular swap business:• Holds itself out as a dealer;• Makes a market;• Regularly enters into them

for its own account; OR• Engages in regular

business causing it to be commonly known in the market place as a dealer or market maker

Source: CFTC, 17 C.F.R. pt. 240, http://cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf

Major Swap Participant

A MSP would be any person who is not a SD and:• Maintains a substantial position in swaps (excluding

swaps held for hedging or mitigating risk); • Whose outstanding swaps create substantial

counterparty exposure that could have serious adverse effects on the U.S. banking system or financial markets; or

• Is a non bank highly leveraged “financial entity” that maintains a substantial position in swaps.‒ Financial entity is defined as:

• SDs and MSPs; • Commodity pools;• Private funds; and • Employee benefit plans

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CFTC and SEC joint release adopting SD definition (Release No. 34-66868): – Guidance provided on the terms: “holding out”, “regular business” and

“commonly known”– Guidance provided on hedging activity that would not be considered to be dealer

activity– Swaps between affiliates excluded as dealer activity– Adopted a de minimis exception of aggregate gross notional amount of $3B, with

initial $8B threshold during a phase-in period across all asset classes

– SEC’s dealer-trader distinction may be applied in identifying swap dealers

Hedge funds are generally considered traders and not securities dealers by the SEC


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Registration of Swap Dealers and Major Swap Participants (cont.)

CFTC and SEC joint release adopting MSP definition (Release No. 34-66868):

– Both qualitative and specific quantitative guidance provided on the terms:

“Substantial position”“Hedging or mitigating commercial risk”“Substantial counterparty exposure”“Financial entity”“Highly leveraged”

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For security-based swaps with the SECFor other swaps, with the CFTCRequires:

– Capital and margin requirements (set by Federal Reserve Board and other US banking agencies for domestic and foreign banks)

– Segregation requirements – Reporting and recordkeeping, including daily trading records– Business conduct standards

Requires that SDs that receive margin collateral from customers for cleared swaps to register with the CFTC as a futures commission merchant (FCM)


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Uncleared Swap Margin ProposalsCFTC and the bank regulatory agencies have issued proposals, the SEC has notBoth CFTC and banking agency proposals allow a choice between prescribed percentages of notional amounts and quantitative models

– Bank SD margin models would need to be approved by the appropriate banking agency

– The CFTC proposal would allow:Models approved by the CFTC;Models used by a CFTC-registered derivatives clearing organization;Models used by an entity subject to regular assessment by a banking agency for margining uncleared swaps; orVendor models

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Classes of Margin CounterpartiesCFTC Proposal:Three classes of counterparties: 1) Swap entities (SDs and MSPs) : 2) Nonfinancial end users, 3) Financial end usersBank Agencies Proposal:Separates high and low risk financial end users – low risk financial end users:

– Have swaps or security-based swaps that fall below a specified ‘‘significant swaps exposure’’ threshold;

– Predominantly use swaps to hedge or mitigate the risks of its business activities, including balance sheet, interest rate, or other risk arising from the business of the counterparty; and

– Are subject to capital requirements established by a prudential regulator or state insurance regulator.

Under bank agency proposal, foreign bank SDs do not have to collect margin from foreign counterparties


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Uncleared Swap Margin ProposalsCFTC proposal requires initial and variation margin to be calculated daily for all counterparties, but does not require collection from non-financial end users

– Calculation information may be used for risk management and regulatory capital charges

– Margin must be collected from swap entities and financial end users

Bank agency proposal requires credit exposure thresholds for non-financial and low-risk financial end users below which they must collect initial margin

– Minimum thresholds proposed for low-risk financial end users– Threshold for swap entities and high-risk financial end users is zero– Variation margin must be collected daily from swap entities and financial end

users, weekly from non financial end users

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Standards for ModelsCFTC and the banking agency proposals both require:At least one year of historic price data and must incorporate a period of significant financial stress appropriate to the uncleared swaps to which the model is appliedThe model shall set margin to cover at least 99% of price changes byproduct and by portfolio over at least a 10-day liquidation time horizonMonthly recalibration of the model (CFTC proposal specifically calls for monthly stress and back testing)A factor or benchmarking process designed to ensure that the initial margin required is at least as much as a designated clearing organization would charge if the same of similar swap was cleared


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Uncleared Swap Margin ProposalsUnder both proposed rules, eligible collateral is limited to:Immediately available cash funds (denominated in either U.S. dollars or in the currency in which payment obligations under the swap are required to be settled); Any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, the United States;With respect to initial margin only, any senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks and Farmer Mac; and With respect to initial margin only, any obligation that is an ‘‘insured obligation,’’ as that term is defined in 12 U.S.C. 2277a(3), of the Farm Credit System banks.

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Segregation Proposals

Uncleared swaps:Under the statute:

– Counterparty has the right to request segregation of initial margin– Segregated collateral must be held at an independent custodian

SEC has not issued a proposal, the CFTC and banking agencies haveBanking agency margin rule proposal requires independent custodian to be in the same bankruptcy jurisdiction as the bank SD


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Segregation Proposals

Cleared swaps:SEC has not issued a proposal, the CFTC has adopted its rulesCFTC Part 22 rules call for “Legally Separate, Operationally Commingled” segregation

– Central clearing organization must maintain subaccounts representing the cleared swap margin held for each customer of the FCM

– Daily reconciliation between the amounts held by the FCM and thesubaccounts of the central clearing organization

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Legal Entity Considerations


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Primary Swap Dealer Legal Entity Considerations

Restrictions imposed by statute:– The “Push Out” provision– FCM registration requirement for clearing customer swaps– Registration of entities that are either unregulated or currently

regulated by a foreign regulator

Margin and capital requirementsCredit standing of legal entity candidates for SD registration

– Ability or willingness of the parent to guarantee the SD subsidiary

Potential renegotiation of swap contracts

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ConsiderationsNon Bank Swap Dealers U.S. Banks

Foreign Banks

Certain European banks Others

Push Out N/A Swaps must be pushed out of U.S. banks except for interest rate, currency and certain credit default swaps

All swaps must be pushed out of U.S. branch

All swaps must be pushed out of U.S. branch

FCM registration for cleared customer swaps

SD may also be an FCM

Must clear customer swaps in a separate FCM and capitalize it



Capital Must be separately capitalized under SEC and CFTC rules

No change — can use Basel standard



Margin Must collect margin from financial counterparties

Must collect: 1) variation margin from all parties; 2) initial margin from high risk financial counterparties; and 3) initial margin from others when it exceeds thresholds

Not required to collect margin from foreign counterparties. From US persons it must collect: 1) variation margin from all parties; 2) initial margin from high risk financial counterparties; and 3) initial margin from others when it exceeds thresholds

Not required to collect margin from foreign counterparties. From US persons it must collect: 1) variation margin from all parties; 2) initial margin from high risk financial counterparties; and 3) initial margin from others when it exceeds thresholds

Credit Standing/ Guarantees

Will likely need a lot of capital and a parent guarantee

Holding company can guarantee subs

If the parent is the bank, it may not be able to provide guarantees to subs

Holding company can guarantee subs

Primary Swap Dealer Legal Entity Considerations


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Questions & Answers

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Contact InformationMichael P. JamrozPartnerDeloitte & Touche [email protected]

Ricardo P. MartinezPrincipal, Enterprise Risk ServicesDeloitte & Touche LLP 212.436.2086 [email protected]

Kathryn M. TrklaPartnerFoley & Lardner LLP312.832.5179 [email protected]

David M. ReicherPartnerFoley & Lardner LLP414.297.5763 [email protected]

Emory IrelandPartner Foley & Lardner LLP414.297.5624 [email protected]

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