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A Dodd-Frank Derivatives Update

September 6, 2012Presented ByAnna Pinedo

David KaufmanGlen Rae

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Program Summary Brief overview of Dodd-Frank Title VII

Status of Title VII rulemaking to date

Extraterritoriality issues

Compliance and Registration Deadlines

Entity and Product Definitions

Compliance issues for Swap Dealers/MSPs

Clearing Documentation for Swaps

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Title VII Overview Objectives of Title VII

Reduce systemic risk posed by the swaps market to the U.S. financial system Increase transparency of the swaps market, particularly as to both pre and post

execution pricing Enhance the integrity of the swaps market and improve the conduct of major

market participants

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Title VII Overview Regulates products

Swaps Security-based swaps (SBSs)

Regulates entities Swap dealers Security-based swap dealers Major swap participants (MSPs) Major security-based swap participants Derivatives Clearing Organizations (DCOs) Swap Execution Facilities (SEFs) Swap Data Repositories (SDRs)

Splits regulation between CFTC and SEC CFTC regulates swaps, swap dealers and major swap participants SEC regulates security-based swaps, security-based swap dealers and major security-based

swap participants

For convenience, we will generally use the CFTC terminology to refer to both categories, unless we note otherwise

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Status of Rulemaking

Critical building blocks of the Title VII regulatory regime have recently been jointly adopted by the CFTC and SEC

Entity Definitions (adopted in April and published in May 2012) covering definitions of swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant (referred to as the Entity Definitions)

Product Definitions (adopted in July 2012, and published August 2012) covering definitions of swap and security-based swap

However, still awaiting final action by the U.S. Treasury regarding the exemption of FX forwards and FX swaps for certain purposes

Publication of Product Definitions triggered a host of compliance dates under the CFTC’s Title VII regulations, but will not have a similar effect with respect to the SEC’s Title VII regulations

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Status of Rulemaking CFTC is moving ahead toward commencing implementation of significant

components of its Title VII regime during the fall of 2012 CFTC has been more active than SEC in adopting final rules under Title VII, since April 2012,

the CFTC has finalized rules for: Internal Business Conduct Standards for Swap Dealers and MSPs Phase in Schedule for Mandatory Clearing Core Principles for Designated Contract Markets Customer Clearing Documentation and Timing Requirements End-User Exception OTC Trading Documentation Requirements Reporting of Pre-enactment and Transition Swaps

CFTC recently provisionally registered ICE Trade Vault as a swap data repository and approved DTCC-SWIFT as an interim provider of “Legal Entity Identifiers” (LEIs) to permit compliance with swap data reporting requirements

CFTC also recently proposed its first list of swaps (covering certain categories of interest rate and credit default swaps) to be designated for mandatory clearing

Subject to a post-publication 30-day comment period, this list could become final sometime in September or October 2012

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Status of Rulemaking Other recent rulemaking actions by the CFTC include:

CFTC in April 2012 adopted an interim rule providing for a modified commodity trade option exemption and in August 2012 issued a no action letter providing temporary relief from certain aspects of the modified trade option exemption to afford the CFTC time to evaluate further comments on the interim rule and volumetric options in forward contracts

CFTC recently proposed two rules providing for clearing exemptions One would cover swaps between certain affiliated entities The other would cover swaps with certain cooperatives that generally engage

in hedging and risk mitigation activities (such as rural electric cooperatives)

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Status of Rulemaking With the recent publication of the Product Definitions, registration for swap dealers

and major swap participants is to become mandatory on October 12, 2012, though the practical impact of this date is being debated, as we discuss below

Once this registration requirement occurs, many other Title VII rules adopted by the CFTC will begin to take effect at that time or shortly thereafter, including:

Real-time Reporting for Credit and Interest Rate Swaps General Recordkeeping and Reporting for Credit and Interest Rate Swaps Various Internal Business Conduct Standards for swap dealers and MSPs External Business Conduct Standards Position Limits for physical commodity-based futures and swaps for spot

months and, for legacy agricultural commodities, non-spot months (CFTC recently provided temporary no-action relief from certain aggregation requirements under its position limit rules)

Also under CFTC’s rules, FCMs will be required in November 2012 to implement the LSOC method for segregating customer initial margin posted for cleared swaps

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Status of Rulemaking SEC is taking a different approach to Title VII rulemaking

It appears that no registration requirements will be imposed until all substantive Title VII rulemaking by SEC is complete

Two of the CFTC’s Commissioners (Sommers and O’Malia) indicated they had hoped that the CFTC would proceed in a similar fashion

SEC’s substantive rulemaking has lagged significantly behind the CFTC’s In some cases, the SEC is yet to publish a proposed rule on matters that the

CFTC has long since published proposed rules on or even proceeded to adopt final rules

For example, as yet no SEC proposed rule on: margin requirements for OTC swaps or capital for non-bank registrants cross border application of SEC’s Title VII regulation

Even where SEC has published proposed rules, the timeline for finalizing these rules is unclear

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Extraterritorial Guidance CFTC is also working to finalize guidance and compliance relief

relating to the cross-border application of Title VII and the CFTC’s Title VII rules

In late June, CFTC issued: Proposed Guidance regarding the application of its Title VII rules beyond the

U.S. borders, and Proposed Exemptive Order to permit delayed compliance with certain Title VII

requirements for foreign entities Comment period for Exemptive Order closed on August 13, 2012, and

comment period for Proposed Guidance closed on August 27, 2012 Extensive comments were submitted by many groups and market participants

Following the applicable comments periods, Proposed Guidance could be finalized in September or October 2012, but

many issues will need to be resolved and finalization could take longer, and Proposed Exemptive Order could be finalized in September 2012 and as much

in advance of October 12, 2012 effective date as possible

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Extraterritorial Guidance Proposed Guidance attempts to address cross-border matters by:

distinguishing between “Entity-level” requirements and “Transaction-level” requirements of Title VII

defining who is a U.S. Person for cross-border purposes considering how Title VII should apply to foreign branches, subsidiaries and affiliates of U.S.

Persons, as well as how guaranties by U.S. Persons might impact these considerations contemplating, in the case of some Entity-level requirements, potential “Substituted

Compliance” based on comparably robust home country regulation

The Proposed Guidance is already attracting a significant adverse reaction from the international banking and financial regulatory community

Proposed Exemptive Order supplements the Guidance by allowing delayed compliance for certain (but not all) Entity-level requirements

Primarily for non-U.S. swap dealers/MSPs who by complying with the order may delay some compliance until July 2013

However, U.S. swap dealers/MSPs who comply can delay their compliance with some Entity-level requirements until January 1, 2013. Additional relief is also afforded foreign branches of U.S. swap dealers and MSPs.

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Extraterritorial Guidance As expected, the Proposed Guidance and Proposed Exemptive Order have

garnered extensive substantive comments from foreign and international regulators, industry groups and major market participants

Many commenters have raised fundamental issues, such as: The Proposed Guidance and Proposed Exemptive Order exceeding the extraterritorial

authority granted under Dodd-Frank and existing case law The failure of this effort to be sufficiently coordinated with G-20 efforts as had been

contemplated, creating significant risk of inconsistent and duplicative regulations, market fragmentation and disruption and regulatory arbitrage rather than harmonization

The inappropriateness of issuing guidance rather than going through a formal rulemaking process, which imposes more rigorous procedures and cost-benefit standards

Unintended compliance disparities that will result between U.S. and non-U.S. swap dealers Need for general delay in registration and compliance dates to allow sufficient time to resolve

issues, finalize guidance and then structure businesses accordingly

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Extraterritorial Guidance In addition, commenters have raised numerous specific comments and

issues about aspects of both the Proposed Guidance and the Proposed Exemptive Order, including

Lack of clarity in the U.S. Person definition (which differs from the SEC’s Regulation S definition)

Aggregation requirements for swap activities of affiliated non-U.S. persons Treatment of inter-affiliate transactions and, in particular, the use of non-U.S. affiliate

“conduits” Treatment of non-U.S. counterparties that are guaranteed by a U.S. Person Treatment of non-U.S. branches (i.e., commenters argue these should be treated as any other

non-U.S. person) Permitting substituted compliance for “Transaction-Level” requirements Simplify and expand approach to recognizing substituted compliance A renewed call for “Limited Designation” if a foreign swap dealer conducts its U.S. swap

activities through its U.S. based affiliate Request to clarify how Proposed Exemptive Order and Proposed Guidance affect NFA

registration process and to eliminate resulting confusion and inconsistencies Permit delayed and substituted compliance for certain reporting and recordkeeping

requirements (such as daily trade records requirement) Expanding emerging markets exception to branches of non-U.S. swap dealers

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Compliance and Registration Deadlines

October 12, 2012 is generally regarded as the date by which swap dealer and MSP registration is required

However, as we discuss later, it is possible that alternative dates may apply

Whenever registration does occur, each newly registered swap dealer or MSP will face a host of other regulatory compliance dates

The registration process has been delegated to the NFA and will be conducted as follows

Registration will be made on a provisional basis, by filing forms 7-R, 8-R, finger print cards and compliance documentation, and paying required filing fees

A registrant will need to include with its application to NFA materials demonstrating its ability to comply with any “4(s) Implementing Regulations”, which consist of:

Capital and Margin (Section 4s(e)); Reporting and Recordkeeping (Section 4s(f)); Daily Trade Reporting (Section 4s(g)); Business Conduct Standards (Section 4s(h)); Documentation Standards (Section 4s(i)); Duties (Section 4s(j)); CCO Designation (Section 4s(k)); and Segregation Requirements for Uncleared Swaps (Section 4s(l))

Compliance will be demonstrated on a rolling basis, so that as compliance dates occur a registrant will need to supplement its application to show its ability to comply with those additional 4(s) Implementing Regulations for which compliance is then required

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Compliance and Registration Deadlines

However, whether October 12, 2012 will in reality be the filing date for most swap dealers and MSPs is currently a matter of debate

Swap dealer rule provides that registration is not required until two months after the month in which swap dealer’s activity exceeds de minimis threshold with counting starting on the effective date (without a lookback). (See Rules 1.3(ggg)(4)(i) and (iii)). An entity using this provision would delay registration until at least December 31, 2012.

MSP rule provides that a filing requirement arises two months after the end of the first fiscal quarter in which the registration criteria are met (subject to certain re-evaluation rights). If this test does not apply retroactively, presumably the first quarter end would be December 31, 2012, resulting in registration by the end of February 2013

Uncertain whether the CFTC will provide formal guidance on these matters, but apparently industry groups have at least discussed the swap dealer registration issue with the CFTC

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Compliance and Registration Deadlines

Registration deadline is further complicated by the various compliance dates and phase in periods established by the CFTC, including the following:

For reporting obligations Swap dealers/MSPs are subject to a phase in regime with IR and Credit swaps first being subject to

reporting commencing October 12, 2012 and Equity, FX and Commodity swaps subject to reporting 90 days later

For recordkeeping obligations “Daily Trade Records” requirements become effective October 12, 2012, but entities can individually

apply for an alternative compliance schedule and SIFMA has submitted a no-action request to the CFTC seeking 6 to 12 month relief for various of these requirements

Other recordkeeping requirements might be subject to delayed compliance by non-U.S. swap dealers depending upon final form of Cross-Border Exemptive Order

For trading documentation and certain related external business conduct requirements CFTC has adopted a separate phase in regime in its recent rulemaking Practical effect is to defer significant portion of external business conduct requirement to January 1, 2013

For clearing and related clearing documentation, A phase in regime applies, which is keyed off of the date on which a particular swap or category of swaps

is formally designated as subject to mandatory clearing For non-U.S. swap dealers, certain other “Entity-Level” requirements may be subject to delayed compliance

depending upon final form of Cross-Border Exemptive Order

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Compliance and Registration Deadlines

At present: a confusing patchwork of registration dates, compliance dates, phase in periods and unfinished regulatory actions and uncertainties:

How will various compliance dates and phase in periods work with delayed swap dealer/MSP registration dates?

What will final form of Cross-Border Exemptive Order and Cross-Border Guidance cover and when will they be finalized?

When will first set of cleared swaps be designated? When will CFTC complete action on margining for OTC swaps and SEF

requirements (market structure, block trade definition and available to trade criteria)?

When will CFTC complete action on capital requirements for non-bank swap dealers and MSPs?

If and when will Treasury act on exemption for FX Forward and FX Swaps?

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Entity Definitions

Swap dealers and MSPs are two of the most heavily regulated new entities established by Title VII. The statutory definitions for these entities provide:

Swap Dealer: Any person who– Holds itself out as a swap dealer; Makes a market in swaps; Regularly enters into swaps with counterparties as an ordinary course of

business for its own account; or Is commonly known in the trade as a dealer or market maker in swaps

Major Swap Participant: Any person who is not a dealer and– Maintains a substantial position in swaps, excluding positions held for hedging

or mitigating commercial risk; Outstanding positions create substantial counterparty exposure that could have

serious adverse effects on the financial stability of the U.S. banking system or financial markets; or

Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to a Federal banking agency’s capital requirements

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Entity Definitions

CFTC and SEC have jointly adopted rules and provided guidance in an effort to clarify these statutory definitions:

For swap dealers, the regulations and guidance include: A three-step process to be followed in determining swap dealer status Importance of the “dealer-trader” distinction in this analysis-this is a concept long

used by the SEC in regulating securities broker-dealers Exclusion of some hedging activities from the “dealer” determination Further description of what types of activities will be considered “market making” Clarification of the exclusion for swaps executed in connection with loan

originations, though this exclusion is only available to insured depository institutions

Expansion and phasing in of the “de minimis” exemption

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Entity Definitions

For MSPs, the regulations and guidance include: Definitions of “major swap participant” and “major security-based swap

participant” focus on the market impacts and risks associated with that person’s swap and security-based swap positions. (Note that “swap dealer” and “security-based swap dealer” definitions focus on activities)

Major participants generally must follow the same statutory requirements that apply to swap dealers and security-based swap dealers since their activities could pose a high degree of risk to the U.S. financial system generally.

MSP: Any person who is not a dealer and– Maintains a substantial position in swaps, Outstanding positions create substantial counterparty exposure that could

have serious adverse effects on the financial stability of the US banking system or financial markets; or

Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to federal bank capital requirements

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Product Definitions On July 6, 2012, the SEC approved the Product Definitions on a

unanimous vote of the SEC Commissioners. On July 10, 2012, the CFTC held an open meeting at which it approved the final Product Definitions in a 4-1 vote of the Commissioners (with Commissioner Chilton voting against the final rules).

Title VII generally bifurcates regulation of the OTC derivatives markets, with the CFTC having jurisdiction over “swaps” and the SEC having jurisdiction over security-based swaps (“SBS,” and with “swaps,” “Title VII Instruments”).

The SEC and CFTC share jurisdiction over “mixed swaps.” The CFTC also has regulatory and enforcement authority over

“security-based swap agreements” (“SBSAs”), but the SEC has antifraud and certain other authority over SBSAs.

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Product Definitions Title VII defines a “swap” broadly to include transactions involving a

purchase, sale, payment or delivery that is dependent on the occurrence, nonoccurrence, or extent of occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence

This broad scope raised concerns regarding the status of a number of different types of products and instruments, and the final definitions include guidance regarding quite a number of products that are excluded from the definitions provided certain conditions are met. In the next series of slides, we will outline the treatment of a number of these products.

The final rules also establish a process by which parties may request a joint interpretation from the CFTC/SEC regarding whether a particular OTC derivative or type of derivative that is subject to Title VII of Dodd-Frank should be treated as a swap, SBS or mixed swap.

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Product Definitions Key exclusions from the swap/SBS definition:

Consumer Transactions: certain consumer transactions primarily for personal, family or household purposes were excluded, including real estate transactions, mortgages, personal service transactions and interest lock and caps related to such transactions

Commercial Transactions: those involving customary business or commercial arrangements, such as employment, sales, servicing, or distribution, business combinations, and equipment, inventory and IP transfers or leases, and many commercial finance arrangements

Forward Contracts on Physical Commodities: consistent with longstanding distinction between forward contracts and futures contracts, with helpful clarification regarding bookouts, embedded optionality and other common commercial terms, such as requirement, output and evergreens

Forward Contracts on Securities: confirmed MBS TBA transactions are covered Participation Agreements: excluded both LSTA true sale participations and LMA

risk participations Insurance Products: provided a safe harbor based on either being an “Enumerated

Product” or satisfying a “Product Test”

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Product Definitions Rules also provide guidance for allocation between swaps and SBSs

One major basis for allocation is narrow-based versus broad-based index SBSs generally relate to narrow-based index, which swaps generally relate to broad-based index CFTC/SEC provides extensive discussion of this area, including the following guidance:

An index that is not narrow-based is considered broad-based; the determination of whether and index is narrow-based or broad-based turns on prior guidance from the CFTC—look to the statutory definition of “narrow-based index” and to various joint orders that provide guidance regarding “narrow-based indices”

If the composition of an index is set prior to execution or is subject to change based on a pre-set algorithm, formula, rules, etc. then the classification of the index is set at inception—that means that the index is a narrow-based index if it was so at execution (and the corollary: the index is a broad-based index if it was so at execution)

“Migrating” indices: it is possible that an index might shift in characterization over time (where, for example, an index is not “rules-based”); however, the determination as to whether an instrument is a swap or SBS is set at execution (this means that an instrument that is based, at execution, on a broad based index is a swap, and, even if over time the index migrates and becomes a narrow-based index, the instrument is still a swap). However, if you know at execution that the index may migrate over time (due to the term of the index), then the instrument referencing the index will at execution be termed a mixed swap

Rules provide a grace period (to minimize market disruption) for instruments based on security indices traded on DCMs, SEFs, etc.

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Product Definitions Treatment of Total Return Swaps (TRS) provides a sharp illustration

of the regulatory divide between swaps and SBS TRS are swaps or SBS which can cover one loan, multiple loans or

other underlyers (including securities, narrow or broad based securities or commodities indices and non-security reference assets)

In general under a TRS, one party receives the appreciation and pays the depreciation on the underlyer and also pays a synthetic financing payment based on an interest rate and notional amount

CFTC/SEC guidance confirms that the synthetic interest based payment is incidental to the structure and therefore would not convert a TRS that is a SBS into a mixed swap

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Product Definitions CFTC/SEC also confirmed the following allocation of TRS between

the swap and SBS categories: A TRS on a single loan, a single security or a narrow-based security index is an

SBS A TRS on two or more loans or a broad-based security index is a swap

Allocation between single loan and multiple loan TRS is a result of a very strict reading of the statute which defines a SBS to include a swap based on “a single security or loan . . .”

Creates odd result that, if for convenience, parties used a single confirmation to evidence a TRS on two loans rather than two separate confirmations with otherwise identical terms the TRS would be a swap rather than a security-based swap

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Product Definitions Treatment of FX Swap and FX Forwards remains one of the more

puzzling aspects of the Product Definitions Title VII permits the U.S. Treasury to exempt FX Swaps and FX

Forwards (but not other types of FX transactions) from the swap definition for some, but not all, aspects of Title VII

FX Swaps and FX Forwards are narrowly defined by the statute As a result, many other types of FX transactions (such as non-deliverable forwards,

cross-currency swaps and FX options) are within the swap definition

In general, FX market participants have been operating under the assumption that the U.S. Treasury would finalize this exemption prior to the effective date of the Product Definitions

U.S. Treasury issued a proposed exemption in May 2011

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Product Definitions At present, the Final Product Definitions cover FX Forwards and FX

Swaps If the Treasury does not finalize its exemption prior to the effective date of the

Product Definitions, then market participants would be forced to treat FX Forwards and FX Swaps as swaps for all purposes of Title VII

This would have a major impact on many middle bracket financial institutions that presumed they would be able to continue to provide basic FX Forward and FX Swap dealing services for institutional clients without having to worry about registering as a swap dealer or MSP (so long as they didn’t engage in other FX transactions)

Failure of Treasury to act in a timely manner could cause unintended market disorder and illiquidity

Even if Treasury does act, FX Forwards and FX Swaps remain subject to Title VII reporting and business conduct standards

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Product Definitions SummaryPRODUCT CHARACTERIZATION PRODUCT CHARACTERIZATION

Cash/spot trades NOT TITLE VII Option on a single stock NOT TITLE VII

CDS on a broad security index SWAP Option subject to securities laws NOT TITLE VII

CDS on a narrow security index SBS Option on a swap SWAP

CDS on a single name SBS OTC option on a single non-security loan SBS

Commercial agreement NOT TITLE VII Retail OTC FX NOT TITLE VII

Commodity swap SWAP SBS also based on certain CFTC-regulated rates, MIXED SWAP

Consumer agreement NOT TITLE VII indices, currencies, commodities, etc.

Correlation swap on a broad security index SWAP Security forward NOT TITLE VII

Correlation swap on a commodity-based SWAP Spot FX transactions NOT TITLE VII

Dividend swap on a broad security index SWAP Swap on an exempt security (other than muni) SWAP

Dividend swap on a narrow security index SBS Swap on municipal security SBS

Dividend swap on a single security SBS TBA MBS NOT TITLE VII

Foreign exchange forward SWAP* TRS on a broad security index SWAP

Foreign exchange swap SWAP* TRS on a narrow security index SBS

Forward delivery contract NOT TITLE VII TRS on a single security SBS

Guarantee of a swap SWAP Variance swap on a broad security index SWAP

Guarantee of a SBS NOT TITLE VII Variance swap on a narrow security index SBS

Insurance products NOT TITLE VII Variance swap on a single security SBS

Interest rate swap SWAP Weather, energy, or emissions swap SWAP

LCDS on multiple loans SWAP

LCDS on a single loan SBS

Abbreviations:

CDS – credit default swap; FX – foreign exchange; LCDS – credit default swap on loan(s); LTRS – total return swap on loan(s); MBS – mortgage backed security; SBS – securities based swap; BA – to be announced; TRS – total return swap

Notes:

Not Title VII means instruments are outside the scope of Title VII of Dodd-Frank, but might still be subject to CFTC/CEA regulation

* Treated as swap until Treasury determines otherwise

Listed futures contract NOT TITLE VII

Listed FX option contract NOT TITLE VII

LTRS on multiple loans SWAP

LTRS on a single loan SBS

Non-deliverable forward (NDF) SWAP

Option on a SBS SBS

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Compliance Issues Swap dealers and MSPs face a significant array of regulatory and

compliance burdens, including

External Business Conduct Standards Internal Business Conduct Standards Real time Reporting and General Recordkeeping and Reporting Trading Documentation Requirements Clearing Documentation and Processing Requirements Margining and Collateral Segregation Requirements Capital Requirements

As noted earlier, the precise compliance dates for these are complex and, given the uncertainty over the required registration date for swap dealers and MSPs, somewhat uncertain

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Compliance Issues Even assuming the most delayed registration deadline, swap dealer

and MSP registrations face major compliance issues and challenges such as:

Policies and procedures: developing the required policies and procedures to demonstrate compliance with all “4s Implementing Regulations”

Supervision and CCO compliance: demonstrating that a strong supervisory system is in place, with skilled supervisory personnel along with a qualified CCO, is likely to be a critical item assessed by the NFA

Training programs: internal training programs regarding policies and procedures

are likely to be assessed by the NFA

IT and related infrastructure: the ability to comply with the required policies and procedures will demand extensive IT and infrastructure development by registrants

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Compliance Issues External and internal business conduct standards and recordkeeping

and reporting are requiring prospective registrants to devote considerable resources to be ready to comply with these requirements

External Business Conduct Standards General standards include:

Verification of counterparty status KYC and institutional suitability requirements Disclosure obligations relating to material risks, characteristics and conflicts of

interest Daily mark-to-market values Clearing Documentation Trading Documentation

Additional standards apply to interactions with Special Entities

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Compliance Issues To comply with external business conduct standards, swap dealers and MSPs will

need to implement enhanced due diligence procedures prior to executing transactions with swap counterparties

In addition to establishing policies and procedures, swap dealers and MSPs will need to alter and supplement counterparty documentation in order to comply with external business conduct standards

To facilitate this documentation process, ISDA together with its membership have developed a suite of documents and an implementation system

Referred to as the ISDA August 2012 DF Protocol Result of months of work and negotiation among ISDA and sell and buy side

representatives Though not a solution to all external business conduct requirements, it is

intended to help regulated entities address many of the due diligence and documentation challenges they face as a result of these requirements

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Compliance Issues What does the ISDA August 2012 DF Protocol consist of?

ISDA August 2012 DF Protocol Agreement (including form of Adherence Letter) ISDA August 2012 DF Supplement (including Schedules with representations) ISDA August 2012 DF Protocol Questionnaire (and Questionnaire Answer Sheet) ISDA August 2012 DF Terms Agreement (to be used where parties do not have a master

agreement in place but wish in any event to comply for swaps they execute)

What does the ISDA August 2012 DF Protocol address? Entity status

Verify identity Confirm ECP status Determine Special Entity status Identify and verify advisory relationships

Confirm essential details Presence of advisor/agent Hedging status

Suitability issues Disclosure requirements Confirm application of regulatory safe harbors

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Compliance Issues How does the ISDA August 2012 DF Protocol function?

The protocol, in effect, establishes a set of standard amendments to ISDA Master Agreements or other agreements governing swap transactions

An entity joins the protocol by submitting, online, its adherence letter together with a required $500 fee.

This is done on the ISDA website. An agent may adhere on behalf of multiple entities

In addition, an adhering entity must complete the Questionnaire and effect delivery of the Questionnaire to those trading parties for which it wishes the Protocol to be effective

ISDA and Markit have established ISDA Amend, an online system, to facilitate the delivery of Questionnaires being pairs of entities

By adhering to the Protocol and delivering a completed Questionnaire a party will have amended is covered agreements to include various representations that address many external business conduct requirements and, in particular, are geared to satisfying certain compliance “safe harbors” that are available to swap dealers and MSPs under the applicable regulations

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Compliance Issues What is the substantive effect of the Protocol?

Each adhering party will make the representations in Schedule 1 and 2 to the DF Supplement, which cover certain generally applicable matters (e.g., ECP status)

Certain adhering parties will make the representations in Schedules 3 through 6 to the DF Supplement, which cover cases where a party has a “Designated Evaluation Agent” or is an ERISA or non-ERISA Special Entity

The Protocol is not intended and does not purport to address all external business standard compliance requirements

In addition, ISDA notes that further protocols may be needed to address regulatory requirements that have not yet been adopted

Verification of “Commercial End-User Status” is not directly addressed by the ISDA Protocol Swap dealers and MSPs will need to separately diligence this issue, unless a subsequent

ISDA protocol is developed to cover this issue Also note that end-users that are public companies need to implement certain board or

committee approvals to take advantage of this status CFTC’s new OTC Trading Documentation rules also address this issue

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Compliance Issues Internal Business Conduct Standards

CFTC final rules: Requires registrants to adopt risk management programs Requires that swap documentation with counterparties address certain matters, including

payments netting, events of default and termination, transfers, governing law

Complying with the new Internal Business Conduct Standards will present many new challenges, including addressing:

Changes In Communications Between Swap Dealers and Third Parties Communications Involving Research Analysts Communications Involving Research Reports Relationship Between Clearing and Business Trading Units Role of the Chief Compliance Officer Required Annual Compliance Report Reporting and Recordkeeping for Swap Dealers-Trade and Marketing Data Reporting and Recordkeeping for Swap Dealers-Governance Data Duties of Swap Dealers Required Risk Management Program for Swap Dealers (including a new products policy) Diligent Supervision Requirement

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Compliance Issues Recordkeeping and Reporting

The requirements include: General recordkeeping and reporting requirements Real-time public reporting requirements Requirements to maintain “daily trade records”

Under the CFTC’s rules: General recordkeeping and reporting requirements mandate the reporting of “creation

data” and “continuation data” relating to swaps Creation data consist of

• Primary economic terms data (“PET”) and• Confirmation data (i.e., all of the terms of the swap as confirmed by the parties)

Continuation data consist of information arising during the term of a swap, such as:• Valuation data• Changes to previously reported economic terms

Real-time public reporting requirements mandate that certain economic data be reported to SDRs “as soon as technologically practicable” so that the SDR can then publicly disseminate that information

Daily trade recording requirements mandate that a swap dealer maintain records that are sufficient to permit comprehensive and accurate trade reconstruction and identifiable and searchable by transaction and counterparty, including both pre-execution and post-execution information

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Compliance Issues Trading Documentation

Rules very recently adopted by CFTC Require documentation to address

Confirmation timing and practices Portfolio reconciliation Portfolio compression Trading document requirements End-user documentation requirements

CPO and CTA compliance issues By expanding “commodity interests” to include swaps and removing the 4.13(a)(4) exemption

from CPO registration, the CFTC has triggered a complex and in some cases unanticipated compliance challenge for many pooled investment vehicles and their advisors

The securitization industry and other key financial market participants are struggling with the potential risk that entities that previously were not faced with potential CPO registration might now technically have to concern themselves with this possibility

No-action and other relief are being sought by various groups and market participants

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Clearing Documentation As swap clearing becomes a reality, additional or modified documentation

will be required The ISDA Master Agreement may serve a lesser or different role for cleared OTC swaps CFTC regulations place certain constraints on clearing-related documentation

Clearing firms currently are proposing the following three types of documents:

Futures Account Agreement (“FAA”) Governs the relationship between the parties to the swap and their regulated clearing

members

Cleared OTC Derivatives Addendum to FAA Necessary because FAAs do not address swaps or close-out rights in relation to cleared

swaps

Execution Agreement New documentation must address consequences if a transaction that is expected to clear

is not accepted for clearing

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Clearing Documentation Futures Account Agreement (“FAA”)

Sets out the bilateral relationship between the clearing member and its customer Not standardized, differs among dealers Historically used as contract to trade futures Sell-side friendly and, in relation to futures, not highly negotiated

Unilateral hair trigger defaults Discretion of dealer to charge whatever margin dealer believes is required to

protect its interests In negotiations to clear derivatives under the FAA, buy side typically attempts to

make FAA more like an ISDA Master Agreement by Limiting defaults against buy side Including cure periods for defaults Limiting the amount of margin that dealer may require its counterparty to post

(for example, by requiring dealer to rely on DCO margin calculations) In addition, buy side often attempts to negotiate for a commitment to clear (a

“committed facility”)

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Clearing Documentation Cleared OTC Derivatives Addendum to FAA

Addendum makes FAA applicable to cleared swaps Not standardized, differs among dealers Market standard Addendum was thought to be close to final in March 2011 However, dealers determined that they needed a legal opinion in relation to netting for

regulatory cap purposes The most significant unresolved issue, which relates to the required netting opinion, is close

out rights upon termination Some market participants want to follow futures model (menu of broad rights upon

termination, not especially transparent) Others want to follow an ISDA-like model (market quotation or similar, greater

transparency) A revised standardized document was published by ISDA and the FIA in early August 2012 In addition to addressing close out rights, Addendum forms used in the market typically also:

Contain representations as to authority, non-reliance language and tax provisions Require a clearing member to transfer (“port”) the customer’s trades to another clearing

member upon client’s request in accordance with a National Futures Association rule

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Clearing Documentation Most market participants will need to negotiate the Cleared OTC

Swaps Addendum Many have already negotiated and agreed to the prior version and will likely need

to renegotiate based on the August version Under phase-in rules, most end users will have until either 180 or 270 days after

swaps are designated for clearing until they are required to comply with mandatory clearing regime

Swap dealers, MSPs and certain active funds have a shorter 90 day period Comment period on first proposes set of cleared swaps ends September 6, 2012

so final CFTC action on those swaps is unlikely to be completed and published until some in October 2012

As a result, mandatory clearing for most end-users will not become a reality until well into 2013

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Clearing Documentation As compared to its earlier version, the newly published Cleared OTC

Swaps Addendum has the following significant features: Covers all derivatives transactions amenable to clearing (including forwards and

options), not just swaps Liquidation provision (Section 7) have been dramatically expanded

Provides detailed liquidation and close out methodology for clearing members Following a “Close-out Event” a clearing member may execute “Close-out

Transactions”, but also may execute “Risk-reducing Transactions” and “Mitigation Transactions”

All such close out activity is to occur in accordance with a defined Liquidation Standard that based on good faith and commercially reasonable procedures, though also recognizes that a clearing member may have to effect a close out in circumstances where no prevailing market prices or bona fide quotations are available

However, if despite its commercially reasonable efforts, a clearing member determines it cannot satisfy the Liquidation Standard based on quotations, prices and other market data, then it may base its valuation on internal sources

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Clearing Documentation Another significant changed feature of the new Addendum is an expanded set of

tax provisions (Section 8), including references to FATCA gross up and indemnity provisions tax liquidation event provisions and tax documentation requirements

This is MoFo. 46

Clearing Documentation Cleared Swaps Execution Agreement

This agreement sets out the procedure for trade affirmation or rejection and states what happens if a transaction that is expected to clear is not accepted for clearing

Document is not yet final, ISDA in discussions with its membership to update its draft in view of recent CFTC final rules (see next page)

Each of the parties to the original transaction (dealer and client) represents that it has a clearing agreement with a clearing member

Once a transaction is accepted for clearing, neither dealer nor client has any obligation to the other (DCO becomes a party to both sides of transaction)

If a trade does not clear, then unless otherwise agreed, at the option of the dealer:

The dealer (if it a clearing member) may elect to accept the transaction in its capacity as clearing member, or have a clearing member affiliate do so

If the transaction is not legally required to be cleared, the dealer may enter into the transaction on a bilateral (uncleared) basis or

The transaction may be terminated at the dealer’s side of the market if the transaction’s failure to clear is caused by the client or its clearing member

(including the client’s clearing member breaching a position limit imposed by the relevant DCO) at the client’s side of the market if the transaction’s failure to clear is caused by the dealer or its clearing member

(including the dealer’s clearing member breaching a position limit imposed by the relevant DCO)

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Clearing Documentation In accordance with recently released CFTC rules, Execution Agreement will likely be

bilateral only, between dealer and client As proposed by the Futures Industry Association and ISDA, the Execution Agreement

could be trilateral, with optional annexes under which either party’s clearing member could become a party to the agreement

Trilateral arrangement provided for limits notices, in which a clearing member would specify the transactions it would commit to accept under the Execution Agreement

If a transaction that a party’s clearing member committed to clear did not clear because of an issue caused by that clearing member, and an early termination amount was payable by that party, then the party and its clearing member were to be jointly liable for such early termination amount

Triparty arrangement was a major point of contention with the buy side, which was concerned that clearing members would steer trades to their own affiliates and restrict the dealers with which the buy side could transact

Market consensus is that recent final rules released by CFTC effectively prohibit a trilateral agreement

Under those rules, among many other restrictions, clearing members may not enter into any arrangement that

discloses to the clearing member the identity of the member’s customer’s original executing counterparty or restricts the size of the position a member’s customer may take with any individual counterparty, apart from an

overall limit for all positions held by the customer at the clearing member

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Clearing Documentation Collateral Segregation for Cleared Swaps

The CFTC has adopted the LSOC Model which stands for legal segregation of collateral with operational commingling

Under the LSOC Model, each clearing firm and DCO would enter (or “segregate''), in its books and records, the Cleared Swaps of each individual customer and relevant collateral and would ensure that such entries are separate from entries indicating (i) clearing firm or DCO obligations, or (ii) the obligations of non-cleared swaps customers. Operationally, however, each clearing firm and DCO would be permitted to hold (or “commingle'') the relevant collateral in one account. Each clearing firm and DCO would ensure that such account is separate from any account holding proprietary property or holding property belonging to non-cleared swaps customers