decoding otc derivatives regulation - chatham financial

CHATHAM FINANCIAL – PROPRIETARY AND CONFIDENTIAL – ALL RIGHTS RESERVED 11CHATHAM FINANCIAL – PROPRIETARY AND CONFIDENTIAL – ALL RIGHTS RESERVED

Dodd‐Frank Update:Decoding OTC Derivatives Regulation

Clark Maxwell, Director of Accounting Services

Luke Zubrod, Director Derivatives Regulatory Advisory Services

CHATHAM FINANCIAL – PROPRIETARY AND CONFIDENTIAL – ALL RIGHTS RESERVED 22

Agenda

• Our Involvement

• Background/Overview of OTC Derivatives Regulation

• The Legislative Journey

• Case Study

• The Legislation

• The Legislative Impact

• What’s Next?


Our Involvement in OTC Derivatives Legislation• Actively engaged in the derivatives public policy debate

• Met regularly with key policy makers in the House, Senate, Federal Reserve, Treasury,

and CFTC

• Testified before Congress on October 7, 2009

• Worked closely with congressional committees

• Authored numerous policy papers

• Featured in: WSJ, Financial Times, American Banker, Risk, and Treasury & Risk

• Advised the Coalition for Derivatives End Users:


• In 2009, the notional amount hedged in the OTC derivatives market exceeded $600 trillion (down from the peak of $692 trillion in 2008)

Growth in OTC Derivatives

Source: BIS Time Period

No

tio

nal

Vo

lum

e i

n T

rill

ion

s

Interest Rate & Currency Derivatives: Outstanding Notional

0

100

200

300

400

500

600

700

800

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


Derivatives – Villains from the Recent Crisis?

“Derivatives are financial weapons of mass destruction. The dangers are now latent—but they could be lethal.”

~Warren Buffett, March 2003

“Once Congress deregulated the swaps market in 1999 it became a $600 trillion high‐stakes casino for Wall Street to take big risks and bring our economy to the brink.”

~Senator Maria Cantwell (WA), April 2010

“If the [derivatives] business goes overseas...fine, let that casino be offshore. Let some other government have to bail out the next AIG.”

~Rep. Brad Sherman (CA‐27th), June 2009


Evaluating the Regulatory Mandate• During the credit crisis (3Q 2007 through today), worldwide financial institutions have

recognized ~$1.7 trillion in losses on all types of financial products, including loans, CDOs, asset‐backed securities, derivatives, etc. Of note, less than 4% of such losses were the result of derivatives (more than half of which came solely from AIG).

• Of the financial products that resulted in losses for banks, there were 13 other types of financial products that had a greater impact on losses than derivatives. Nevertheless, derivatives became a centerpiece of the recent financial reform.

Source: Bloomberg, WDCI Function


• Following the bailout of AIG, whose troubles included billions in losses on credit default swaps, the Administration and Congress were intent on regulating OTC derivatives

• OTC derivatives previously were lightly regulated (only dealers)

• The significant size and growth of the market increased pressure to regulate• The “$600 trillion” amount can be misleading and dramatically overstates the true size of

the exposure

• The Bank for International Settlements estimates that the total mark‐to‐market value is approximately $25 trillion

• After taking into account netting of offsetting contracts, the total credit exposure is “only” $4 trillion (2/3 of which is collateralized)

• Treasury Secretary Timothy Geithner’s May 13, 2009 letter to Senate Majority Leader Reid laid out four principles for regulation of the OTC derivatives market:

Contain and reduce systemic risk

Promote efficiency and transparency in the market

Prevent fraud and abuse

Protect unsophisticated market participants

The Legislative Journey


The Legislative Journey (cont.)

• Most stakeholders broadly agree on those principles, but there were key elements of controversy• Presence and scope of an end‐user exemption

• Need for a trading requirement

• Swap desk spin‐off provision

• The Dodd‐Frank Wall Street Reform & Consumer Protection Act, which includes comprehensive OTC derivatives regulation, was signed into law in July 2010. The rule‐making process is now underway.

• Key features include: • Creation of swap data repository

• Increased central clearing, margin and capital requirements

• Increased trading on organized venues

• End‐user exemption focused on non‐financial hedgers


• Dodd‐Frank did what was necessary to reduce systemic risk and increase transparency

• Collateralization between systemically risky financial institutions

• Increased transparency for regulators to identify emerging risks

• Dodd‐Frank likely went beyond what was necessary to reflect the lessons learned from the financial crisis

• Narrow end‐user exemption

• Trade‐off between systemic risk containment and economic growth

• Transparency mechanisms could come at the expense of liquidity/pricing

• Moving forward, regulator decisions are critical in assessing the extent of unintended consequences

• Interpretation of key terms: “substantial position,” “commercial risk”

• Applicability of trading/clearing requirements to large or illiquid trades

• Ability to use customized OTC derivatives in a cost effective manner

Evaluating Dodd‐Frank on OTC Derivatives


Case Study – Real Estate Company

• A commercial property company executed a $640 million, 5.5% pay‐fixed swap in 2007 to lock‐in its cash flows on its 1‐month LIBOR‐based floating‐rate debt facility,resulting in an all‐in debt cost of 6.40% (5.5% plusa 90 basis point credit spread)

• Benefits of the OTC market included:• Pricing efficiency: $6 million in interest savings over the life of the loan vs.

the fixed‐rate loan alternative

• Favorable prepayment terms: Two‐way prepayment language tied to movements in interest rates, allowing the company to potentially benefit from rising rates upon early termination

• Perfectly matched cash flows: No economic risk to rising rates and fixed interest expense of 6.40% each period


Case Study – Real Estate Company (cont.)

• If central clearing and/or exchange trading had been mandated in 2007, the company would have faced the following:• Inability to use the property as collateral for the swap• An upfront cash collateral requirement of ~$19.2 million (3% of notional)• Ongoing mark‐to‐market collateral posting (variation margin), currently $160

million based on current interest rates• Higher financing costs due to posted collateral

– Company’s 6.40% financing cost increases to an all‐in rate of 8.70% when considering the lost opportunity to invest capital at a 10% return

• Extrapolating this impact from one building in one city to the economy at large produces staggering results—a substantial drain on working capital• ISDA estimates that the industry‐wide margin requirements equal $1 trillion• The National Corn Growers Association and National Gas Supply Association

estimate $700‐900 billion


The Legislation

• Split jurisdiction

• Regulatory classifications

• Regulatory requirements

• Timeline

• What’s next?


Entity Classification Under Derivatives Legislation

Swap Dealer

Major Swap Participant (MSP)

Financial Entity

Non-Financial Entity (Commercial End User)

User Categories Typical Derivatives Use

Those that buy/sell swaps as part of their regular business

Systemically significant institutions

Anyone predominantly engaged in financial activities

Non-financial companies that use derivatives to manage risk*

Possible Examples

* Transactions of commercial end users that do not qualify as “hedges” are subject to requirements applicable to financial entities


Requirements Applicable to Different EntitiesDealer

Central clearing*

MSP Financial Commercial End User

Exchange trading*

Swap execution facility trading*

Bilateral margin*

Business conduct standards

* Provisions apply to some trades, but will not likely apply to all trades

Capital requirements

Reporting

Bookkeeping

RegistrationClearing/Trading

Exemption if:

• “Hedging”

• “Commercial risk”

• CFTC notification

• Board approval

…but end users will be affected and must stay engaged

? ?


Focus for Commercial End Users

Ensure that risk strategies qualify as “hedges of commercial risk”

Ensure entities are not “financial”

Monitor activities to ensure that firm continues to qualify as an end user

Obtain board approval

Comply with financial notification requirement

Re‐evaluate tools and practices:- Trading venue- Counterparty risk management- Collateral management- Product selection- Documentation- Publicly available trade data

Other requirements

Despite legislative exemption from clearing/trading requirements, end users will continue to focus on regulations, compliance and opportunities

End User Regulatory ActionsEnd User Regulatory Actions

End users with large hedging portfolios and those that provide swaps to customers could have more substantial compliance requirements


Financial Entity

MSP

Dealer

Dealer

Dealer

End User

End User

End User

Application of Central Clearing Requirement

Application of Central Clearing Requirement

Central Clearing

Central Clearing Platforms

CCP

Financial Entity

Financial Entity

“Central clearing party” (CCP) steps in between the parties & guarantees performance

Clearinghouses insulate from counterparty default

Initial & variation margin

Calculated on a portfolio basis

Margin calls occur at least daily

Segregation requirements

Margin, fees and other features can vary significantly between clearinghouses

Netting considerationsExisting ClearinghousesExisting Clearinghouses

IR FX

BM&F Bovespa (Brazil)

LCH.SA (France)

LCH (UK & US)

CME (US)

IDCG (US)


Trading Overview: Exchange & Swap Execution Facilities• Financial entities: required to execute

certain transactions on an exchange or swap execution facility (“SEF”)

• SEFs: third party trading platforms• Some exist today

• Others are expanding their platforms due to regulation

• Exact definition subject to controversy and to be clarified during rulemaking

• Fees and features vary significantly between SEFs

• Exchanges: developing new products that attempt to address shortfalls in customizability

Eris Exchange

Selected Exchange and Likely SEF Participants

Selected Exchange and Likely SEF Participants


Reporting Requirement

• Non‐cleared trades must be reported to a data repository

• Private, regulated entities

• TriOptima for IR derivatives currently only accepting data from large dealers

• Regulators to determine data elements and transmission methods

• Banks will handle post‐trade reporting for non‐dealer customers

Dealer

End User

Regulators

Reporting RequirementsReporting Requirements


Grandfathering for Clearing & Margin• Grandfathering approach on key requirements:

• Clearing: explicit grandfathering provision

• Margin: no explicit grandfathering provision

• Application of margin provision:• Regulators are required to impose margin on swap dealers and major swap

participants

• There is no explicit authority granted for regulators to impose margin on financial entities or end users

• There remains some ambiguity as to whether regulators will have the ability to impose margin on end users

• Regulators have not confirmed that they will not impose margin on end users or pre‐existing trades

• Potential impact of regulatory interpretation:• Liquidity risk

• Termination risk


Public Reporting of Pricing Information

• Real‐time public reporting

• Confidentiality considerations

• Block trades

• FINRA’s TRACE system is a possible model (see figure)


Capital Requirements

• Applicability: Applicable to Swap Dealers and Major Swap Participants

• Responsible Regulator: Set by bank regulators and proportional to risk of the product

• Risk: Regulators increase capital requirements to make non‐cleared trades very expensive, thereby creating an incentive to clear

• Drivers: Basel III recommendations will also play a central role


2010 2011

J A S O N D J A S O N DJ F M A M J J

Enactment

Reporting may be required for products already being cleared today

Interim rule by regulators identifying reporting requirements for swaps executed prior to enactment

Earliest required date for reporting of swaps executed prior to enactment

May be extended by interim rule

(applies to trades that no clearinghouse will accept)

Effective date of bill

Margin and capital requirements applied

Clearing and trading requirements apply

Registration of swap dealers & MSPs

Reporting of trades executed after enactment

May be extended by rule

2012

If allowed by rule, latest possible date for reporting of swaps executed prior to enactment

Implementation Timeframe

Note: Swap desk spin-off provision implemented 2-years following effective date (extendable by 1 year)


Possible Negative Unintended Consequences

Harvey Pitt, SEC Chairman (2001 – 2003):

“The current reform proposals…assure that we will experience anew the law of unintended consequences.” (WSJ, May 17, 2010)

Some potential unintended consequences that have been highlighted:

• Many end‐users will continue to hedge, but a higher cost and/or negative impact on working capital and liquidity

• Some end‐users will choose not to hedge and will be exposed increased market risks and economic volatility

• Many banks and large end‐users will simply move their derivative activities overseas where regulation is lighter and more business‐friendly

• Onerous OTC regulation will increase the use of embedded derivatives, reducing transparency as more swaps, options, and forward contracts are embedded in loans, leases, and structured financings to avoid regulation


What’s Next? • Regulatory rulemaking is currently taking place in earnest

• Regulators are currently accepting comments

• Regulators to release proposed rules by mid‐December

• Enactment: July 15, 2011

• Key rulemaking questions:• Margin requirements for end users

• Grandfathering

• Magnitude of capital requirements

• Interpretation of key definitions (“substantial position,” “commercial risk”)

• Exemption for FX forwards and swaps

• Criteria used to determine trades subject to clearing requirement

• For those interested in more detail, visit our dedicated website on OTC derivatives regulation at www.HedgingWorks.com


Questions

Denver10901 West Toller Drive, #301Littleton, COUSAT: 720.221.3501

North America

Kennett Square235 Whitehorse LaneKennett Square, PA 19348USAT: 610.925.3120

Krakowal. Słowackiego 64, I piętro30‐004 KrakówPolandT : +48 (0)12.294.6160

Europe

London4th Floor, 16 Garrick StreetLondon WC2E 9BAUnited KingdomT : +44 (0)20.7557.7000

Asia

Singapore20 Cross StreetChina Square Central #02‐16/17Singapore T : +65 6507.0680

Luke ZubrodDirector

Derivatives Regulatory Advisory Services

[email protected]

T: 610.925.3136

Contacts

Offices

Clark MaxwellDirector

Accounting Services

[email protected]

T: 484‐731‐0235

decoding otc derivatives regulation - chatham financial

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