legal regulatory issues otc derivatives apac 2014

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Copyright InsightLegal Asia Consulting 2013-2014. All rights reserved

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LEGAL AND REGULATORY ISSUES - OTC

DERIVATIVES IN APAC

THE IMPACT OF NEW US AND EU REGULATIONS

Presented by Gareth Pyburn, Esq.

[email protected]

May 26 – 27, 2014

2 Copyright InsightLegal Asia Consulting

2013-2014. All rights reserved www.insightlegalasia.com

Day One 1. Overview: The challenges and limits of standardization 2.  ISDA Master Agreement – key differences between 1992 and

2002 versions 3.  Key negotiated provisions in the Master Agreement 4.  Key provisions for specific asset classes: FX, equity and

credit



The Limits of Standardization Regulatory objectives •  To reduce systemic risk post-GFC, regulators worldwide strive

to standardize derivative transactions and trade, clear and settle trades via central counterparties (CCPs)

•  Trading, clearing and settlement via CCPs involves a high degree of transactional standardization, which for certain transactions/asset classes is not practicable (as we discuss in detail on Day Two)

•  These obligations only apply to the extent that CCPs offer trading and clearing to any given type of transactions



The Limits of Standardization Techniques •  Dodd-Frank (DF), EMIR and other legislative initiatives are

primarily aimed at reducing systemic risk, enhancing the transparency of OTC derivatives (via trade reporting repositories) and segregating high risk trading from banks into non-bank entities

•  This imposes higher margin, collateral and other regulatory costs for non-cleared trades

•  “Substituted compliance” may apply to certain regulatory

regimes that are substantially similar to the US and EU are recognized (e.g., Singapore and Hong Kong)



ISDA Master Agreement

Section overview •  Comparative analysis of key material provisions in the 1992 and 2002

Master Agreements

•  Analysis of key negotiated provisions of 2002 ISDA Master Agreement (i.e., Schedule Section 13); further, select provisions drawn from particular asset classes (equity--including “closed market” provisions--and credit)

•  Objective: protection of organization against potential problem areas such

as Events of Default, Termination Events, regulatory change and tax



ISDA Master Agreement – Key Differences between 1992 and 2002

Key differences •  The main differences can be categorized as follows:

–  differences in the Payments Upon Early Termination;

–  differences in the Events of Default and Termination Events; and

–  addition of Set-off to the 2002 ISDA




Payments Upon Early Termination •  Inclusion of “Close-out Amount” in 2002, a provision

that sets out a single measure of damages where trades are being terminated as a result of an “Event or Default” or a “Termination Event”

•  In the 1992 ISDA, the parties may elect between two different measures of damages, “Market Quotation” or “Loss”




Payments Upon Early Termination (continued) •  “Close-out Amount” was developed to offer greater

flexibility to the party determining the amount due upon termination of their trades under an ISDA and to address some of the perceived weaknesses of Market Quotation that were highlighted during periods of market stress in the late 1990s




•  Market Quotation •  Market Quotation is a payment measure

determined on the basis of quotations obtained from leading dealers in the relevant market selected by the party terminating the trades (unless a Termination Event has occurred in which there are two affected parties, for example a Tax Event (as defined in the ISDA), in which case both parties make the relevant determinations)

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•  Market Quotation (continued) •  The dealer quotations will be for the replacement

cost of the relevant terminated transactions

•  If three or more quotations are provided, the Market Quotation will be the arithmetic mean of those quotations, without reference to the highest and lowest quotations




•  Market Quotation (continued) •  If only three quotations are provided, the highest and

lowest quotations will be disregarded and the remaining one will be the Market Quotation

•  If less than three quotations are provided (i.e., a Market Quotation cannot be determined), or if the party making the determination does not reasonably believe that Market Quotation would produce a commercially reasonable result, then Loss will apply




•  Market Quotation (continued)

•  Typically entities that believe they are more likely to be the party subject to an Event of Default or a Termination Event will negotiate for the applicability of Market Quotation in a 1992 ISDA in order to gain transparency in the calculation of the settlement amount




•  Loss

•  Loss is a payment measure based on the principles of general indemnification

•  The party terminating the ISDA will reasonably determine in good faith its total losses and gains in connection with the terminated transactions

•  The terminating party’s Loss may, but need not, be based on quotations obtained from leading dealers in the relevant markets




•  Loss (continued) •  Typically entities that believe they are less

likely to be the party subject to an Event of Default or a Termination Event will negotiate for the applicability of Loss in a 1992 ISDA in order to gain flexibility in the calculation of the settlement amount




• 

Close-Out Amount •  In an illiquid market, market quotations could be widely

divergent

•  Close-out Amount balances the need for increased flexibility (lacking in Market Quotation) while incorporating certain objectivity and transparency requirements (lacking in Loss)




• 

Close-Out Amount (continued) •  In determining the Close-out Amount, the party terminating the transactions

may consider, without limitation, one or more of the following three categories of information:

–  (i) quotations, either firm or indicative, from third parties (which may include dealers, end-users, information vendors and other sources);

–  (ii) relevant market data (e.g., yields, yield curves, volatilities, spreads and correlations); and

–  (iii) information from internal sources of the type described in clauses (i) and (ii)




•  Close-Out Amount (continued) •  The definition of Close-out Amount clarifies that the

determining party will consider quotations and market data provided by third parties unless it reasonably believes in good faith that such quotations or relevant market data are not readily available or would not produce a commercially reasonable result

•  When markets are functioning in a normal manner, the expectation is that third-party (as opposed to internal) sources should be considered in calculating the Close-out Amount




Events of Default and Termination Events

•  Section 5 addresses Events of Defaults and Termination Events and the 2002 ISDA introduced various changes into this section

•  The most noteworthy of these changes are:

–  (i) a reduction in the applicable grace or cure periods; –  (ii) an expansion of the definition of “Specified Transaction”; and –  (iii) the addition of Force Majeure as a Termination Event




Reduction of Cure Periods

•  In the 1992 ISDA, more lenient cure periods are provided than in the 2002 ISDA

•  Under the 1992 ISDA, a failure to pay or make a delivery under a transaction only crystallizes into an Event of Default if such failure is not cured within three Local Business Days after notice of such failure has been given by the non-defaulting party

•  Under the 2002 ISDA, the cure period is one Local Business Day (or one Local Delivery Day in the case of delivery failures)




Reduction of Cure Periods (continued) •  Similarly, where a “Specified Transaction” is not subject to a

cure period under the terms that govern it directly, a cure period is granted through the ISDA

•  That period is three Local Business Days under the 1992 ISDA and one Local Business Day under the 2002 ISDA

•  Additionally, involuntary insolvency filings and enforcement actions are subject to a 30-day cure period under the 1992 ISDA, but only fifteen days in the 2002 ISDA




Expansion of the Definition of “Specified Transaction” •  Section 5(a)(v) of the ISDA, sometimes described as

a limited cross-default provision, provides that an Event of Default will occur if a party to the ISDA defaults under a “Specified Transaction” with the other party (subject to any cure periods provided for under such Specified Transaction)




Expansion of the Definition of “Specified Transaction” (continued) •  Under the 1992 ISDA, “Specified Transaction” is defined as a

derivative transaction entered into between the parties to the ISDA that is a rate swap, basis swap, forward rate, commodity swap/option, equity or equity index swap/option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option or any other similar transaction or any combination of these transactions




Expansion of the Definition of “Specified Transaction” (continued) •  The 2002 ISDA expands the definition of Specified Transactions

to include the following transactions: swap option, credit protection transaction, credit swap, credit default swap/option, total return swap, credit spread transaction, repurchase transaction, reverse repurchase transaction, buy/ sell back transaction, securities lending transaction, weather index transaction or forward purchase or sale of a security, commodity or other financial instrument or interest




Expansion of the Definition of “Specified Transaction” (continued)

•  Thus, the 2002 ISDA includes any transaction that is similar to the specifically enumerated transactions “that is currently, or in the future becomes, recurrently entered into in the financial markets and which is a forward, swap, future, option or other derivative on one or more rates, currencies, commodities, equity securities or other equity instruments, debt securities or other debt instruments, economic indices or measures of economic risk or value, or other benchmarks against which payments or deliveries are to be made”




Expansion of the Definition of “Specified Transaction” (continued) •  The expansion of the definition of Specified Transaction effectively

brings within the scope of this limited cross-default provision the parties’ re-purchase (repos), securities lending, and securities forward transactions

•  In adding repos, securities lending and securities forward transactions as potential triggers for an Event of Default under the ISDA, the 2002 ISDA also addresses delivery failures which as a practical matter, may occur due to administrative errors, settlement system problems or scarcity of the underlying security




Expansion of the Definition of “Specified Transaction” (continued)

•  Section 5(a)(v) of the 2002 ISDA clarifies that where repos, securities lending and securities forward transactions are subject to a master agreement, a failure to deliver a security under such agreement will only trigger an Event of Default under the ISDA if all transactions under the relevant master agreement are accelerated or terminated




Force Majeure •  The 2002 ISDA introduces the Force Majeure (or impossibility) Termination

Event in Section 5(b)(ii), which may be triggered if by reason of a force majeure event or act of state that is beyond the control of a party (or its credit support provider):

–  (i) the office through which a party (or its credit support provider) is acting is prevented from making or receiving payments or deliveries or complying with any other material obligation under the ISDA or a credit support document or it becomes impossible or impracticable for that office to make or receive payments or deliveries or comply with any other material obligation under the ISDA or a credit support document;

–  (ii) such party (or credit support provider) could not overcome the force majeure event using reasonable efforts; and

–  (iii) a waiting period of eight business days has elapsed (unless the force majeure event affects a payment or delivery or the ability to comply under a credit support document, in which case there is no waiting period).




Force Majeure (continued)

•  The Force Majeure provision is rarely negotiated, but

there are a few important points to note about the provision

•  There is no definition of “force majeure”, other than that it is a force majeure or act of state that prevents or makes it impossible to make or receive payments or deliveries or comply with obligations under the ISDA or credit support document




Force Majeure (continued)

•  Additionally, although a party (or its credit support provider) is required to attempt to overcome the force majeure event using reasonable efforts, such party need not incur a loss in doing so

•  Finally, only the party affected by the Force Majeure event is the “Affected Party,” and therefore, it is the party that determines the Close-out Amount (based on mid-market values)




Set-off •  The 2002 ISDA standardized set-off language that prior to 2002 was

often incorporated by participants in the Schedule to the 1992 ISDA is based on language suggested in the User’s Guide to the 1992 ISDA

•  Often market participants seek to expand the set-off right to include

amounts owed under agreements with affiliates




Set-off (continued) •  Section 6(f) permits the non-defaulting party, upon the termination of

all transactions due to the occurrence of an Event of Default or a Termination Event where all outstanding transactions are terminated, to offset any amount owed under the ISDA against other amounts owed under other agreements between the parties (whether mature or contingent)




•  Q&A



ISDA Master Agreement – Key Negotiated Provisions

Credit •  Some of the most significant negotiating points relate to a

party’s ability to declare an Event of Default (EOD) or Termination Event (TE), which grants the right to terminate all transactions under the ISDA and potentially triggering defaults under other agreements that the defaulting party has in place

•  More creditworthy counterparty will seek to broaden the EOD and to shorten the cure periods to maximize its ability to terminate the trades under the Agreement promptly




Cross-Default

•  Section 5(a)(vi) provides that an EOD will occur if a party defaults on a third-party obligation and the default or the obligation is in excess of a specified Threshold Amount

•  The third-party obligation must be an obligation in respect of borrowed money (whether present or future, contingent or otherwise) and is referred to as “Specified Indebtedness”




Cross-Default (continued)

•  The negotiation of the Cross-Default provision typically revolves around the following three points:

–  amendment of the provision to provide for cross-acceleration and the addition of an administrative error carve-out;

–  expansion of the definition of Specified Indebtedness; and

–  agreement on a Threshold Amount




Cross Acceleration and Administrative Error Carve-Out

•  Corporate and buy-side participants often seek to delay or eliminate the application of the Cross-Default provision

•  With respect to the first prong of the Cross-Default provision (clause (1)), which addresses any type of default having occurred under Specified Indebtedness, they require that in order to trigger an EOD not only must the default have occurred under the Specified Indebtedness, but the creditor must have also chosen to demand payment of the obligation (“cross acceleration”)




Cross Acceleration and Administrative Error Carve-Out (continued)

•  Under the second prong of the Cross-Default provision (clause (2)), which addresses payment defaults under the Specified Indebtedness, they require that a payment default will not trigger an EOD if the failure to pay was due to an administrative or operational error, the party had the funds necessary to make the payment and the payment is cured within a certain period of time, usually between one and three Local Business Days (“administrative error carve-out”)




Expanding the Definition of Specified Indebtedness

•  Sell-side participants sometimes seek to expand the definition of Specified Indebtedness to include Specified Transactions (and to expand the definition of Specified Transactions to include transactions with third parties)

•  Participants are most likely to request this change from counterparties that have little in the way of “borrowed money” (mainly loans)

•  Thus, if a counterparty defaults on an obligation under a derivative or securities transaction with a third-party in excess of the Threshold Amount (and where cross-acceleration applies such obligation is accelerated), the non-defaulting party may declare an EOD




Expanding the Definition of Specified Indebtedness (continued) •  Thus, if a counterparty defaults on an obligation under

a derivative or securities transaction with a third-party in excess of the Threshold Amount (and where cross-acceleration applies such obligation is accelerated), the non-defaulting party may declare an EOD




Threshold Amount •  A party to an ISDA will attempt to negotiate a size-able

Threshold Amount for itself to prevent an EOD from being triggered by a default on a de minimus loan obligation or payment

•  On the other hand, parties will want to keep their counterparties’ Threshold Amount as low as possible in order to allow for greater opportunities to declare an EOD




Threshold Amount •  Parties often agree to asymmetrical Threshold Amounts which are fair to

each party as they are set at either:

–  (i) a percentage of an entity’s shareholders’ equity or members’ capital, for corporations or limited liability companies, or net asset value, for investment funds (3% is typical);

–  (ii) a fixed dollar amount which makes sense for each party based on their borrowed money; or

–  (iii) the lesser of (i) and (ii)




Default Under Specified Transaction

•  Certain parties prefer the 2002 ISDA because of its expanded definition of “Specified Transaction,” which affords more opportunities to declare an EOD

•  It is not uncommon for parties negotiating a 1992 ISDA to

incorporate the 2002 ISDA definition of “Specified Transaction” •  Some parties push for an even broader definition of Specified

Transaction to pull in the parties’ obligations under prime brokerage agreements




Additional Termination Events

•  Section 5(b)(v) provides for either or both parties to specify “Additional Termination Events” (ATEs) applicable to a party (the “Affected Party”), which will entitle the other party (also referred to as the non-affected party) to terminate the transactions under the ISDA

•  ATEs are intended to be early indicators of the deteriorating credit condition of the Affected Party

•  ATEs provide the non-affected party an opportunity to get out of its trades before the counterparty’s problems lead it to default




Additional Termination Events (continued)

•  ATEs are specifically tailored to the type of entities involved, such as:

–  (i) a private corporation; and –  (ii) a rated entity




Additional Termination Events – Private Corporations

•  “Maintenance of Ownership” provision

–  When entering into an ISDA with a subsidiary of a customer (e.g., a bank entering into a swap with a subsidiary of its debtor), a sell-side participant will want to ensure that the subsidiary’s ownership, if its credit relationship is really with the parent, does not change

–  For instance, it may provide that an ATE occurs if the parent entity fails to own either directly or indirectly more than 51% of the voting securities of its counterparty




Additional Termination Events – Rated Entity •  A “credit rating downgrade” ATE is often requested from a

counterparty that is a rated entity or that is guaranteed by a rated entity

•  The ATE can be drafted in numerous different ways, but the upshot is that should such rated entity, or its guarantor, suffer a downgrade in its credit-rating (e.g., below investment grade or higher), the other party will be entitled to terminate all the outstanding transactions under the ISDA

•  The utility of a credit-rating downgrade ATE hinges on the accuracy* of the ratings published by the rating agencies




Cure Periods

•  Under the 1992 ISDA, the most commonly negotiated cure period is failure to pay or deliver

•  If the parties agree to reduce the cure period for this EOD from three Local Business Days to one, they will also likely amend the corollary EOD in the Credit Support Annex (failure to deliver margin) and reduce the cure period specified there from two Local Business Days down to one Local Business Day

•  The standard 2002 ISDA provides for cure periods of one day for failure to pay or deliver




Counterparty Credit Risk •  In order to mitigate counterparty credit risk, parties enter into a

CSA

•  The CSA provides a contractual framework for the posting of collateral to secure a party’s “Exposure”

•  For any given day, Exposure is the net amount that one party would pay to the other based on the mid-market replacement value of all transactions between the parties, as if they were to be terminated on that day




Counterparty Credit Risk (continued) •  The form CSA provides that: on every valuation day

(defined in Paragraph 13 – usually every business day) the party that is in-the-money (the “Secured Party”) may make a demand for collateral (a “collateral call”) to the other party (the “Pledgor”), who will have to transfer collateral (“variation margin”) within the amount of time specified in the agreement

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Counterparty Credit Risk (continued)

•  If the market moves in favor of the Pledgor and the Secured Party is over collateralized, the Pledgor may make a collateral call and the Secured Party will return collateral to the Pledgor

•  Either party can be the Pledgor or the Secured Party depending on which party is in-the-money




Segregation of Independent Amounts •  If parties choose to collateralize their obligations under the CSA,

one party may be required to post an “Independent Amount”

•  The Independent Amount--or initial margin--has historically been an amount required by sell-side participants to guard against credit exposure that may arise between the demand for and the delivery of variation margin including movements in value occurring between the time a party defaults and the time the non-defaulting party designates a termination date




Segregation of Independent Amounts (continued)

•  The Independent Amount is posted in addition to the daily variation margin requirements in the CSA

•  A dealer may hold a significant amount of assets as Independent Amounts for a single trading counterparty depending on the size of its OTC trading portfolio




Segregation of Independent Amounts (continued) •  When the dealer becomes a credit-risk and enters insolvency proceedings,

as was the case with Lehman, the counterparty’s claim for a return of its Independent Amounts becomes a general unsecured claim

•  Since Lehman’s insolvency, many buy-side participants have requested that their Independent Amounts be held with a third-party custodian in order to ensure that the collateral posted to cover their Independent Amount is held with a bankruptcy-remote entity from which it is more readily recoverable

•  Segregation of Independent Amounts can be a costly proposition, both in terms of the upfront legal and other fees required to set-up the relationship as well as the ongoing fees to the custodian




Eligible Collateral

•  In Paragraph 13 of the CSA, parties specify the forms of “Eligible Collateral” that may be delivered as collateral

•  The most common forms of Eligible Collateral are U.S. dollars and U.S. treasuries

•  Parties agree on the class and maturities of the assets that would be considered Eligible Collateral, as well as the discount (a.k.a. a “haircut”) that applies to the valuation of the assets in determining how much collateral has been posted




Transfer Timing

•  “Transfer Timing” refers to the period within which collateral called for under the CSA must be transferred

•  A failure to transfer within that period will give rise to a Potential Event of Default




Transfer Timing (continued)

•  The standard CSA provides that if a collateral call is made before the notification time (a time agreed by the parties), then the collateral must be transferred by close of business on the next Local Business Day

•  If the collateral call is made after the notification time, then the collateral must be transferred by close of business on the second Local Business Day




Transfer Timing (continued) •  Current market practice calls for collateral demands to be satisfied within one

business day

•  Therefore, parties will often seek to reduce the transfer timing such that if a call is made before the notification time, then the collateral must be transferred by close of business on the same day, otherwise the transfer must be made by close of business on the next Local Business Day

•  Whether this timeframe is operationally feasible for a trading entity often depends on the notification time (in particular where counterparties are in different time zones)




Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii)

•  Section 2(a)(iii)(1) of the ISDA provides that each obligation of a party to make each payment or delivery specified in a confirmation is subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing

•  Accordingly, if an Event of Default or Potential Event of Default has occurred with respect to a party (the defaulting party), the other party (the non-defaulting party) at its option may either (i) designate an Early Termination Date under the agreement, or (ii) cease making any payment or delivery obligations to the non-defaulting party in reliance on Section 2(a)(iii)(1)




Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued) •  Paragraph 4(a)(i) of the CSA provides the non-defaulting party

a corresponding right to cease transferring collateral upon the occurrence and continuance of an Event of Default, Potential Event of Default or Specified Condition

•  The non-defaulting party may choose not to terminate its trades under the ISDA, perhaps because it is net out-of-the-money on all trades, and yet may cease performing in reliance on these provisions




Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued)

•  In the meantime, the defaulting party is still required to make timely payments, deliveries and margin transfers to the non-defaulting party

•  Section 2(a)(iii)(1) allows the non-defaulting party to game the

market by refusing to terminate its transactions under the Agreement until it is beneficial for it to do so, or when the market swings in its favor




Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued)

•  The negative consequences to the defaulting party can be significant

•  Excess collateral and settlement payments owed to the defaulting party may be withheld by the non-defaulting party, thereby creating or further deepening the defaulting party’s credit problems

•  This lack of liquidity may cause the defaulting party to default on its obligations with other trading counterparties, triggering a wave of defaults that leads to the defaulting party’s demise




Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued) •  In order to prevent this result, parties will often negotiate a limitation on the

right to rely on Section 2(a)(iii)(1) in not making any payment or delivery obligations, by providing that the non-defaulting party may only cease to perform for a certain number of days after the occurrence of the Event of Default that gave rise to such right

•  Typically the parties agree to anywhere between 30 and 90 days, the rationale being that such number of days is sufficient time for the non-defaulting party to decide if it will continue performing to the defaulting party (thereby preserving the trading relationship), or terminate the trades under the ISDA




“Fish or Cut Bait”

•  A related but different legal limitation is commonly referred to as the “fish or cut bait” or “use it or lose it” provision

•  This term provides that upon the occurrence and continuance of an Event of Default or Termination Event, the non-defaulting party or non-affected party will have to terminate its trades under the ISDA within a certain number of days or forever waive its right to terminate the trades based on such event




“Fish or Cut Bait” (continued)

•  The “fish or cut bait” is negotiated principally to address the occurrence of misrepresentations, which do not have a cure period, as well as ATEs that either cannot be cured or may take some time to cure



ISDA Master Agreement – Key Negotiated Provisions Ring-fencing Issues •  ‘Ring fencing’ protects foreign counterparty from

convertibility and transferability issues at settlement

•  Ring-fencing to cover political events, currency controls and other “closed market” issues

•  Include all transactions or only particular types of transactions?



ISDA Master Agreement – Key Negotiated Provisions Ring-fencing Issues (continued) •  All obligations (ISDA 2(a)(i)) or only net payments (ISDA

6(e))? •  Does ring-fencing survive insolvency proceedings,

whereby branch non-payment would be included in 6(e) calculation of Unpaid Amounts?



ISDA Master Agreement – Key Negotiated Provisions Close-out netting

•  Close-out netting is a central pillar of ISDA Master Agreement for both risk mitigation (credit risk exposure) and cost reduction (reserves)

•  Upon default all transactions taken into account to determine single net amount



ISDA Master Agreement – Key Negotiated Provisions Close-out netting (continued)

•  Is netting agreement enforceable?

•  Recognized netting agreements (such as ISDA) allow OTC transactions to be treated on a net basis for capital adequacy purposes

•  Close-out netting concerned with accounting between parties, not set-off since no accrued debt exists prior to determination of net amount



ISDA Master Agreement – Key Negotiated Provisions Close-out netting (continued) •  Single agreement provision (ISDA 1(c)) and the

flawed asset provision (ISDA 2(a)(iii))

•  Payment netting important in FX transactions since ‘daylight risk’ further mitigated (ISDA 2(c))



ISDA Master Agreement – Key Negotiated Provisions Close-out netting (continued)

•  Post-insolvency distinction between contingent and executory contracts

•  Contingent debts are accelerated but executory debts are not

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ISDA Master Agreement – Key Negotiated Provisions Automatic Early Termination (AET) •  All transactions automatically terminate upon

occurrence of specified events within the bankruptcy event of default immediately prior to winding-up petition (ISDA 6(a))

•  Removes need for non-defaulting party to serve termination notice

•  All transactions terminate and non-defaulting party uses close-out netting provisions immediately



ISDA Master Agreement – Key Negotiated Provisions AET (continued) •  Disadvantages of AET is that non-defaulting party loses

right to determine when to terminate

•  Non-defaulting party may not be aware that termination has occurred and make payments outside the ISDA architecture



ISDA Master Agreement – Key Negotiated Provisions Disruption Events

•  Examples of Disruption Events

–  natural disasters

–  social events

–  changes in law




Disruption Events •  Capital/exchange controls may impose restrictions

on currency convertibility and transferability making it:

–  Illegal –  Impossible –  Impractical to perform obligations under a Transaction




Disruption Events (continued) •  Such controls often used to protect currencies and local

markets during crises, but…

•  Have the potential to adversely impact counterparties and pose potential systemic risk to the broader market




Disruption Events (continued)

•  Documentation should address:

–  (a) Whether a Disruption Event constitutes a Termination Event (TE)?

–  (b) Primacy in the event of any inconsistency between a Confirmation and an ISDA (e.g., Illegality TE) as to whether a TE has occurred?




Disruption Events (continued)

•  Trade association (eg., ISDA) involvement often

includes non-binding recommendations to resolve market-wide issues following Disruption Events



ISDA Master Agreement – Key Negotiated Provisions Issue: undocumented trades

•  Undocumented trades with no long-form Confirmation

(e.g., only deal tickets or phone recordings) with pricing terms but no express standard or bespoke credit or legal terms

–  Boilerplate provisions missing (e.g., governing law?)




Repudiatory breach? •  Is repudiatory breach available in that the non-defaulting

party has the right to terminate and net all transactions with a defaulting counterparty?

•  In the absence of any specific contractual right, the solvent party may be required by a liquidator to pay the insolvent party (a.k.a. ‘cherry picking’)




Non-ISDA Transactions

•  Be careful to include a ‘sweeper’ clause in your ISDA Schedule so that all transactions (including deal tickets) are deemed Transactions covered by ISDA termination and netting provisions



ISDA Master Agreement – Key Negotiated Provisions •  Exercise date(s) depend on option type

–  American (exercisable at any time until maturity)

–  European (only exercisable at maturity)

–  Bermudan (exercisable on certain defined dates, similar to a series of Europeans)

–  Asian (exercisable according to an average market price over a defined option period rather than one date and time)




•  Q&A



Key Negotiated Provisions From Specific Asset Classes Analysis of advanced issues from specific asset classes •  FX/Currency

•  Equity

•  Credit



Currency Derivatives Issues FX Risk Mitigation •  FX settlement risk (‘daylight’ risk) is the primary

risk in OTC FX transactions:

–  Post-trade risk that one party goes insolvent (or unable to perform) after other party settles

–  Risk increases with time between trading and settlement



Currency Derivatives Issues

FX Risk Mitigation

•  Potential systemic risk if large counterparty defaults?

•  Solution: clearinghouse stands between counterparties and becomes a central counterparty (CCP) guaranteeing contractual performance (through novation and collateral)—pre-cursor to today’s broader CCP requirements for other asset classes

•  E.g., CLS – multilateral payment netting and payment versus payment (simultaneous settlement)



Currency Derivatives Issues Non-convertibility •  FX derivative markets initially developed to address delivery

and settlement issues around non-convertibility (‘soft’ currencies)

•  A non deliverable forward (NDF) is a synthetic forward contract enabling hedging and position taking in countries subject to currency regulations and/or high political risk

•  Singapore and HK developed as main APAC trading hubs for NDFs



Equity Derivatives Key Provisions

Equity Swaps Total Return Swaps (“TRS”) and other ‘delta one’ structures transfer economic performance of underlying asset to investors

Party A

(Equity Amount Payer)

Party B (Equity Amount

Receiver)

Equity Amount

Floating Amount

Shares

Pass-though economic performance and dividends



Equity Derivatives Key Provisions Variance Swaps Pay-offs vary according the volatility (up or down) of a share or index

•  EAP amount is volatility of underlying asset (variance from initial price) in either direction

Party A

Party B



EAP amount

Floating amount

Equity Derivatives Key Provisions Equity Options Right, but not obligation, to sell (put) or buy (call) underlying at pre-determined price

–  Party A writes an option and is paid a premium upfront –  Party B only exercises if option is in-the-money (“ITM”) at the

exercise date(s) (subject to any barrier or cap/floor/collar features in the case of exotic equity options)

Party A Party B (writes option/pay-out if ITM)

(buys option/pays premium)




Forwards •  One party buys shares at the forward price and (if physically-settled)

such shares are delivered at maturity (or cash-settled economic equivalent)

•  In the case of cash-settled forwards, the economic equivalent (positive or negative amount over or below the forward price) is paid to ITM party by non-ITM party



Party A

Party B

(pays/delivers shares if ITM)

(pays/delivers shares if OTM)


Benefits of equity derivatives over cash positions •  exposure to equity with lower transaction costs •  avoidance of capital gains tax •  monetization and financing structures •  market access •  greater returns (eg., though use of multipliers/leverage) •  hedges against adverse movements in cash positions •  fewer disclosure requirements in many markets



Equity Derivatives Key Provisions Valuation •  Fundamental to determine payout of

transactions:

–  Scheduled Trading Day

–  Disrupted Day/Market Disruption Event

93



Equity Derivatives Key Provisions Adjustment Events (Article 11)

•  Potential Adjustment Events

•  Adjustments to Indices

94


www.insightlegalasia.com 3

Equity Derivatives Key Provisions Extraordinary Events (Article 12)

•  Merger Events/Tender Offers

•  Nationalization/Insolvency/De-listing




Additional Disruption Events (Article 12.9)

•  Change in Law (illegal to deal in share) •  Failure to Deliver (due to illiquidity) •  Insolvency Filing (proceeding commence) •  Hedging Disruption (unable to hedge price risk) •  Increased Cost of Hedging (material increase) •  Loss of Stock Borrow (unable to borrow) •  Increased Cost of Stock Borrow



Negotiating Closed Market Provisions •  Different documentation for “open” versus “closed”

markets

•  A closed market is a local equity market—Malaysia-- where certain shares are restricted to onshore investors and therefore not directly available to offshore investors

•  Asia-ex Japan closed markets include India, Indonesia, Korea, Malaysia, Taiwan and Thailand



Negotiating Closed Market Provisions

•  Market access products enable investors that are not able to directly invest in closed market shares (or indices) to gain synthetic economic exposure

•  Transfer of economic exposure to local shares or indices is done via an equity derivative with a Qualified Foreign Institutional Investor (QFII)




•  Market access products can either be bilaterally

negotiated (i.e., OTC format) or in securitized format with standardized terms and conditions

•  Exchange traded funds (“ETFs”) may also be used to transfer economic exposure to local equity indices




100

QFII Buyer

(1. premium paid upfront)

1. premium proceeds

(1. sell ZEPO)

1.  buy closed market shares at trade date 2.  sell closed market shares at exercise date

2. share sale proceeds

(2. share sale proceeds)

ZEPO = Zero Exercise Price Option




•  ‘Delta-one’ products have a price/pay-out

structure that closely tracks the price of the underlying asset and risk free rate

•  Delta-one products may be ‘perfectly hedged’ if the seller holds 100% of underlying shares (but not required)






•  Delta (Δ) is the rate of change of the option price with respect to the underlying

Option

price

A

B Slope = Δ = 0.6

Stock price

102


•  Examples of securitized delta-one products

–  Low exercise price warrants (“LEPW”)

–  Participatory Notes (“P-Notes”)

–  Certificates




•  Participatory Note (P-Note) example above is a fully-funded securitized structure whereby a purchase price equal to the share price at issue date is paid by the Buyer (plus a built-in fee) to the QFII

104

QFII Buyer

(1. P-Note purchase price plus fee)

1. P-Note proceeds

(1. sell P-Note)

1.  buy closed market shares at issue date 2.  sell closed market shares at maturity date

2. share sale proceeds

(2. share sale proceeds)




•  Market access products are always cash-settled and denominated in a convertible currency

•  FX risk of local currency is typically borne by the investor (but can be mitigated with a Quanto or other FX derivative)




•  Market access products risks include

– Market risk – Political risk

– Currency risk

– Basis risk



Negotiating Closed Market Provisions •  MAP risks are heavily negotiated between buyers and

sellers in the OTC market

•  Buyer wants same risk/benefit profile as if directly purchasing underlying

•  Seller is acting as a neutral intermediary and therefore wants to allocate all risks to buyer




•  Final price determination

–  Objective (good for buyer)

–  Actual (good for seller)

–  Hypothetical broker dealer (compromise)



Closed Market Provisions

•  Optional early termination

– By buyer

– By seller




Taxation •  All taxes (especially dividend and capital gains)

are typically borne by buyer

•  Greater tax complexity, uncertainty and potential retroactivity in closed markets

•  Tax indemnity from buyer to seller as a form of ‘claw-back’



Negotiating Closed Market Provisions Additional Disruption Events •  Seller keen to remain economically neutral and pass

all risks related to hedge position to buyer

•  Hedging Disruption and Increased Cost of Hedging provisions may need to be extended to cover currency and dividend risks

•  Difficult to foresee all risks and draft such protection into market access products




•  Example: PRC market access products representations to be obtained from buyer

•  We can see from the text in the PRC example that the primary concern is that onshore investors do not purchase offshore interests (directly or indirectly) in underlying shares

•  Similar concerns for regulators in other closed markets



Corporate Derivatives Legal Issues

Overview •  What is a corporate derivative and what makes

them unique?

– An equity derivative over shares of a listed company (“ListCo”) with a shareholder, director or ListCo itself




Transactions with shareholder

•  Shareholder with a large position seeks to monetize stake (lock-in price) in ListCo without disposing of shares

•  Shareholder cannot dispose of shares but wishes to lock-in current price (via collar)




Transactions with shareholder (continued) Monetization structure

115

Shareholder Bank

Shares

Securities Lender

Securities Market



sell call / buy put lend shares

return shares

sell shares

Payment of strike price

delivers shares


Transactions with shareholder (continued)

•  Alternatively, shareholder wishes to raise finance without disposing of existing stake as seen in this example of a Financing structure




Financing structure

117

Shareholder Bank

Shares

Payment of premium

Cash settlement of option

Zero strike call option

Equity swap floating amount payments

Payments of excess share value over premium amount

Payments of excess share value under premium amount

shares as collateral return of collateral


Problem areas •  Insider trading (for shareholder and bank)

•  Market misconduct

•  Disclosure



Corporate Derivatives Legal Issues Insider trading

•  Is the bank a ‘connected’ person that may have access to material information re ListCo shares?

•  Large shareholder is going to be connected and may well possess material non-public information

•  Is there ‘equality of information’ between shareholder and bank?




Insider trading (continued)

•  Bank should seek representation from Shareholder that it is not in possession of material non-public information

•  Is the derivative transaction itself material information (i.e., likely to affect ListCo’s share price)?




Insider trading (continued) •  Bank is acting as neutral intermediary (for a

spread) and merely hedging its position, not seeking to profit or avoid loss

•  Bank should create a ‘Chinese wall’ internally so team in possession of material non-public information is kept separate from team entering into hedging transaction




Market misconduct •  Does transaction effect market price?

•  False trading: intent (or recklessness) as to the effect of creating misleading appearance of active trading or price




Disclosure •  Do all long and short positions created by

transaction need to be disclosed under any listing rules?




•  Transactions with ListCo directors include similar insider trading and market misconduct issues discussed above

–  Additionally, are directors’ duties to ListCo (eg.,

fiduciary duties) being met?

–  Are there any blackout periods during which director is prevented from transacting (such as quarterly and annual results reporting)




Transactions with ListCo

•  Synthetic buy-backs (cash-settled) may replicate economic effect without breaching restrictions applicable to physical buy-backs

•  ListCo cannot be connected with itself so insider

dealing not a concern

•  Market misconduct? –  Similar analysis as above

125 Copyright © Gareth M. Pyburn 2013


Transactions with ListCo (continued)

•  Offer to the public?

–  requires approval by independent shareholders and an offer document

•  On-market purchase (restrictions and disclosures)

•  Off-market purchase (requires special independent shareholder resolution at general meeting)

•  Cash-settled derivative may avoid off-market restrictions on ListCo buying own shares




– Directors’ fiduciary duties to ListCo may be breached if ListCo buys a put or sells a call option over own shares (depending on facts surrounding transaction)

– Also, restrictions on subsidiaries holding shares in ListCo need to be considered



Transactions with ListCo (continued) •  Notifiable transactions

–  acquisition/disposal of assets

–  options to acquire/dispose of assets or securities

–  ListCo providing a guarantee/indemnity/financial assistance

128





•  Connected transactions (eg., directors, CEOs, substantial shareholders) may require written agreement subject to independent non-executive director review

•  General disclosure obligations regarding material information to avoid creating a false market in shares or price



2011 Equity Definitions •  2002 Equity Definitions provide a foundation,

but…

–  Over 50 Master Confirmation Agreements (“MCAs”) make standardization difficult (low levels of electronic confirmations for equity products) and greater transparency is desirable

–  New structure and approach (modular instead of product specific approach)



2011 Equity Definitions

•  ‘Main Book’ intended to be a universal framework document containing core definitions and provisions (300 pages long)

•  ‘Appendix’ designed for further tabular options and features of new products, or new definitions not in Main Book




•  ‘ISDA Transaction Matrices’ are product specific spreadsheet-style documents with standardized elections for trading a product

•  ‘Transaction Supplements’ which set out trade specific economic terms of a transaction




•  Substantive changes from 2002 Equity Definitions include

–  Cancellation Amount

–  Extraordinary Events

–  Calculation Dispute Resolution Procedure



2011 Equity Definitions Cancellation Amount •  Different optional methods of calculating the

transaction value, rather than following a purely replacement value approach which was appropriate in all cases

•  Greater detail on how and when Cancellation Amount is to be determined, data to be taken into account and how losses/gains from hedge close-outs are allocated



2011 Equity Definitions Extraordinary Events •  More choice as to the consequences of

Extraordinary Events with optional fallbacks

•  Range of automatically applied Extraordinary Events and optional Additional Disruption Events greatly expanded and the majority of existing provisions have been amended




Calculation Dispute Resolution Procedure •  Reflects the less mechanical role played by the

Calculation Agent in equity derivative transactions and provides procedural options

•  Procedure applies to determinations made by the Calculation Agent, but also to those made by a party determining a Cancellation Amount (which may or may not be the Calculation Agent)




•  Implementation

–  Main Book does not affect existing transactions under 2002 Equity Definitions or existing MCAs

–  Expected to be gradual and coincide with the publication of ISDA Transaction Matrices



Equity Derivatives Legal Issues

Insider trading •  Person connected to issuer who has relevant information

–  deals so as to profit from non-public information (includes equity derivative transactions)

–  counsels another person to enter into transactions over shares

–  discloses price-sensitive information to another with

reasonable belief that person will deal/counsel another to deal




Insider trading •  Obtain representation from counterparty

•  Chinese walls arrangement that divide/segregate departments with material non-public information (eg., corporate finance) from other departments (eg., sales and trading desks, especially prop trading) can be an effective defense for banks

–  physically measures such as segregating departments, security codes, support staff and machines

–  compliance procedures documenting non-physical segregation measures, enforcement of procedures, dealing rules, restricted lists, control of communications between departments




Market Misconduct •  Actions that affect normal dealings in shares or

have effect on shares price such as ‘false trading’

– misleading appearance of active trading

– creating/maintaining artificial price




Market Misconduct (continued) •  Hedging transactions typically not false trading

•  Advisable to obtain representation that counterparty to the equity derivative transaction (and any related hedging transaction) has no intention (and is not reckless) to create a false market




Market Misconduct (continued) •  Price rigging (‘wash sales’ that cause change in value of

listed shares) •  Market manipulation (two or more transactions likely to

increase or decrease value of shares with intent to induce another person to buy, sell or refrain from trading shares)




Takeovers •  Use of cash or physically-settled derivatives by offerors

to obtain exposure to target company shares

–  does derivative transaction constitute an ‘offer’ (i.e., does offeror have firm intent to offer) and need to be announced?

–  disclosure of interests in derivative positions?

–  do restrictions on dealing apply?




Short Selling

•  Short seller must have presently exercisable and unconditional right to vest the shares with buyer

–  stock borrowing and lending agreement –  title to securities that are convertible into shares –  option to acquire shares –  subscription rights or warrants over shares –  right to return of shares under title transfer CSA

•  Uptick restrictions




•  Q&A



Credit Derivatives Key Provisions

•  Significant development of credit derivatives in APAC, but…

•  Volume and complexity of some structured credit products in APAC has dropped since the financial crisis

–  Synthetic collateralized debt obligations (“CDOs”)

–  Synthetic securitizations, CDO squared (and cubed)

–  Constant credit proportion portfolio insurance (“CPPI”)




Market •  Large institutional market with inter-bank trades and non-

bank end-users

–  Insurance companies –  Hedge funds –  Asset managers –  Corporates

•  Also, retail expansion of credit derivatives via private banking and wealth management products



Credit Derivatives Key Provisions Assets •  Main types of credit derivative underlying assets

(i.e., Reference Entities)

–  Corporates –  Sovereigns –  SPVs –  Single name –  Baskets –  CDX indices




•  Reference Obligations include corporate bonds and loans, asset-backed securities (ABS), leveraged loans and…

•  CDS indices such as Markit iTraxx Asia ex-Japan IG




Credit default swap (CDS) (physically settled)

150

Party A (protection

buyer)

Party B (protection

seller)

(protection premium)

(physical settlement amount)

Delivery of deliverable obligations upon credit event




Credit-linked notes (CLNs) •  Noteholder (protection seller) makes an upfront

payment to purchase CLN and receives enhance coupon (CDS premium from issuer) until maturity unless a credit event occurs

•  If credit event occurs issuer (protection buyer) redeems the CLN at a reduced value




On balance-sheet CLN

152

Party A

(protection buyer)

Party B

(protection seller)

(CLN purchase price)

(CLN redeemed at par if no credit event; if credit event occurs redemption amount reduced by fall in market value)

(enhanced yield on coupon)




Off-balance sheet CLN structure

153

Party A

Collateral

Party B SPV



(CDS protection premium)

(settlement under CDS)

(CLN with enhanced coupon)

(CLN purchase price)

(collateral purchase price)

(interest income from collateral)


Total return swap

154

Asset

Party A Party B

(coupon on asset plus increase in market value)

(payment plus plus decrease in market value)


Credit-linked loan •  Funded structure documented in loan rather than

CLN format

•  Borrower is protection buyer and lender is protection seller

•  Borrower repays principal at maturity unless a credit event occurs, in which case borrower repays a lesser amount early by delivering obligations to lender (or cash-settled equivalent)




Credit-linked deposit •  Similar to CLN but documented in form of a deposit

•  Bank is protection buyer (over reference entity) and customer is protection seller

•  Customer receives higher interest rate (similar to CDS premium) and deposit amount at maturity

•  If credit event occurs, bank delivers obligations (or cash-settled equivalent) to customer




Credit spread option •  Differs from CDS in that no credit event needs to occur

for payout

•  Option buyer gets credit protection in relation to credit spread between one reference entity and another highly rated third party (bps spread b/w A and B)

•  If spread between entities diverge to strike level, option buyer is in-the-money




Contingent credit default swap (CCDS) •  Uses a variable notional amount based on marked-

to-market value at termination of a ‘hypothetical derivative transaction’

•  If credit event occurs in relation to reference entity, credit protection amount crystalizes

•  Credit protection amount more closely reflects actual loss of protection buyer

158



Documentation (2003 Credit Definitions) •  The 2003 ISDA Credit Derivative Definitions

(“2003 Credit Definitions”) are widely used in a broad range of credit derivatives

•  Designed for OTC credit derivative transactions, but typically incorporated into securitized and other credit risk delivery formats mentioned above



Documentation (2003 Credit Definitions) •  ‘Reference Entity’ over which protection is bought

–  Corporate –  Sovereign –  SPV –  Basket –  CDS index

•  …includes any ‘Successor’ (merger, consolidation, and other)



Documentation (2003 Credit Definitions)

•  ‘Obligations’ of Reference Entity over which protection is bought

–  Includes direct obligations such as bonds or loans

– May include indirect obligations such as guarantees




•  ‘Reference Obligation’ that is being hedged by credit derivative transaction

•  ‘Deliverable Obligations’ of Reference Entity

to be delivered upon physical settlement




•  ‘Credit Events’ refer to deterioration of creditworthiness of Reference Entity

– Bankruptcy – Failure to pay (above de minimus threshold) – Restructuring – Repudiation/Moratorium – Obligation Acceleration – Obligation Default



Documentation (2003 Credit Definitions) •  Conditions to Settlement

–  Credit Event Notice

–  Notice of Publicly Available Information

–  Notice of Physical Settlement



Documentation (2003 Credit Definitions) Physical settlement

•  Not subject to debate over Calculation Agent’s valuation or methods

•  Often difficult to acquire Deliverable Obligations in which case protection buyer loses economic benefit of protection




Cash settlement

•  No need for protection buyer to actually acquire Deliverable Obligations

•  Calculation Agent has discretion in valuation process that may disadvantage counterparty

166



Documentation (2003 Credit Definitions) Auction-based settlement •  Industry forms determinations committees and

protection amount is determined by auction

•  Avoids difficulties of acquiring Deliverable Obligations after Credit Event of major Reference Entity and…

•  Valuation is standardized and less unpredictable in a distressed market

167



Documentation (2003 Credit Definitions) •  Initially auction-based settlement was voluntary

•  Big Bang and Small Bang Protocols replaced prior practice of voluntary committees

•  Protocols allow all existing and future transactions to be subject to Credit Derivatives Determinations Committees

168



Documentation (2003 Credit Definitions) •  Determination Committees look at publicly

available information (factual) and provisions of standard CDS contracts to determine

•  whether Credit Event has occurred

•  whether auction should be held to determine the final price for CDS settlement

•  which obligations should be delivered or valued in the auction



Documentation (2003 Credit Definitions) •  Determination Committee Rules published alongside Big

Bang Protocol and March 2009 Supplement

•  DCs are structured to represent a variety of market perspectives and to ensure that each DC member has market expertise

•  Votes process requires deliberation and must represent protection buyers and sellers



Documentation (2003 Credit Definitions) •  Determinations requiring interpretation of 2003 Credit

Definitions need 80% supermajority to ensure protection buyers and sellers treated fairly

•  If an 80% supermajority is not achieved the question proceeds to External Review



Documentation (2003 Credit Definitions) •  Standardization and the reduction of basis risk

–  Legal/Interpretation Basis Risk (uniform contractual terms and determinations of material provisions)

–  Economic Basis Risk (uniform settlement method)




•  Under adverse economic conditions borrowers may try to buy-back debt inexpensively via ‘synthetic buy-back’

•  Provide exposure to own indebtedness and the Reference Entity is also the protection seller



Documentation (2003 Credit Definitions) •  Protection buyer requires a funded structure

(with upfront payment by seller such as a CLN) to address credit risk of protection seller if Credit Event occurs

•  Funded structures could also include collateralized OTC CDS, credit-linked loans and credit-linked deposits




•  CLN issuer’s payment obligations of interest and principal at par upon maturity if no Credit Event occurs in relation to Reference Entity

•  If Credit Event occurs, issuer no longer obligated to pay principal and interest; instead,…

•  Issuer delivers Deliverable Obligations to Noteholder



Credit Derivatives Legal Issues

•  Re-characterization risk that credit derivative will be deemed by regulators to be something else

•  For example, guarantees or risk sub-participations will be treated differently from a legal or regulatory standpoint

176



Credit Derivatives Legal Issues

•  If credit derivative seen as means of by-passing

regulatory obstacles the regulator could ‘look through’ formal structure and deem it to be another type of financial instrument



Credit Derivatives: Advanced Structures

Synthetic CDOs/securitizations

•  Cash CDO is a debt security backed by a pool of underlying debt obligations (loans, bonds…)

•  Synthetic CDO uses a credit derivative (CDS) to transfer credit risk off-balance sheet for regulatory capital purposes (or for arbitrage opportunities in credit spreads)



Credit Derivatives: Advanced Structures Equity default swap (EDS) •  Hybrid concept similar to CDS except that the

triggering event is an ‘equity event’ such as a steep fall in Reference Entity’s shares

•  EDS is basically a deeply out-of-the-money equity barrier put option

•  If equity event occurs, protection seller pays settlement amount to protection buyer



Credit Derivatives: Advanced Structures Onshore/offshore structures •  Synthetically work around restrictions on capital

flows

•  Credit risk of on-shore loan transferred offshore by way of a CDS (embedded in a CLN) offshore



Credit Derivatives: Advanced Structures On-shore/off-shore structure

181

Offshore Branch

Onshore Subsidiary

Onshore Branch

3rd Party Investors

Offshore Parent

USD

Local currency loan

USD

Bonds

CLN referencing onshore subsidiary

Onshore

Offshore



Negotiated Credit Derivative Provisions

•  Q&A



LEGAL AND REGULATORY ISSUES - OTC

DERIVATIVES IN APAC

THE IMPACT OF NEW US AND EU REGULATIONS

Presented by Gareth Pyburn, Esq. [email protected]

Kuala Lumpur May 26 – 27, 2014



DAY TWO

1.  US regulatory framework 2.  Dodd-Frank Act and the Volcker Rule 3. ISDA Protocols Part A: Dodd-Frank Protocols 4.  ISDA Protocols Part B – EMIR Protocol 5.  Central counterparties (CCPs) and comparative

analysis of US and EU clearing obligations 6. FATCA: A new global risk 7. OTC Legal and regulatory trends in APAC: predictions



US Regulatory Framework

Section overview •  Commodities and Futures Trade Commission (CFTC)

•  Securities and Exchange Commission (SEC)

•  Dealers' response to Dodd-Frank and industry-led lawsuit against CFTC

•  US extraterritoriality and the impact on APAC




CFTC •  Primary regulatory ambit for all swaps, except for

“security-based” swaps which fall to the SEC

•  Drafts proposed and final rules pursuant to DF and also acts as the enforcement wing for most derivatives activity

•  “Swap” are defined very broadly and captures most derivative transactions




SEC •  Primary regulator for all securities, but also responsible

for “security-based swaps” that have single stocks, share baskets or share indices as the underlying

•  Limited rule-making authority under DF, which is specific to security-based transactions (primarily equity derivatives)




Other Regulatory Entities Beyond the CFTC, SEC and Federal Reserve itself: •  Comptroller of the Currency

•  Federal Deposit Insurance Corporation (the “FDIC”)




Dealers' response to Dodd-Frank and industry-led lawsuit against CFTC •  SIFMA and ISDA took legal action against the CFTC after it issued

its guidance in July 2013, claiming that CFTC’s Chairman Gary Gensler was acting by individual fiat by using guidance and staff advisory documents, rather than formal CFTC commissioned rules:

–  “The commission attempted to excuse itself from those [rulemaking] requirements by issuing a sweeping, international compliance directive that it characterized as mere guidance”




Dealers' response to Dodd-Frank and industry-led lawsuit against CFTC (continued) •  Plaintiffs argued that Gensler was unlawfully

circumventing procedures, failing to conduct legally required cost benefit analysis and imposing rules that were contrary to international co-operation

•  The EU concurred that the CFTC had over-reached by requiring foreign market participants to follow the US rule book if they trade with a US counterparty




Dealers' response to Dodd-Frank and industry-led lawsuit against CFTC (continued) •  Lobbying groups seek to apply pressure on CFTC to

draft clear rules that industry participants can understand/comply with

•  EU also criticized these CFTC rules on extraterritoriality “…which seem to us to go against both the letter and spirit..” of the division of oversight agreement Gensler hammered out with the EU




•  Q&A



The Dodd-Frank Act

Overview •  Dodd Frank is an overarching reform of Wall Street that targets

swaps, prop trading and other activity deemed too risky for Fed “insured” banks

•  DF rolls back many of the Graham-Bleach-Liley Act’s amendments made during the 1990s allowing banks to engage in market activities, thereby re-introducing certain Glass-Steagall era divisions that segregated credit and market risk in the 1930s (i.e., lending and trading activities kept separate)

•  Beyond the transactional level, DF also puts in place many risk

management safeguards focused on business conduct and risk management



The Dodd-Frank Act

Jurisdictional responsibilities •  The CFTC has gained considerable power post-GFC

and is the primary regulator for most DF reforms

•  CFTC has defined “swaps” very broadly

•  The SEC retains its bailiwick vis-à-vis “security-based swaps”



The Dodd-Frank Act

CFTC and/or SEC registration requirements •  Registration requirements revolve around certain key

terms:

–  Swap dealer (SD) –  Major swap participant (MSP) –  Swap Exchange Facility (SEF) –  Derivatives Clearing Organization (DCO)



The Dodd-Frank Act

Derivative clearing organizations (DCOs) •  Central counterparties (CCPs) seek to transfer and

minimize counterparty credit risk through the use of the novation concept

–  Counterparty risk is transferred to the CCP so that each side to trade faces the credit of the CCP, not the economic counterparty directly



The Dodd-Frank Act

The swap push-out rule •  Restricts the derivatives trading activities of all FDIC-

insured institutions

•  Large components of the detailed Volcker Rule are derived from the push-out rule, which has fundamentally changed what types of trading banks can engage in



The Dodd-Frank Act

The Volcker Rule: Overview •  Extraterritorial impact of the Final Rule on non-U.S. banks

•  Ends prop trading within banks, with exceptions for hedges aligned to actual proprietary positions (must be able to match trade to underlying position being hedged)

•  The Volcker Rule constrains the worldwide activities of virtually all internationally active non-U.S. banks and their affiliates



The Dodd-Frank Act

The Volcker Rule’s Effect •  In the absence of an exception, both proprietary trading in

most financial instruments and sponsorship of and investment in alternative funds will be prohibited



The Dodd-Frank Act

Volcker Rule: Exemptions •  The worldwide market making, underwriting and hedging

activity of affected banks may be exempt from the prohibition on proprietary trading, but these exemptions are narrowly defined

•  Any bank with substantial trading activity can only rely on these exceptions if it has implemented an elaborate compliance program and reports a number of detailed “metrics” to U.S. regulators



The Dodd-Frank Act

Volcker Rule: Exemptions (continued) •  Under the critical SOTUS exception, the Final Rule

allows non-U.S. banking entities to trade with some U.S. counterparties, subject to certain execution and other requirements that will require trading arrangements to be re-examined and conformed



The Dodd-Frank Act

Volcker Rule Exemptions (continued) •  The Final Rule permits any non-U.S. bank to trade in its

home country’s sovereign debt, without regard to where the trading activity is conducted or booked

•  It also permits a licensed and regulated non-U.S. subsidiary (but not a foreign branch) of a U.S. bank to trade in the sovereign debt of the country in which the non-U.S. subsidiary is organized

202



The Dodd-Frank Act

Volcker Rule: Exemptions (continued) •  The Final Rule continues to bar most investments by

non-U.S. banks in “covered funds,” but, in an important development, exempts any private fund organized outside of the United States with no U.S. investors from the “covered fund” ban on investments by these banks

•  The Final Rule exempts UCITS and similar public funds, and covered bond vehicles, from the reach of the Volcker Rule



The Dodd-Frank Act

Volcker Rule Proprietary trading ban •  Proprietary trading under the Final Rule is defined as trading

activity in “financial instruments” (a term that includes securities, options and derivatives (including FX swaps and forwards), but which does not include spot FX and currency transactions) that falls within any of the following buckets:

–  trading with the principal purpose of short-term resale, benefiting from short-term price changes, realizing short-term arbitrage profits or hedging any such positions;



The Dodd-Frank Act

Volcker Rule Proprietary trading ban (continued)

–  trading in financial instruments that are covered by the U.S. market risk capital rule and booked as trading positions, to the extent that the banking entity is subject to the U.S. market risk capital rule; or

–  in financial instruments by a banking entity that is a securities, swap or security-based swap dealer registered in the United States to the extent that the trading is in connection with dealing activities requiring registration, or is engaged in the business of a foreign dealer to the extent that the trading is connected to its dealing activities



The Dodd-Frank Act

Volcker Rule: Exceptions •  By including virtually all dealing positions, the Volcker Rule’s

definition of “proprietary trading” is extraordinarily broad and the exceptions are of critical importance. The exceptions are extremely complex and detailed, including:

–  market making;

–  underwriting activities;

–  risk-mitigating hedging;



The Dodd-Frank Act

Volcker Rule: Exceptions (continued)

•  transactions conducted in accordance with a “documented liquidity management plan”;

•  trading in obligations of the U.S. government; •  trading by a non-U.S. bank in the sovereign obligations

of its home country (the “Foreign Sovereign Exception”);

207



The Dodd-Frank Act

Volcker Rule: Exceptions (continued) •  trading by a U.S. banking entity’s non-U.S. banks and

non-U.S. regulated securities dealers in the sovereign debt of the country in which they are organized;

•  trading on behalf of customers; •  trading by a banking entity that is a regulated insurance

company; and



The Dodd-Frank Act

Volcker Rule: SOTUS Exception •  trading by a non-U.S. banking entity that is conducted “solely

outside of the United States” (the “Proprietary Trading SOTUS Exception”)

•  Non-U.S. banks will probably want to rely where possible on the exception for trading “solely outside the United States,” which generally entails less burdensome assessment and reporting of financial metrics



The Dodd-Frank Act

Volcker Rule: SOTUS Exception (continued) •  Under the SOTUS exception, a banking entity may engage in

proprietary trading if:

–  it is not organized or controlled by a banking entity organized under the laws of the United States, and is a “qualifying foreign banking organization” or satisfies similar criteria establishing that its business is principally outside of the United States; and

–  the trading activity occurs “solely outside of the United States”



The Dodd-Frank Act

Volcker Rule: Summation •  The Final Rule imposes time-critical and substantial

governance, compliance and reporting burdens on non-U.S. banks that engage in trading activity, with very little deference to the equivalence of home country obligations

•  The Final Rule will not be the last word on the Volcker Rule and will be further interpreted by the regulators in an ongoing dialogue between banks, their legal advisers and the regulatory agencies



The Dodd-Frank Act

Volcker Rule: Summation (continued)

•  Although the compliance deadline has been extended to July 21, 2015, institutions with the largest U.S. footprints will need to begin reporting the detailed trading and other metrics required by the Final Rule to the Agencies on June 30, 2014



Dodd Frank Extraterritorial Impact

Application to foreign banks and US subsidiaries of foreign entities •  The recently announced CFTC Final Guidance on

Extraterritoriality (July 12, 2013) is intended to ‘phase in’ Dodd Frank compliance for:

–  non-U.S. persons

–  non-U.S. branches of U.S. banks

–  cross-border transactions




Key terms •  “U.S. person” includes:

–  entities organized or with their principal place of business in the US (along with their non-U.S. branches)

–  collective investment vehicles majority owned by U.S. persons (excluding non-U.S. affiliates of U.S. persons)



Dodd Frank Extraterritorial Impact •  For purposes of swap dealer (SD) registration,

non-U.S. persons need only consider dealing swaps with:

– U.S. persons and their guaranteed affiliates

•  May omit swaps with non-U.S. branches of U.S. banks




•  For major swap participant (MSP) thresholds a

non-U.S. person would ‘count’ only

–  swaps with U.S. persons and their guaranteed affiliates

–  swaps between a third party non-U.S. person and a third party U.S. person in which such potential registrant guarantees the obligations of the third party non-U.S. person




•  Non-U.S. CFTC-registered swap dealers and

major swap participants must comply with entity-level requirements, but…

•  May use “substituted compliance” instead and abide by local law requirements (where recognized)




•  When do transaction-level requirements apply to

cross-border transactions and when is “substituted compliance” with local laws permitted?



Dodd Frank Act

•  Q&A



Dodd Frank Protocol •  The CFTC recently adopted new rules for swap

trading relationship documentation (STRD), portfolio reconciliation and confirmations

•  Mandatory clearing determinations for certain classes of IRS and CDS (to be implemented on rolling calendar) require further documentation to manage the implementation process

•  Use of the ‘end-user clearing exception’ also requires certain documentation



Dodd Frank Protocol

•  The ISDA DFII Protocol provides a multilateral contractual amendment mechanism for agreements between any two adhering parties

–  a party submits an adherence letter to ISDA

–  parties bilaterally exchange protocol questionnaires



Dodd Frank Protocol

What the DFII Protocol Provides

–  standardized swap trading relationship documentation where the parties have not negotiated an ISDA

–  methodology for the daily valuation of all swaps to satisfy STRD requirements

–  an agreement for conducting mandatory portfolio reconciliations

–  agreements to establish that existing confirmation matching processes on an electronic platform comply



Dodd Frank Protocol

What the DFII Protocol Provides (continued)

–  an opportunity to communicate a participant’s status for purposes of of mandatory clearing

–  an opportunity for an end-user to make a one-time election to use the ‘end-user clearing exception’

–  notices and disclosures (including buy-side notices of status for purposes of ‘orderly liquidation authority’)

223



Dodd Frank Protocol


– may be used to amend existing agreements governing swaps between a SD or MSP and any other party (Protocol Covered Agreements or “PCAs”)

–  customizable based on the information and elections provided in the questionnaire



Dodd Frank Protocol


–  allows parties to selectively deliver questionnaires to dealers in order to use the DFII Protocol to supplement PCAs

–  can be used to establish a deemed 2002 ISDA Master Agreement between parties for trades not otherwise subject to a master agreement



Dodd Frank Protocol

•  Components of the DFII Protocol

– Agreement

– Questionnaire

– Supplement

– Master Agreement



Dodd Frank Protocol

•  Who can participate in the DFII Protocol?

–  any party that is an SD or an MSP –  any party that has PCAs with an SD or MSP seeking

to incorporate the representations, covenants and agreements of the DFII Protocol into such PCAs

–  a participant acting as principal or agent acting on behalf of others

–  a participant may only supplement PCAs it has directly executed (as principal or agent)



Dodd Frank Protocol

•  DFII Protocol Agreement sets forth the agreement of participants as to the mechanism by which they may supplement existing PCAs

•  Includes terms that give effect to elections made in the Questionnaire



Dodd Frank Protocol

•  Participants will be deemed to have entered into the DFII Protocol Master Agreement if both such participants have elected to do so in their matched Questionnaires



Dodd Frank Protocol

•  The DFII Protocol Supplement provides representations, covenants, disclosures, acknowledgements and notifications in multiple Schedules:

–  Schedule 1 – Defined Terms –  Schedule 2 – General Agreements between an SD or

MSP and any other party –  Schedule 3 – Calculation of Risk Valuations and

Dispute Resolution –  Schedule 4 – Portfolio Reconciliation



Dodd Frank Protocol

•  Schedule 2 provides

–  CFTC requirements regarding representations and non-default language

–  confirmations may be created through exchange on an electronic platform

–  representations that are triggered by trading swaps subject to mandatory clearing

–  representations that are triggered by an election to use the end-user clearing exception

–  delivery of notifications regarding status as a covered Financial Company or an Insured Depository Institution



Dodd Frank Protocol

•  Schedule 3 provides agreements designed to fill gaps in underlying documentation while minimizing disruption and preserving existing agreement terms as they relate to collateral requirements



Dodd Frank Protocol

•  Schedule 4 provides

–  required frequencies range from daily to annually, and depend on type of counterparty and size of swap book

–  reconciliations must cover all swaps (including historical swaps) and must reconcile valuations (trade by trade) and ‘material terms’

–  terms for conducting reconciliations must be agreed in writing

–  reconciliations are performed on tight timelines and valuation differences over $20 million that cannot be resolved in time must be reported to the CFTC



Dodd Frank Protocol

•  Schedule 4 provides a basic agreement on portfolio reconciliation covering

–  notification from an SD or MSP regarding required

frequencies –  agreement to reconciliation dates –  minimum data requirements –  methods of data delivery and comparison

–  reconciliation deadlines



Dodd Frank Protocol

•  Schedule 4 provides three methods of portfolio reconciliation

–  if one of the parties is not a CFTC Swap Entity parties may agree to one-way delivery of portfolio data

–  parties may agree to exchange portfolio data

–  The parties may also agree to reconcile material terms of portfolio data against the data contained by swap data repositories (“SDR”)



Dodd Frank Protocol Agreement

•  The Questionnaire requires participants to provide

–  name and Legal Entity Identifier (LEI)

–  city for purposes of determining Local Business Days

–  email addresses for the delivery of notices, risk valuations, and portfolio data




•  Questionnaire also requires parties to specify their legal status as:

–  a CFTC Swap Entity (SD or MSP) –  a financial entity

–  a financial company

–  an insured depository institution




Questionnaire elections

–  non-financial entities elect whether to incorporate provisions of the DFII Supplement related to risk valuations (Schedule 3)

–  non-SDs/MSPs elect whether to incorporate provisions for portfolio reconciliation (Schedule 4)




Questionnaire elections (continued)

•  If non-SDs/MSPs elect to incorporate portfolio reconciliation provisions (Schedule 4) then they may further elect:

•  whether to receive and review portfolio data or to bilaterally exchange portfolio data; and

•  whether to reconcile against SDR data



Dodd Frank Protocol

•  Q&A



ISDA EMIR Protocol EMIR Reporting Obligations •  ISDA 2013 Portfolio Reconciliation, Dispute

Resolution and Disclosure Protocol (EMIR Protocol)

•  Nature of the obligation – Article 9



ISDA EMIR Protocol EMIR Reporting Obligations (continued) •  All counterparties and CCPs must report:

–  details of all derivative contracts concluded, modified or terminated

–  no later than the working day following the event to

registered or recognized trade repository--if not available, to ESMA



ISDA EMIR Protocol EMIR Reporting Obligations (continued)

•  Applies to derivative contracts which:

– were entered into before 16 August 2012 and remain outstanding on 16 August 2012

– were entered into on or after 16 August 2012



ISDA EMIR Protocol EMIR Reporting Obligations (continued) •  Distinction between Counterparty Data and

Common Data

•  Counterparties will also keep a record of any derivative contact they have concluded and any modification for at least 5 years following the termination of the contract



ISDA EMIR Protocol Risk Mitigation – Portfolio Reconciliation •  Compliance start date: 6 months after entry into force of

technical standards (15 September 2013)

•  FCs and NFCs must have formalized processes which are robust, resilient and auditable in order to reconcile portfolios (Article 11(b))

•  FCs and NFCs must agree in writing or by other equivalent electronic means with their counterparties the terms on which portfolios will be reconciled before entering into an OTC derivative contract (Article 13(1))



ISDA EMIR Protocol Risk Mitigation – Portfolio Reconciliation (continued) •  Portfolio reconciliation must cover key trade terms and

the valuation attributed (Article 13(2))

•  Portfolio reconciliation can be carried out by a third party



ISDA EMIR Protocol Risk Mitigation – Dispute Resolution •  Compliance start date: 6 months after entry into force of

technical standards (15 September 2013)

•  FCs must report to the competent authority any disputes for an amount in excess of €15m and outstanding for at least 15 business days relating to:

–  an OTC derivative contract; –  valuation of an OTC contract; or –  exchange of collateral (Article 15(2))



ISDA EMIR Protocol Risk Mitigation – Dispute Resolution (continued)

•  FCs and NFCs, must agree detailed procedures and

processes at the outset in relation to:

–  the identification, recording and monitoring of disputes relating to the recognition or valuation of the contract and exchange of collateral; and

–  the resolution of disputes in a timely manner with a specific process for disputes outstanding for more than five business days (Article 15(2))



ISDA EMIR Protocol Reporting •  What has to be reported:

–  Counterparty data –  Common Data –  Delegation



ISDA EMIR Protocol Reporting (continued) •  Section 1 (Reporting Roles)

–  Delegation options between the parties –  Appointment of a third party delegate

•  Section 2 (Reporting Obligations)

–  Agreement of Data –  Delegation obligations



ISDA EMIR Protocol Remedies •  Remedies for Breach:

–  No Event of Default and/or Termination Event

–  Disagreement on Common Data - both parties report

–  Reporting Party fails to report - non-Reporting Party can report or appoint a reporting delegate



ISDA EMIR Protocol “Protocol Covered Agreement” •  ISDA Master Agreements and any existing written agreements

governing:

–  “derivatives” or “derivative contracts” (as defined in EMIR)

•  Exclusions:

–  Other agreements which expressly reference these requirements or otherwise exclude the Protocol

–  Portfolio reconciliation and dispute resolution provisions only apply to uncleared “OTC derivative contracts”



ISDA EMIR Protocol Portfolio Reconciliation Methods •  The Two Reconciliation Methods:

1.  “Exchange of Portfolio Data” –  Both parties send the Portfolio Data to each other –  Both reconcile and notify the other of discrepancies (if any)



ISDA EMIR Protocol Portfolio Reconciliation Methods (continued)

2. “One-way Delivery of Portfolio Data” –  Sender (PDSE) sends Portfolio Data to Receiver (PDRE) –  Receiver reconciles and notifies Sender of discrepancies (if any) –  Deemed affirmation if Receiver is silent

•  Discrepancy - parties “consult ... in an attempt to resolve ... in a timely fashion”



ISDA EMIR Protocol Portfolio Reconciliation Methods (continued) •  Timing - “as agreed” with a fall back to EMIR

–  PR Due Date –  Data Delivery Date –  PR Requirement Start Date

•  Portfolio Data •  Key Terms •  Data Reconciliation



ISDA EMIR Protocol Portfolio Reconciliation Status

•  Status:

–  a Portfolio Data Sending Entity; or –  a Portfolio Data Receiving Entity

•  Which method applies?

–  Two PDSEs = Exchange of Portfolio Data –  One PDSE, One PDRE = One-way Delivery of Portfolio Data –  Two PDREs = Bilaterally agree a method (or status change)



ISDA EMIR Protocol Dispute Resolution Method/Agreed Process

•  Dispute Notice

•  Resolution

–  Consult –  Try to resolve –  Timely manner

•  Agreed Process or Other Process •  Internal Processes •  Specific Process – 5 joint business days



ISDA EMIR Protocol Confidentiality Waiver

•  The Obligations – to report among others:

–  EMIR Article 9(1)

–  Practical considerations

–  EMIR Article 9(4)



ISDA EMIR Protocol Confidentiality Waiver (continued)

•  Part II Confidentiality Waiver

–  Each party consents to disclosure –  “to the extent required or permitted under, or made in

accordance with,” EMIR and supporting regulation” –  Also covers: within groups, to service providers

•  Scope is broad



ISDA EMIR Protocol Remedies for Breach

•  Remedies for non-compliance

–  Does not constitute an event of default or grant a termination right

•  However, other remedies remain, as do regulatory sanctions



ISDA EMIR Protocol •  Q&A



Central Counterparties (CCPs)

Overview •  Aftermath of GFC prompted a great deal of new

regulation globally

–  banks required to hold more capital –  banks required to satisfy liquidity ratios –  CCPs for OTC derivatives (our focus) –  bonuses subject to more scrutiny –  limits to proprietary trading (discussed on Day

One, Dodd-Frank Act Volcker Rule)



Central Counterparties (CCPs) Overview (continued) •  The OTC market is becoming more like the exchange-traded market

•  New regulations introduced since the global financial crisis mean that

–  standard OTC products must be traded on swap execution facilities (SEF)

–  a central clearing party (CCP) must be used as an intermediary for standard products

–  trades must be reported to a central registry




•  Global (G-20) initiatives led by US (Dodd-Frank) and EU (EMIR) have the following regulatory objectives:

–  move an increasing range of OTC derivatives to CCP

clearing to reduce systemic risk

–  improve OTC market transparency through reporting requirements to repositories

–  impose incentives to use CCP clearing by way of higher margin requirements for non-cleared OTCs




Settlement Risk •  CCP clearing insures buyer will receive possession and

seller will be paid on time (mitigates settlement and counterparty risk)

•  Many buyers and sellers using same CCP may simplify multiple settlements (and reduce risk) by netting out transactions multilaterally




Inter-regulatory challenges •  Different regional and country-specific approaches

to OTC CCP clearing

•  Many disputes between US and EU over what OTC products should be covered

•  Much of APAC has taken a ‘wait-and-see’ approach

(i.e., let US and EU iron-out regulatory wrinkles first)




•  Market participants’ concerned that cross-border

derivatives could result in duplicative, conflicting or inconsistent regulatory burdens

•  Regulators (CFTC and EU) wish to reduce the incentive to engage in regulatory arbitrage



Central Counterparties (CCPs) Substituted compliance •  Applicable regulators should defer to regulatory

requirements in another jurisdiction when it is ‘justified’ by the quality of that regime

•  CFTC and EU focused on coordinated cross-border approach that does not permit overseas guaranteed affiliates and branches of US and EU persons to operate outside of their regulatory regimes




Dodd-Frank

•  Non-US swap dealer (SD) that is not affiliated with or guaranteed by a US person is only subject to CFTC’s ‘transaction-level’ requirements in transactions with US persons and guaranteed affiliates of US persons




Dodd-Frank (continued)

•  Non-US branches of US SDs may be able to comply with CFTC rules through ‘substituted compliance’ (complying with equivalent requirements of home jurisdiction)



Comparative Analysis of CCPs in EU and US •  For mandatory clearing, the CFTC and the EU

have agreed upon a “stricter-rule-applies” approach in that where exemptions from clearing would apply in one jurisdiction but not another, such transactions would need to be cleared



Comparative Analysis of CCPs in EU and US •  EU and US regimes impose clearing and reporting

requirements on different classes of OTC derivatives

•  US clearing obligation falls on everyone who trades an eligible contract (narrow exemption when non-financial entities enter into certain hedging transactions)



Comparative Analysis of CCPs in EU and US

•  EU clearing obligation only applies to

–  transactions between financial counterparties

–  non-financial counterparties whose positions (excluding certain hedges) exceed a specified clearing threshold

–  certain non-EU entities




Trade Reporting •  Both regimes include broad requirement on

counterparties to report all OTC derivatives transactions to trade repositories and keep records of transactions

•  Greater transparency, but concerns remain over duplicative reporting to multiple trade repositories




Margin •  Both regimes envisage mandatory margin rules

for un-cleared derivative transactions

•  However, both regimes have stalled on these rules pending the outcome of BCBS-IOSCO consultations on common international standards




Business conduct rules •  Both regimes envisage registration and conduct of

business rules for dealers (eg., EU rules under MiFID)

•  US also requires registration, business conduct, margin and other risk mitigation rules and capital requirements for major swap participants




•  EMIR applies some obligations more broadly to apply to all financial and non-financial counterparties

–  confirmations –  reconciliation –  compression –  dispute resolution

•  Obligations to carry out daily valuations and exchange collateral apply to all financial and non-financial counterparties above clearing threshold




•  Both regimes seek to allow cross-border clearing by allowing the recognition/exemption of non-domestic CCPs, but…




•  US less flexible in relation to cross-border provision of trade repository services

–  US requires full compliance with US regime

–  EU recognizes non-EU repositories conditional on conclusion of a treaty




•  US requires execution of OTC derivatives subject to the clearing obligation on a swap execution facility (SEF) or designated contract market (DCM) (if such a facility or market makes the swap available to trade)

•  In the EU, these issues are being addressed separately as part of the legislative proposals to replace MiFID




•  EU has no equivalent to the US:

–  “Push out" rule restricting the derivatives trading activities of FDIC-insured institution

–  "Volcker rule" restricting proprietary trading of bank groups

–  Provisions allowing regulators to restrict banks owning CCPs

•  UK proposed legislation to significantly limit the derivatives business of ring-fenced retail banks




Major differences

•  EMIR contains exemptions from clearing, margin and other risk mitigation rules for intra-group transactions

•  No corresponding provisions in Dodd-Frank but the CFTC has proposed rules exempting transactions between affiliates from the clearing obligation




Extraterritoriality

•  CFTC has proposed guidance that would impose the US swap dealer requirements on non-US persons that engage in more than de minimus swap dealing activities with US persons



Central Counterparties (CCPs) Extra-territoriality (continued) •  EMIR applies to certain transactions between

EU and non-EU entities (and between non-EU entities), but…

–  deems a transaction to have complied with the clearing, reporting and risk mitigation rules if one counterparty is established in a non-EU jurisdiction that the EC determines to have an equivalent regulatory regime




•  The US head start on the adoption of implementing rules means that a significant part of the US regime will be in force in advance of the EU rules



The Scope of the Clearing Obligation

•  What OTC transactions and entity types are covered?




•  What OTC transactions and entity types are not covered?




Non-cleared OTC trades •  Non-cleared OTC derivatives market will remain critical

to the global economy and play an important role in many industries for operations and to risk management

–  for corporations –  investment and pension funds –  governments and financial institutions



The Scope of the Clearing Obligation Non-cleared OTC trades

•  Types of products likely to remain non-cleared include

–  majority of interest rate swaptions and options (caps, collars, floors) –  cross-currency swaps

–  single-name credit default swaps –  various types of equity and commodity swaps

•  Non-cleared because they do not fit the eligibility requirements of CCPs




Swaptions (an option to enter into a swap)

•  Non-cleared due to lack of liquidity and pricing difficulties in periods of distress

•  Help large corporations, banks/financial institutions and asset managers manage interest rate, financing and other risks



The Scope of the Clearing Obligation Cross currency swaps

•  Companies achieve more favorable interest rates by issuing debt in alternative currencies

•  Investors manage or eliminate foreign currency exposure from foreign assets

•  Pension funds, insurers and other liability-driven investment managers also use them to manage the currency risk in their asset portfolios




CDS

•  Non-cleared CDS will remain since many reference entities are lightly traded with low liquidity

•  Most CDS trading occurs in a small percentage of reference entities



The Scope of the Clearing Obligation Commodity and energy derivatives

•  These smaller OTC derivatives asset classes have relatively fewer transactions

•  Generally tailored to meet the specific needs of an end-user and too bespoke to be cleared by a CCP

•  Lack of liquidity and high degree of customization possible makes clearing more difficult




Equity derivatives •  Equity and equity index options with non-standard

underlying assets or non-standard option characteristics

•  Total return swaps are primarily financing instruments with tailored financing terms and a wide range of underlying assets



Trends and Predictions

•  What OTC products can we expect to be cleared in the future?

•  Does CCP clearing reduce systemic risk or merely concentrate such risk in larger CCP entities?



Trends and Predictions

•  Global and Regional (APAC) •  Malaysia

– greater range of OTC derivative products

– broader base of users and providers



CCP Clearing and Reporting •  Q&A



FATCA FATCA: A new global risk? •  The Foreign Account Tax Compliance Act

(FATCA) refers to US Internal Revenue Code sections 1471 through 1474, which became with effective on January 1, 2013

•  FATCA seeks to help the IRS “combat tax

evasion by U.S. persons holding investments in offshore accounts”



FATCA Impact on derivatives •  FATCA imposes a 30% withholding tax on an

expansive list of payments, including payments of gross proceeds to non-participating Foreign Financial Institutions (FFIs) and other payees that are not FATCA compliant



FATCA Protocol What the FATCA Protocol achieves •  Carves out FATCA withholding tax from the

definition of “Indemnifiable Tax” in the ISDA Master Agreement

•  Places the FATCA withholding tax burden on the recipient of the payment



FATCA Protocol What the FATCA Protocol achieves •  The rationale is that the recipient is the sole

party that has the ability to avoid the withholding tax by complying with the FATCA rules; therefore, the recipient should be the party burdened with the FATCA withholding tax if it chooses to not comply



FATCA Protocol FATCA risk •  FATCA tax applies to payments by an FFI/USFI to a non-FATCA

compliant counterparty, so if all counterparties are FATCA compliant, a FFI/USFI payer will not need to gross up for FATCA tax, even in the absence of FATCA language in an ISDA

•  Trades Where FFI/USFI Payer is at Risk

•  Trades entered into or materially modified after December 31, 2012 with a term that extends beyond December 31, 2013 with a counterparty that is not FATCA compliant if FATCA language is not contained in the ISDA



FATCA Protocol

FATCA risk •  Collateral held beyond December 31,

2013 that generates US source payments to a non FATCA-compliant counterparty where FATCA language is not contained in the Master Agreement



FATCA Protocol

FATCA risk (continued) •  FATCA compliant counterparties include the following that provide

adequate FATCA documentation to the payer:

–  A US person

–  An FFI located in an IGA Country that has not been identified as a non-participating FFI

–  An FFI located in a non-IGA Country that has entered into a Participating FFI agreement or otherwise qualifies for an exemption from FATCA withholding

–  A non-financial foreign entity Note: documentation requirements can be rather onerous for foreign entities



FATCA Protocol Existing ISDA language •  2(d) (i) Gross Up. All payments under this Agreement will

be made without any deduction or withholding for or on account of any Tax unless such deduction or withholding is required by any applicable law, as modified by the practice of any relevant governmental revenue authority, then in effect. If a Party is so required to deduct or withhold, then that party (“X”) will: ...



FATCA Protocol Existing ISDA language (continued) •  (4) If such Tax is an Indemnifiable Tax, pay to Y, in addition to the payment to which Y is

otherwise entitled under this Agreement, such additional amount as is necessary to ensure that the net amount actually received by Y (free and clear of Indemnifiable Taxes, whether assessed against X or Y) will equal the full amount Y would have received had such deduction or withholding been required. However, X will not be required to pay any additional amount to Y to the extent that it would not be required to be paid but for :--

•  (A) The failure by Y to comply with or perform any agreement contained in Section 4(a)(i), 4(a)(iii) or 4(d); or

•  (B)The failure of a representation made by Y pursuant to Section 3(f) to be accurate and true unless such failure would not have occurred but for (I) any action taken by a taxing authority, or brought in a court of competent jurisdiction, after a Transaction is entered into (regardless of whether such action is taken or brought with respect to a party to this Agreement) or (II) a Change in Tax Law.



FATCA Protocol

Protocol language •  The following text shall be added to the Schedule to the Covered Master

Agreement:

–  “Withholding Tax imposed on payments to non-US counterparties under the United States Foreign Account Tax Compliance Act. “Tax” as used in Part 2(a) of this Schedule (Payer Tax Representation) and “Indemnifiable Tax” as defined in Section 14 of this Agreement shall not include any U.S. federal withholding tax imposed or collected pursuant to Sections 1471 through 1474 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), any current or future regulations or official interpretations thereof, any agreement entered into pursuant to Section 1471(b) of the Code, or any fiscal or regulatory legislation, rules or practices adopted pursuant to any intergovernmental agreement entered into in connection with the implementation of such Sections of the Code (a "FATCA Withholding Tax"). For the avoidance of doubt, a FATCA Withholding Tax is a Tax the deduction or withholding of which is required by applicable law for the purposes of Section 2(d) of this Agreement.”



FATCA Protocol Protocol language (continued) •  This Protocol and the amendments set forth in this Attachment shall replace

any Express Provisions, where “Express Provisions” means:

–  (a) any provisions expressly set out in any confirmation of a Transaction that supplements, forms a part of, and is subject to, a Covered Master Agreement; or

–  (b) any provisions expressly set out in any Schedule to a Covered

Master Agreement; –  in either case, that provide for amendments to (i) any Payer Tax

Representation contained in such Covered Master Agreement, (ii) Section 2(d) of such Covered Master Agreement, or (iii) the definition of “Indemnifiable Tax” in such Covered Master Agreement, in each case, only in relation to FATCA Withholding Tax.



FATCA Protocol Additional modifications to ISDA •  Document delivery language for any documents required for FATCA

purposes

•  Termination rights for either or both parties if FATCA withholding may apply

•  Broadening transferee’s right of exchange to facilitate minimal or no withholding on collateral

•  Representations that there are no US persons that have more than a 10% beneficial interest (or a “controlling” interest) in a party to the Master Agreement



FATCA Protocol Additional modifications to ISDA (continued) •  Representations as to FATCA compliance where one party is

required by rating agency considerations to gross up the other party for all taxes

•  Mutual agreement that neither party will delegate withholding responsibility under 1471(b)(3) of the Code to the other

•  Limitation on use of Master Agreement post January 1, 2013 absent insertion of FATCA language



FATCA Protocol Adherence •  ISDA 2012 FATCA Protocol is open for

adherence (as of August 15, 2012)

§  Early adherence is encouraged §  No specific closing date



FATCA Protocol Adherence Process

•  Print, sign and upload the signed Adherence Letter as a PDF attachment (no need to mail the signed original)

•  Once ISDA approves submission, Protocol Participant receives e-mail confirmation of adherence

•  ISDA publishes conformed copy of Adherence Letter and the names of Adhering Parties are published on the website and regularly updated



FATCA Protocol

•  Q&A



Legal and regulatory trends in APAC

To what extent are APAC regulators following the G-20 examples?

•  Hong Kong and Singapore

•  Predictions for Malaysia



End



legal regulatory issues otc derivatives apac 2014

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