otc derivatives - product history and regulation (9-09)

8/13/2019 OTC Derivatives - Product History and Regulation (9-09)

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OTC Derivatives

OTC Derivatives Product History and Regulation September 2009


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Introduction

What is a Derivative? History, Purposes, Types

Common Types of Swaps

Swap Documentation

OTC Derivatives Regulatory


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History of Derivatives

Derivatives are not really products and they are not

really traded

Simply views or bets on future price movements Rice derivatives traded in Japan in 15thC

Stock options traded in the 1800s

Corn and wheat futures traded on the CME today


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What is a Derivative?

Definition of a Derivative a financial instrument (swap, put, call, cap, floor, collar, or

similar option) for the purchase or sale of, or whose value isbased on, one or more interest or other rates, currencies,

commodities, securities, instruments of indebtedness,indices, quantitative measures, or other financial oreconomic interests or property of any kind

Definition of an Over-the-Counter (OTC) Derivative a derivative that is not traded through an exchange or other

regulated market but through a bilateral negotiation betweentwo parties and thus executed off-exchange

The Securities Exchange Act and the CommoditiesExchange Act regulate exchanges


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Purposes and uses of OTC Derivatives

Risk transfer

Hedging

Investment Exposure to different markets

Change an assets balance sheet character

Speculation Leverage


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Common Types of Derivatives

Options

Futures

Forwards Warrants

Swaps

Other


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Options

Options Holder can buy or sell a security/commodity at a set price

on, or prior to, expiration of the option calls or puts, caps or floors

European versus American Style Exercise/Strike Price Options on stocks; pork bellies

Options also are embedded, for example, in Convertible Bonds

Holder can convert bond into shares of stock or other securitiesin the issuing company

Structured Notes Holder can receive a return of principal greater than original

investment if Notes embedded option has adequatelyincreased in value


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Futures

Futures

Futures contract obligates a person to buy or sell acommodity, security (equity) or financial instrument, or abasket of them (S&P 500 index), at a set price, on a set date(or dates) in the future

Standardized contracts only (i.e., exchange traded) only trade specific contracts supported by the exchange

contracts are usually cash settled

Futures have only market risk due to daily re-marginingthrough the exchange


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Forwards

Forwards Like a futures contract, an agreement to buy or sell an asset

at a specified future time and price

Customized between parties and not exchange traded Can be for any underlier

Can be for any settlement date

Forwards are different from futures Forwards entail credit risk exposure to your counterparty Market risk on the trade unless negotiated re-margining


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Warrants

Warrants

Holder can buy securities of the issuing company at aspecified price that is usually higher than the stock

Usually given as consideration of another transaction;sometimes purchased outright with a premium payment

Generally traded over the counter and have longer maturities

than options


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Swaps

Swaps

A cash settled OTC derivative between two counterparties toexchange two streams of cash flows

Fundamental purpose is to change character of an asset orliability on one persons balance sheet without liquidatingthat asset or liability

Usually subject to ISDA documentation including masteragreement, confirmation, and product definitions


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Exchange Traded vs. OTC Derivatives

Exchange Traded exchange central clearing house (CCH) acts as counterparty on both sides

of the transaction credit risk exposure to CCH margin as required by CCH rules

limited number of standardized products Transparent end-of-day valuation simple liquidation

OTC private transaction between two parties creates counterparty credit risk to be managed collateral negotiated between the parties valuation based on models using various and at times differing

assumptions (witness AIGFP) negotiated liquidation and early termination thus more complex

outside of bankruptcy; sometimes skewed in bankruptcy


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Common Types of Swaps

Interest Rate Swaps

Currency (FX) Swaps

Commodity Swaps Credit Default Swaps (CDS)

Equity Swaps

Total Return Swaps (TRS) Other Types


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Interest Rate Swaps

Interest rate swaps developed in 1981 to alleviatemismatch on capital rates, investment returns andimprove issuer balance sheet management

European companies could raise money with fixedrate Eurobonds, but European investments paidfloating rates

US companies often used commercial paper andother floating rate capital markets while investments,such as Treasury, paid fixed returns.


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Interest Rate Swaps Use and Structure

Banks, funds and corporations use interest rateswaps to reduce mismatched interest exposureon other investments or speculate on interestrate movement

Interest rate swaps are standardized/very liquid

A B

Fixed Interest Rate (e.g., 3%)

Floating Interest Rate (e.g., LIBOR + 50 bps)

Notional Amount= $500 million


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Interest Rate Swap Payment Summary

Each payment is based on a notional amount, but the notionalamount is not transferred

One party makes a stream of payments calculated like interest

that would be paid on notional amount with a fixed (or floating)interest rate

Other party does the same but based on another interest index(typically a floating rate such as LIBOR, but can be based evenon another fixed rate interest index)

Fixed and Floating payments typically match on same day (otherwise credit risk) can be made monthly, quarterly, semi-annually etc.


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Currency (FX) Swaps

Originally developed as back to back loans in the

1970s in the UK to avoid government charges onU.S. dollar based loans.

In 1981, Salomon Brothers created first direct

currency swap between World Bank and IBM IBM swapped U.S. dollars to the World Bank for Swissfrancs and German deutschemarks


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FX Swaps Use and Structure

Banks, funds and other financial institutions useFX swaps to reduce currency risk on otherinvestments or to speculate on currencyfluctuations

Currency swaps are standardized and very liquid

A B

5% on $10 Million USD

LIBOR + 2% on $1.2 Billion JPY


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FX Swaps Payment Summary

Parties exchange streams of payments in differentcurrencies to reduce exposure to currency risk

Multiple currency combinations are possible andsome transactions have different currencies swappedbased on exchange rate or other factors

Often used in conjunction with interest rate swapswhere underlying liabilities are financing transactions


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Commodity Swaps

The Chase Manhattan Bank introducedcommodity swaps in 1986

Commodity futures were common for many years,but swaps provided advantages in products andmaturity

The first swaps referenced oil, but the

commodity swap market has expanded natural gas, electricity, coal, other energy

products, as well as metals, agriculture and othercommodities


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Commodity Swaps Use and Structure

Commodity users use swaps to protect themselvesfrom risk of price swings

Banks and financial institutions use commodityswaps to hedge market exposure to suchcommodities or to speculate on future pricemovement

A BAppreciation on Referenced Commodity

Fixed or Floating Payment or other Commodity returns

Depreciation on Referenced Commodity


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Commodity Swap Payment Summary

Transaction relates to a certain amount of a particularcommodity Commodity amount may be for a one time settlement or multiple

settlements at set time periods

One party pays an amount based on change in price ofcommodity

Other party pays a fixed/floating amount on each settlement

date

These are cash settled and commodity is almost nevertransferred


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Credit Default Swaps (CDS)

Developed in 1994 by JPMorgan to overcome bank capital

restrictions on outstanding Exxon loans By transferring Exxon credit risk, JPM could reduce bank capitalrequired to be held against Exxon loans

Credit derivatives expanded to reference loans, corporate,sovereign and fixed income notes, indices, etc.

How is it different from financial guaranty insurance? CDS buyer need not have an insurable interest


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CDS Use and Structure

Banks, funds and other financial institutionsuse CDS

to hedge credit risk on investments gain leveraged exposure to loans, debt etc.

engage in capital structure arbitrage

arbitrage credit markets

Buyer Seller

Fixed PaymentsReference

Entity

DEFAULTPar Value ofReference Obligation


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Treas return + X

Par

Net losses

Structure of Original 1994 JPM CDS

(BISTrO)

J.P. Morgan retains ownership of loans, but sheds credit risk Credit default swap between MGT and SPV transfers risk Investment proceeds invested in U.S. Treasuries, which collateralize

credit default swap (but not entire $9.7 Bn underlying amount)

BISTrO notes exposed to credit risk of larger reference portfolio

US $697 MM of BISTrO notes exposed to risk of $9.7 Bn portfolio

Loan portfolio($9.7 Bn)

MorganGuaranty

Trust (MGT)

SpecialPurpose

Vehicle (SPV)

U.S.Treasuries

Capitalmarket

investors

Credit default swap Fee(X bp p.a.)

Return Par

0.3 % first loss (equity)

Par (minus netlosses) at maturity


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CDS Payment Summary

CDS between Buyer and Seller of credit protection on aReference Obligation

Buyer makes periodic payments (typically monthly or quarterly)

to the Seller which terminate upon Credit Event

Upon the occurrence of a Credit Event, Seller pays Buyersloss resulting from Credit Event Settled by physical delivery of a Deliverable Obligation or cash

settled by difference between par (100%) and Final Price

Credit Events include Bankruptcy, Failure to Pay, ObligationAcceleration, Repudiation, Moratorium and, for some transactions,Restructuring


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Equity Swaps

Developed in late 1980s to avoid premium tax rates

on investments in foreign securities

ISDA publishes Confirmations and Definitions forequities and equity indices (including variance

indices) for most countries and exchanges


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Equity Swaps Use and Structure

Banks, funds and corporations use equityswaps

gain exposure to equities or indices to avoid tax or transaction costs

gain exposure to illiquid markets

hedge investments

A BAppreciation on Referenced Equity

Fixed or Floating Payment or other Equity returns

Depreciation on Referenced Equity


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Equity Swap Payment Summary

Transaction relates to a certain number of shares of a particularequity Equity amounts may be for a one time settlement or multiple

settlements at set time periods

One party pays an amount based on change in price of anequity security

Other party pays a fixed/floating amount on each settlement

date

These are cash settled and equity security is almost nevertransferred


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Total Return Swaps (TRS)

TRS have been around since at least 1987, when SalomonBrothers offered the first Mortgage Swap Agreement

TRS allows Buyers to invest in otherwise unavailable markets,

gain leveraged exposure to assets or arbitrage cost of fundingexpenses

TRS Sellers can hedge against investment exposure and profitfrom cost of funding differential between the parties

TRS used in many structured investment vehicles (SIVs) thatcollapsed at front-end of the Financial Crisis SIVs were rated not on underlying asset quality but rather on Swap

Counterparty credit rating


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TRS Use and Structure

TRSBuyer

Interest payments from Asset

Loss in Value of Asset

TRSSeller

Reference Asset (e.g., bonds, indices, equities,etc.)

Interest payments

Increase in Value of Asset

Interest Payment (LIBOR + Spread)


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TRS Payment Summary

TRS Buyer pays a rate of interest on notional amount ofReference Asset Interest rate typically less than TRS Buyers cost of funding

TRS Seller can hedge exposure to asset and receive interestpayments that are typically greater than TRS Sellers cost offunding

Allows TRS Buyer to derive the benefit of owning an assetwithout having the asset on balance sheet, and gives TRSSeller protection from loss in value


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Other Swaps and Derivatives

Other common derivatives:

weather derivatives electricity derivatives

life settlement indices

sovereign debt

There is no limit on products referenced parties can create derivatives to precisely fit their investmentneeds and goals


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Exotic Derivatives

Parties can also combine derivativeinstruments to create new instruments

A Swaption is an option to enter into a swap and is

a common derivative instrument

Parties also modify payment structure to fitinvestment goals

Swaps can be drafted to be effective only undercertain conditions (interest rate, exchange rate,equity price triggers) or limit parties exposure tocertain percentages of loss or gain


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Questions?

Are there any questions?


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Swap Documentation

OTC Derivatives are traded under Master Agreements

Master Agreements by their terms: net all transactions

Master Agreement nets all transactions for one aggregate liabilityor asset of a party

provide for representations, covenants, and events of default methodology for terminating all transactions and calculating a

final settlement amount


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Swap Documentation - Bankruptcy

Protected features under the Bankruptcy Code Debtor generally has the ability to avoid

pre-petition preferences (S. 547)

fraudulent transfers (S. 548)

unperfected security interests (S. 547) pre-petition set-offs (S. 553) and post-petition transfers (S. 549)

Trustee generally has the right to assume or reject executorycontracts

Gives the trustee the power to cherry-pick assume transactions favorable to debtor

reject transactions favorable to counterparty


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Master Agreements are protected contracts under BankruptcyCode (S. 560) ISDA was very active in lobbying for these changes to the US

Bankruptcy Code and in some 50+ other countries

Other protected contracts include securities contracts (S. 555) commodities contracts (S. 556) forward contracts (S. 556) repurchase agreements (S. 559) master netting agreements (S. 561)

These contracts protected to maintain integrity of financialmarkets In Lehman bankruptcy there were 930,000 outstanding swaps 918,000 terminated soon after the bankruptcy filings (September

2008)


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A party with a protected contract (including Swap Agreements(S. 362(b)(17)), notwithstanding the automatic stay, trusteespowers, or any order of the Bankruptcy Court: may terminate, liquidate, or accelerate the agreement

offset or net termination values, payment amounts or other transferobligations

foreclose on collateral

Under a Swap Agreement, a party may be able to suspend

performance under a transaction without terminating theagreement (Section 2(a)(iii)) interest accrues


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Swap Documentation - Termination

Under 1992 ISDA Master Agreement, parties elect eitherMarket Quotation or Loss Market Quotation: based on (i) average of two middle bids obtained

from 4 reference market makers or (ii) the middle bid of 3 bids so

obtainedposes problems in times of market turmoil Loss: cost of unwinding hedges related to the terminated

transactions under the Swap Agreementunilateral if reasonabledetermination of non-defaulting party

2002 ISDA Agreement adopts single damages measurement

defined as the Close-out Amount requires a good faith determination, using commercially reasonable

procedures, of the losses or gains that are or would be realized inproviding for the economic equivalent of the material terms of andoption rights of the parties under the terminated transactions


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Simplified ISDA Structure

ISDA Master Ag reement

Long form

Confirmation(s)

Short form

Confirmation(s)

Def in i t ions

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Def in i t ions


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ISDA Agreement Structure (2009)

1992/2002 Master

Agreement

1995 Credit Support Deed(Security Interest-English law)

Definit ions: for use in

documenting Transactions

2007 Property Index DerivativesDefinitions

2006 Definitions

2006 Inflation DerivativesDefinitions

2006 Fund Derivatives Definitions

2005 Commodity Definitions

2003 Credit DerivativesDefinitions

2002 Equity DerivativesDefinitions

1998 Euro Definitions

1998 FX and Currency OptionDefinitions

1997 GovernmentBond OptionDefinitions

Credit Support Docum ents:

to reduce credit risk

2001 Margin Supplement

(incorporating 2001 MarginProvisions)

1995 Credit Support Annex(Transfer-English law)

1994 Credit Support Annex(New York law)

1995 Credit Support Annex(Japanese law)

Bridges

2002 Energy AgreementBridge

2001 Cross-Agreement Bridge

1996 FRABBA Bridge

1996 BBAIRS Bridge

2002 Master AgreementProtocol

Conf i rmat ions

Short form confirmations

Master confirmationagreements

Conf i rmat ions

Long formconfirmations

Annexes

ISDA Global Physical Coal Annex

US Emissions Annex

EU Emissions Annex North American Power Annex

North American Gas Annex

GTMA Annex (UK Power)

European Gas Annex

US Crude Oil and RefinedPetroleum Products Annex

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OTC Derivatives Regulatory

History of OTC Derivatives Regulation

Discussion of Over-the-Counter DerivativesMarkets Act of 2009


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Arguments for regulating OTC Derivatives

Speculative nature of the transactions cause marketintegrity issues

Lack of transparency or opaqueness

Precise nature of risk and scope unknown toregulators Leads to potential increased systemic risk

Viewed as having exacerbated the Financial Crises


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Early Derivatives Regulation

Originally regulated in US and UK by common-law

rules against difference contracts could wager anything you wanted, but to go to court to

enforce it had to demonstrate at least one party had a realeconomic interest in the underlying and was using thederivative to hedge against a risk to that interest

akin to insurance law concept of insurable interest


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Early Derivatives Regulation

Didnt mean you couldnt use derivatives to speculate, ratherneeded to come up with ways to make sure counterparts paidon their bets if they had no economic interest in the underlying

Private exchanges created with membership, margin, andnetting requirements designed to make sure speculators wouldmake good on their contracts

Control increased with imposition of government regulators

CFTC and SEC

ISDA Swap Agreements essentially created an OTC derivativesprivate exchange with netting benefits


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CFTC

In 1974 Congress created the Commodities Futures TradingCommission (CFTC)

Congress gave CFTC exclusive jurisdiction over all contractshaving the character of futures contracts and mandated thatsuch contracts, with certain exemptions, only be traded onCFTC-regulated exchanges

CFTC given exclusive jurisdiction over all futures and options onfutures whether underlying was a physical or financialcommodity


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1974 Treasury Amendment

Treasury Amendment proposed over concerns of scope ofCFTCs jurisdiction

Amended CEA to exempt (so long as not conducted on a board

of trade): transactions in foreign currencies

government securities

mortgages

While these exemptions covered the exclusion of a number ofprivate markets of concern to Treasury, a large number ofderivative transactions would not fit into CEA/CFTC statutoryexclusions or exemptions


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1982 Shad/Johnson Accord

1982 Shad/Johnson Accord attempted to clarify theregulatory jurisdiction over futures and options basedon securities and stock indices between the CFTCand the SEC

Banned futures contracts on single stocks and

narrow-based stock indices thus viewed as a prohibition on equity derivatives


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1982 Shad/Johnson Accord

CFTC retained authority over futures contracts and options onfuture contracts on commodities (including exempt securities (other than munis))

foreign currencies not traded on a national securities exchange

certificates of deposit

broad-based indices of securities

SEC retained authority over options on

securities (including certificates of deposit) certain securities indices

foreign currencies traded on a national securities exchange


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1989 CFTC Swap Policy Statement

Reflected CFTCs view: that most swap transactions, although possessing elements of

futures or options contracts, are not appropriately regulated as suchunder the CEA as futures or commodity options

Enacted prior to CFTC having authority to exempt futurescontracts from being required to be traded on CFTC approvedcontract markets

Swap Policy Statement viewed by some as indication thatswaps covered by the Swap Policy Statement were not futurescontracts


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1989 CFTC Swap Policy Statement

To meet the Swap Policy Statement safe harbor, theswap agreement must:

have individually negotiated terms be entered in conjunction with the swap parties line of

business not be terminable without the consent of the other party

If a high net worth individual enters into a swapagreement, what is his/her line of business?


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1989 CFTC Statutory Interpretation Concerning

Certain Hybrid Instruments

Excluded from CEA regulation certain instruments(debt or equity) whose repayment was linked to acommodity component

Rule tested the commodity independent yield andcommodity dependent yield commodity independent yield of the hybrid instrument had

to be between 50% to 150% of the estimated yield on acomparable non-hybrid instrument

Rule led to a number of regulatory uncertainties when it wasapplied


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Futures Trading Practices Act of 1992

Granted the CFTC authority to grantexemptions from the CEA regulation

Again did not specifically address whether aswap agreement is a futures contract or an

option on a futures contract


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1993 CFTC Swap Exemption

CFTC exempted swap agreements that were: entered into with eligible swap participants (ESPs)

not part of a fungible class of agreements that arestandardized as to their material terms

creditworthiness of the parties is a material consideration

swap agreement is not traded through a multilateraltransaction execution facility


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1993 CFTC Swap Exemption

Since swaps were exempt and still not held to not befutures, CFTC still retained anti-fraud and anti-manipulation authority over exempted swapagreements

Swap Exemption applied to most common interest rate,currency and commodity swaps cast doubt on the legality of equity derivatives (which continued

to rely on the Swap Policy Statement)


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1993 CFTC Hybrid Exemption

Eliminated a hybrid instruments commodity independent yieldtest for a predominance test

Predominance test requires the debt and equity component of a hybrid instrument (commodity-

independent component) must exceed the value of the option-likeor futures-like commodity component of the instrument(commodity-dependent component)

CFTC prescribed a method by which the commodity indexation had

to be decomposed by assigning premium values to be assigned tothe commodity options

varying assumptions used produced considerable regulatoryuncertainty


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Post 1993

Two developments led market participants to believe that theCFTC might seek to modify the Swap Exemption Comment letter on SECs broker-dealer lite proposal stated that

the SEC proposal created potential conflict with the CEA to theextent that certain OTCs fall within the ambit of the CEA and are

subject to the exclusive authority of the CFTC CFTC 1998 Concept Release requesting comment of whether OTC

derivatives regulation is appropriate and if so what form should ittake raising uncertainty about the Swap Exemption

1998 Legislation enacted at request of Treasury, Fed, and SEC

limited CFTCs rule-making authority with respect to swaps andhybrid instruments until March 30, 1999 essentially froze the pre-existing legal status of swaps and hybrids

entered into in reliance on prior CFTC policy statements andexemptions


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2000 CFMA

In 1999-2000 need was recognized to overhaul OTC derivativeregulation 1993 Swap Exemption could be revoked by CFTC at any time

CFMA declared OTC derivatives exempt from both CFTC andSEC regulation

CFMA provided legal certainty No OTC derivative contract would be unenforceable under the CEA or

any other federal or state law for failure to comply with exemptions orexclusions provided by CEA

OTC derivatives excluded from requirement to be executed on aregulated trading facility

Repealed Shad-Johnson to permits US trading of security futures futures on individual non-exempt securities futures on narrowly-based groups or indices of non-exempt securities


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2000 CFMA

Provided that swap agreements entered into with eligiblecontract participants that are not executed on a trading facilityare excluded from the CEA

ECPs corporations with $10 million in assets natural persons with $5 million in assets entered into to manage

risk

Much more effective than 1993 Swap Exemption

can be modified only by Congress applies to transactions and not just master agreements ECPs were broader than ESPs Swap Exemption non-fungibility and creditworthiness requirement

eliminated


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2000 CFMA

Also amended the securities laws to define security-based and non-security based swaps agreements. security-based swap agreement is a swap agreement of

which a material term is based on the price, yield, value orvolatility of any security or any group or index of securities non-security based swap agreement means any swap

agreement that is not a security-based swap agreement.

CFMA made security-based swaps agreement subject

to anti-fraud, anti-manipulation and anti-insider tradingprovisions of the 1933 Act and 1934 Act


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2000 CFMA

However, SEC had no regulatory authority oversecurity based swap agreements

SEC could propose no reporting or record-keepingrequirements, procedures, or standards as prophylacticmeasures against fraud, manipulation or insider trading withrespect to any security-based swap agreement

certainly could not require the registration of security-based

swap agreements under Section 5


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2000 CFMA

Excluded from CEA jurisdiction identified bankingproducts to deal with CFTC and banking regulators

jurisdictional issues includes certificates of deposit bank loans

loan participations sold to qualified investors

credit swaps

equity swaps sold to qualified investors


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2000 CFMA

Also provided that CFMA preempts any state or local lawsregulating gaming or bucket shops eliminates concern that excluded or exempt transactions may be

voided for violating these state or local laws

Contained a savings clause that no transaction between ECPs,and no hybrid instrument, shall be void, voidable orunenforceable solely because it fails to comply with the terms ofan exemption or exclusion

Thus with CFMA 2000, OTC derivatives regulatory regime andenforceability was set in stone


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Over-the-Counter Derivatives Markets

Act of 2009 (proposed August 11, 2009)

Significant changes to the regulatory structure

Significant changes to the way OTCs are cleared

Significant rule-making to come


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OTC DMA of 2009 - Overview

Eliminated the unregulated status of OTC derivativesand implemented a new regulatory authority carved up regulatory authority over swaps between SEC and

CFTC Created registration requirements for swap dealers

and major swap participants

Legislated mandatory clearing requirements

for standardized swaps Legislated registration requirements for swap clearing

houses


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OTC DMA of 2009 - Overview

Expansion of regulatory authority over swaps CFTC

would have exclusive jurisdiction over all swaps exceptsecurity-based swaps

swaps include options but does not include foreign exchangeswaps and foreign exchange forwards CFTC would be limited to regulating entities dealing in swaps

and to enforcing anti-manipulation and anti-fraud provisions

SEC would have exclusive jurisdiction over security-based swaps

security based swap are swaps based on a single security, loanor a narrow-based security index SEC would maintain authority over anti-fraud, short-swing

profits, and insider trading


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OTC DMA of 2009 Credit Default Swaps

Allocates jurisdiction over credit-defaultswaps to the CFTC and SEC

SEC has jurisdiction over security-based swaps single security, loan (CDS) or narrow-based security

index (including narrow-based CDS index)

CFTC has jurisdiction over all other swaps includes broad based securities indicies (including CDS)


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OTC DMA of 2009 Standardized and

Non-Standardized Swaps

Distinguishes between standardized swaps and non-standardized swaps standardized swaps will be required to be cleared through a central

clearing house non-standardized swaps will be subject to higher capital and margin

requirements on derivatives dealers and major swap participants CFTC and SEC to define standardized swaps within 180 days

of enactment define as broadly as possible, after taking into account

terms of the trade volume

extent to which a swap is similar to other centrally cleared swaps economically similar to other centrally cleared swaps in a manner to reduce avoidance schemes


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OTC DMA of 2009 - Rulemaking

Where SEC and CFTC cannot agree on rulemakingas required by the Act, Treasury is authorized toimpose rule until agencies reach agreement

SEC and CFTC cannot make rules unless as strict orstricter than those of prudential banking regulators

Proposal also grants limited exemptive authority only where expressly authorized

thus no work around fixeslegislative acts would be required


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OTC DMA of 2009 Registration Requirements

Registration Requirements

requires swap dealers and major swap

participants to register with the CFTC

requires security-based swap dealers and majorsecurity-based swap participants to register withthe SEC


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OTC DMA of 2009 Swap Dealer Definition

Who is a swap dealer? swap dealer is any person who is engaged in the business of

buying or selling swaps for its own account, excludingpersons who do not engage in this activity as part of a

regular business (trader exemption) if trader exemption interpreted consistent with Exchange Act

would potentially exclude many end users such as hedgefunds, insurance companies, and operating companies

No bank exemption as presently under the 1934 Act

for Banks Brokers of security-based swaps will also be required

to register under the 1934 Act


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OTC DMA of 2009 Major Swap Participant

Definition

Who is a major swap participant?

a person who is not a swap dealer but whomaintains a substantial net position in outstanding

swaps, excluding persons who engage in tradingswaps to maintain an effective hedge under GAAP

GAAP hedges is pretty narrowly defined as anaccounting matter

Many financial companies, banks, insurancecompanies, investment companies likely tomeet this definition


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OTC DMA of 2009 Swap Dealer Provisions

Swap dealer and major swap participant are required to meet minimum capital and margin requirements to be established

by Fed/OCC or FDIC for Banks SEC and CFTC jointly (for non-banks)

capital requirements would be higher for non-standardized swaps thanfor swaps

Bank regulators would set a floor for SEC and CFTC requirements

initial and variation margin set by Bank regulators would also set floorfor SEC and CFTC requirements

comply with various reporting and record-keeping requirements must require daily records of swaps, cash, recorded conversations,

including email and IMs a complete audit trail

conform to certain business conduct, documentation and backoffice standards

comply with requirements relating to position limits, disclosure,conflicts of interest, and antitrust


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OTC DMA of 2009 Swap Dealer Provisions

Major security-based swap participants required toregister with SEC potentially resulting in dualregistration (for e.g., may be regulated by the OCC or

under the Investment Company Act)

SEC and CFTC are required to jointly define majorswap participant


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OTC DMA Act of 2009 Mandatory Clearing

Mandatory clearing requires all standardized swaps to be traded on a

designated contract market or alternative swap executionfacility (ASEF)

ASEF must provide that all swaps with same terms andconditions are fungible and may be offset with each other

these mandatory trading requirements would not apply toswaps if

no clearing agency accepts the swap for clearing one of the parties to the swap is not a swap dealer or a major

swap participant swap dealer or major swap participant does not meet the

eligibility requirements of any clearing organization that clearssuch transactions


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OTC DMA of 2009 Trading Facilities

ASEFs for trading of standardized swaps or standardized security-based swaps required to register with CFTC or SEC, as appropriate

As an ASEF, would be subject to

trading procedures deterrence of trading abuses

financial integrity of transactions

ASEFs would have core regulatory principles, and subject to

enforcement, position limits

emergency powers

recordkeeping and reporting

conflicts of interest


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OTC DMA of 2009 Trading Facilities

ASEFs subject to comparable comprehensivesupervision/regulation by another domestic/foreignregulator could be exempted by the Agency

ASEFs would make publicly available aggregate data onswap trading volumes and positions (without disclosingbusiness transactions or individual market positions)


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OTC DMA of 2009 Swap Repository

Parties who enter into non-standardized (uncleared)swaps are required to report such swaps to aregistered swap repository registered swap repositories are required to register with the

appropriate Agency would be required to accept, maintain and make available data

to the Agency

would be subject to inspection and examination

deterrence of trading abuses

financial integrity of transactions seems more like a governmental function raising private

market issues


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OTC DMA of 2009 Final Reporting

Finally, persons whos trades are not cleared or not reported toa registered swap repository would be subject to certainreporting and recordkeeping requirements

Institutional investment managers would be required to reportsecurity-based swap agreements aggregated with their cashpositions on SEC Form 13F

CFTC and SEC would be required to publicly report aggregated

position information (without disclosing business transactions orindividual market positions) derived from clearing organizations

swap repositories

persons otherwise required to report directly to the Agency


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OTC DMA of 2009 Position Reporting

CFTC given power to establish aggregate position limits forcontracts listed by a DCM/ASEF and swap contracts thatperform or affect a significant price discovery function, allowingfor hedging exemptions

SEC has similar authority for position limits for securities listed on a national securities exchange

and security-based swaps that perform or affect a significant pricediscovery function with respect to regulated markets

large trader reporting requirements for security-based swaps that

perform or affect a significant price discovery function with respectto regulated markets


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OTC DMA of 2009 Sections 13d and 16

Sections 13 and 16 would apply also to security-

based swaps and any other derivative instrument theSEC may determine Section 13 turns on beneficial ownership s power to dispose

or to vote which is generally not present in a cash settledsecurity-based swap


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OTC DMA of 2009 ECP Definition

ECP definition would be modified government entities that invest on a discretionary basis

$50m (previously $25m)

individuals with $10m in assets invested on a discretionarybasis (previous just $10m in assets)

Mandatory exchange clearing provisions would notapply to swaps entered into by ECPs


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OTC DMA of 2009 Retail Regulated

Swaps

Unlawful for anyone other than an ECP (i.e., retail) to

enter into a swap unless a swap subject to a regulated futures exchange

a security-based swap entered into on a national securitiesexchange and the trade was registered under the 1933 Act


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Questions

Are there any questions?


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Bill Satchell, Partner

Bill Satchell is a partner in OMelveny's Washington,DC office and a member of the Firms SecuritiesEnforcement and Regulatory Counseling Practice. Headvises financial services organizations in connection

with transactional, litigation, and regulatory matters.Bills practice extends to a broad range of issues,including structured finance, financial institutionmergers and acquisitions, privacy, anti-moneylaundering, residential mortgages, the regulation offinancial products, derivatives, and financial productdistribution.


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Demetri Xistris, Senior Counsel

Demetrios Xistris is a Senior Counsel in OMelvenys New York office and a member of the Firms InvestmentFunds and Securitization Practice. He is highly experienced in financial products and derivatives transactionsincluding equity, credit, fixed income, commodities and hedge fund derivatives. He has extensive knowledge ofstructured products, hedge fund structures and activities, financing and credit enhanced vehicles, corporate,monetization and hedging transactions, prime brokerage, synthetic prime brokerage, structured repo, equityfinance and proprietary trading and has worked on a number of asset acquisitions related to derivative andfinancial products trading businesses. Demetrios is also an authority on master agreements, netting and collateraldocumentation.

Prior to joining OMelveny, Demetrios spent 15 years on Wall Street at various investment banks as theseniorlawyer where he managed the legal, regulatory enforcement, trading, and marketing aspects of the firms' USequities and equity derivatives businesses.

Most recently, Demetrios was a managing director and legal head of the US Equities and Equity Derivativesdivision of Socit Gnrales, the worlds largest (by revenue) equity derivatives house where hechaired theGlobal Legal Departments Hedge Fund Working Group, was a member of its Global Equity Derivatives and ISDAMaster Agreements Working Groups, and participated on the firms US New Products Committee for all newequity products.

His experience also includes working in similar capacities at BNP Paribas, where he was a managing directorresponsible for all legal matters relating to the firm's US Equities and Equity Derivatives business, and atJPMorgan, where he was that banks first equity derivatives lawyer.

During his work at the investment banks, Demetrios was also very active on FINRAs Derivatives ProductsCommittee. He was, and continues to be, a member of various ISDA committees, including the Equity DerivativesCommittee. He co-chaired ISDAs 2006 Fund Derivatives Definitions project and is a founding member of theStructured Products Association.

otc derivatives - product history and regulation (9-09)

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