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OTC in the New Regulatory World

GTA Advisory and Compliance Workshop

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Table of contents

Sections

I The New World

II Regulation – Why, Who and How

III The Practical Implications - End Users

I V The Wash-up

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The New World I

4

The Impact of Regulation

Front Office Pre GFC Front Office Post GFC

Support Divisions Pre GFC Support Divisions Post GFC

5

Regulation – Why, Who and How

II

6

The Derivatives Market is Large !

USD Trillions

615

548

2007 2008 2009 2010 Fixed-Income Foreign Exchange Credit Equity Commodities Other

Total Total Total JuneBreakout of 2009 by Underlying Asset Class

700

600

500

400

300

200

100

0

-8%12%

Exchange

OTC

596

) p y

2) 13% Derivative market traded on Exchange.3) 90% of Fixed Income cleared on CCP's .4) 3% increase in Exchange trading as of June 2010.5) Number of contracts for Exchange traded i tems as of June 2010.

Futures - 101 Mi l lionOptions - 164 Mi l lion

12%

88%

583

-5%

13%

77%9% 5% 1% 1%

7%

87%

Source: BIS Statistical Annex March 2011, ISDA, ICE, and LCH Clearnet

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How did we come to be where we are today?

An evolution in the OTC Derivative Market is forcing market participants to re-examine the dynamics of the market and to evaluate the technical and operational infrastructures in anticipation of upcoming change.

The OTC Derivative market were steadily growing across the various asset classes (i.e. Credit, Interest Rate, Equity, Commodities, etc.) with Dealers facilitating the markets and growing fee revenues.

► Credit was the primary driver utilized by market participants to evaluate default risk in a bilateral market.

Industry did not have many formal regulations and majority of the participants relied on ISDA and the terms outlined within it as guiding principles for OTC derivative transactions.

Emergence of credit crisis accelerated financial institutions to reduce risk quickly impacting on reduction in overall OTC derivative activity.

The collapse of Bear Sterns and Lehman exposed systemic risks embedded within the OTC derivative market: ► Limited insight into credit quality of OTC market participants; ► Concentration of exposure across few Dealers; ► Inadequate capital set aside to cover OTC losses.

Fed enacted TARP in late 2008 and extended the program through 2009 to assist financial institutions and some select large “To big to fail” institutions from collapse and provide stability to overall market.

September 2009 G 20 reached Agreement that “All standardised OTC derivatives contracts should be traded and cleared through centralised counterparties (CCP) by the end of 2012.

“Things are good” – Pre 2007

“Fear and Pain” – 2008 & 2009

“Uncertainty” – Post 2009

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Regulators “Mount Up” - 2010

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Main Objectives of Derivatives Regulation

Require central clearing

Require trade reporting

Constrains proprietary

trading

Reduce counterparty

credit risk

Increase transparency

Reduced market leverage

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The Changing Regulatory Environment – Centralised Clearing

Significant portion of OTC derivatives trades today are handled in a bilateral model, however post-reform market participants will move to a more transparent centrally cleared model, or face the impact of increased capitalization costs.

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The Changing Regulatory Environment – Reporting

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The new environment - The finer details

So

• Target implementation mid 2012 for mandatory central clearing followed by end 2012 for electronic execution.

• Concept of Central Clearing Parties (CCP) with SEC & CFTC regulators - covers all US registered entities trading global underliers.

• Products required to be cleared decided based upon: outstanding notional, trading liquidity, adequate pricing data, availability of adequate market infrastructure (rule framework, capacity, expertise, etc), impact on systemic risk, effect on competition.

• Regulators can limit banks’ control/ownership of clearinghouses.

• Includes sections on Clearing, Margin, Capital requirements, Execution, Reporting, Confirmations and Market Participant registration and restrictions.

• Volker Rule impacting on Propriety trading

• Target implementation December 2012. Issued by the European Commission – currently in review process.

• Covers all European registered entities trading global underliers.

• Focuses on the use of CCP clearing for eligible OTC derivatives and requirements for CCP’s. Includes regulatory reporting requirements to trade repositories.

Markets in Financial Instruments Directive (MiFiD) - European requirements for execution via an

Organised Trading Facility (OTF)

Basel III Agreement - European capital requirements

Voluntary Industry Agreements CPSS / IOSCO Principles for CCP's - recommendations from Bank of International Settlements applying to CCP's - liquidity, position portability, client asset segregation. Reduced capital required under Basel III if using Clearing House which is CPSS/IOSCO compliant.

FED letter G14 commitments - Interest Rate Swaps 92% of new eligible trades, Credit Derivatives 95% of new eligible trades submitted to CCP's.

US - Dodd-Frank Wall Street Reform & Consumer Protection Act

European Market Infrastructure Regulation (EMIR)

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The new environment - More finer details

OTC Derivative CCP (LCH, ICE, CME, etc.)

EOD Process

EOD Pricing

Risk

Position Mgmt

OTC Dealers

CCP Bank

DTCC Market

Client / Counterparty

Client

Regulators

1 2

3

4

Daily

Novated Trades Weekly

Margin Reports

•Intra-day and EOD Prices •Risk Trades •Principal Trades

•Initial Bilateral Trades •Trades for Clearing •Termination and Novation •Direct debit of

Margin Calls

•Cleared Product File •Official EOD Settlement Prices •Hypothetical Trades (Daily) •Intra-day Price Runs

•Payments (Coupon, Dividends, interest, etc) •Trade Reports

•EOD Settlement File •Calculate Daily Mark-to-Market Margin •Calculate Initial Margin •Position Limits and Margin Summary •Guaranty Fund Allocations

ISDA

Illustration of OTC Derivatives CCP Operating Model

Position Management With the emergence of multiple

CCP’s entities for OTC Derivative settlement Dealers will have to take into account trades settled on a bilateral basis with trades settled at the CCP’s.

Participants could also face some risk with timing issues in the novation of trades to CCP done other than on a daily cycle.

Segregation of assets and collateral could cause some operational complexity.

End-Of-Day Pricing CCP’s will provide

intermediaries detail information on cleared products such as open interest by product, intraday and official EOD settlement prices.

CCP’s will have to optimize their independent pricing process to incorporate this information and also have a dispute mechanism to deal with disparate pricing.

Risk CCP’s will provide rules and

guidelines for risk management from an initial and daily variation requirements perspective.

Addition, participants will also capture transaction data, market concentration and systemic risk information for regulators so that they can monitor the proper functioning of OTC markets.

End-Of-Day Processes CCP’s will facilitate the EOD

settlement process for the respective OTC Derivatives trades that are eligible for central clearing.

Manage both initial and variation margin requirements with the CCP’s on a daily basis.

Novation of trades between market participants and CCP’s.

1

3

2

4

* Illustration based on ICE Clearing Model.

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The Practical Implications - End Users

III

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Direct and Indirect Client Impacts

Qualifications

Non financial entities

Using OTC to hedge or mitigate commercial risk.

Trades are reported to the trade depositary on the client behalf by the FI. Some privacy issue

Increase compliance, regulatory and solvency costs

Greater focus on the capital utilization on client facing trades.

Non Cleared trades are being priced to account for Credit Value Adjustment (CVA). Every client is different.

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The Wash-up

IV

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The Market Sentiment

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