Interest Rate Derivatives under Dodd-Frank


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An overview of the impact of the Dodd-Frank Act on interest rate derivatives for market participants that are neither swap dealers nor major swap participants. Summarizes swap clearing and trade reporting requirements.

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Interest Rate Derivatives under Dodd-Frank

  1. 1. Interest Rate Derivatives under Dodd-Frank Implications for market participants other than swap dealers and major swap participants Margaret Scullin 404-530-9372 November 2013
  2. 2. Outline • Overview of Derivatives Regulation • Central Clearing • Clearing Certainty • Portability • Protection of Customer Collateral • Uncleared Swaps • End User Exception • Margin Requirements • Documentation • Trade Reporting
  3. 3. The Dodd-Frank Act is passed in the wake of the financial crisis Size and scope of law unprecedented for financial legislation • 849 pages • 1,601 sections • 398 rulemakings required • Title VII (§§701-774) regulates derivatives
  4. 4. Why derivatives regulation? Concern over size and lack of transparency of derivatives market, most memorably expressed by Warren Buffett: “I view derivatives as time bombs, both for the parties that deal in them and the economic system.” “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Berkshire Hathaway 2002 Annual Report (emphasis added)
  5. 5. Why else? The Bailout of AIG. American International Group, Inc. (AIG) CDS Buyer CDS Buyer AIG Financial Products Corp. CDS Buyer CDS Buyer
  6. 6. Objectives of Dodd-Frank Derivatives Regulation Require central clearing Reduce counterparty credit risk Require trade reporting Increase transparency
  7. 7. Clearing – changing the way derivatives are transacted Historically, derivatives were entered into privately, or over-the-counter (OTC), between two parties Party A Party B
  8. 8. Cleared Environment Introducing the derivatives clearing organization (DCO) as central counterparty In theory, it looks like this: DCO Party A Party B
  9. 9. Cleared Environment In reality, it looks more like this: DCO Party A’s FCM Party A Party B’s FCM Party B
  10. 10. Pros & Cons of Central Clearing Pros Cons • If trade accepted for clearing, original counterparties have no credit exposure to each other • Portability – can transfer positions and related margin from one FCM to another • Instead, counterparties have credit exposure to their FCMs and DCOs • Increased collateral (initial margin + variation margin) • Added transaction costs (FCM/DCO fees)
  11. 11. Wanted: Clearing Certainty • Parties want certainty, prior to executing a trade, that their FCM and DCO will accept that trade. • Where clearing is mandatory and no exemption applies, if a trade is not accepted for clearing, it must be terminated. The parties may incur losses due to the terminated trade. • FIA-ISDA Cleared Derivatives Execution Agreement is a breakage agreement whereby parties specify how trades failing to clear will be treated and allocate breakage costs. • CFTC guidance prohibits mandatory breakage agreements as a condition of access to swap execution facilities.
  12. 12. Improvements Expected • The current system, of post-execution checks coupled with breakage agreements, is an interim solution. • An industry working group is investigating solutions for pre-execution certainty. • Considering three possible models: • Push – FCMs “push” individual customer credit limits to the various Swap Execution Facilities (SEFs) on which cleared derivatives trades are executed; would be fast but inflexible • Ping – messaging between SEFs and FCMs and/or SEFs and DCOs; would be more flexible but slower than push model • Hub – third party service, would work with either push or ping method, and would eliminate the need for FCMs to subdivide credit limits across SEFs
  13. 13. Portability • Ability to transfer trades and related collateral from one FCM to another, without having to close out and re-book • Customer can move trades to another FCM that is financially stronger or that offers better commercial terms (i.e., lower excess margin requirements) • More flexible than OTC model, which requires consent from the counterparty to transfer a trade
  14. 14. Portability: Pre-FCM Default • Customer has right to transfer its trades from an FCM at any time, as long as customer is not currently in default to that FCM (CFTC Rule 39.15(d)) • Customer must have another FCM that is willing to accept the transferred trades • Transfer rule expected to apply would require transfer requests to be completed within 5 business days, unless more time is needed for due diligence (NFA Rule 2-27) • Timing of transfer could be impacted by: • Need to execute clearing documentation with transferee FCM • Partial transfers could result in need to post additional margin to transferor FCM on remaining positions
  15. 15. Portability: Post-FCM Default • DCO will try to transfer non-defaulting customers’ positions to a solvent FCM • In the event of an FCM bankruptcy, the trustee and bankruptcy court will determine whether and when customer positions can be transferred • Any shortfall in customer funds at the FCM is likely to prevent or limit transfers • Under the Bankruptcy Code, any losses must be shared pro rata among customers (because cleared swaps are “commodity contracts” under the Bankruptcy Code) • Trustees of defaulted FCMs have always sought permission of Bankruptcy Court to transfer customer funds
  16. 16. Protection of Cleared Swaps Customer Collateral • Critical issue, especially given volume of transactions that will be required to be centrally cleared • Existing futures model was considered inadequate because of “fellow customer risk”: risk that nondefaulting customers’ collateral can be taken to satisfy a shortfall created by another customer’s default, which causes the FCM to default to the DCO (a “double default”) • CFTC considered various models and adopted Legal Segregation with Operational Commingling (LSOC)
  17. 17. LSOC Benefits • Eliminates fellow customer risk in the event of a double default • DCOs (and trustees) will have information about individual customers’ positions and collateral Limitations • Customer collateral at risk if FCM defaults to a DCO for any reason other than customer default(s), such as investment losses or misuse of customer collateral • Bankruptcy Code still requires pro rata distribution of collateral liquidated by DCO in event of FCM bankruptcy
  18. 18. FCM Bankruptcies: Ripped from the Headlines… October 31, 2011 July 10, 2012
  19. 19. What Went Wrong? MF Global PFGBest • Proprietary trading activities led to increased capital requirements and demands for collateral • “Excess” funds were “borrowed” intra-day from customer accounts • Credit rating downgrade worsened liquidity crisis • $1.6 billion shortfall in customer funds • Fraud began in 1993 • Bank statements falsified • CEO set up fake P.O. box to intercept regulatory documents • Customer funds were misappropriated; used to cushion capital, pay regulatory fines, etc. • $215 million shortfall in customer funds
  20. 20. CFTC Response • Amendments to CFTC Rule 1.25, limiting permitted investments for customer funds (removing corporate debt, foreign sovereign debt and repurchase transactions with affiliates from list of permitted investments) • Rule 1.25 will now apply to Rule 30.7 accounts (for customers trading on foreign exchanges) instead of only Rule 4d accounts (for customers trading on domestic exchanges) • FCMs must post collateral to clearinghouses on a gross, rather than net, basis • Final DCM rules include minimum requirements for financial surveillance of FCMs by SROs • LSOC
  21. 21. CFTC Response (continued) • FCMs can no longer use the “alternative method” for calculating the total amount of customer funds required to be kept in Rule 30.7 accounts (and the “regulatory excess”) • “Corzine Rule”: no withdrawals of >25% of excess funds without written management approval and prior notification to regulator • Daily segregated account reports and identification of customer funds depositories • CFTC must be granted direct online (read-only) access to FCMs’ depository accounts • Enhanced standards for auditing of FCMs
  22. 22. Other Protections for FCM Customers? MF Global Trustee Giddens, some legislators and customer groups have argued for an insurance mechanism • FDIC and SIPC protect bank depositors and securities holders; why not similar protection for futures customers? • Canadian Investor Protection Program – MF Global Canadian customers were made whole
  23. 23. Uncleared Swaps: Exceptions to Mandatory Clearing The Dodd-Frank Act requires all swaps to be cleared, except: • Swaps entered into before the effective date of the clearing rules (“pre-enactment swaps”) • Certain foreign exchange swaps • Swaps entered into by non-financial entity end-users as hedges of commercial risk (the “end user exception”) • If specifically exempted by the CFTC: • Exception to definition of “financial entity” allows “small banks” (total assets <$10 billion) to avail of end user exception • Cooperatives • Eligible treasury affiliates
  24. 24. Evidencing End User Exception • Swap counterparties that elect the end user exception must retain evidence of their eligibility and basis for the exception • Public companies electing the exception must obtain board approval of the decision to enter into uncleared swaps
  25. 25. Margin Requirements • Cleared Swaps – subject to initial and variation margin required by the derivatives clearing organization, as well as any excess margin requirements imposed by FCM under clearing agreement between customer and FCM • Uncleared Swaps – CFTC reopened the comment period on proposed rule, with view to international harmonization; general aim is to impose requirements sufficiently high to incentivize clearing, with some exceptions: • Non-financial end users using swaps for hedging would not be required to post margin • Financial end users subject to capital requirements set by a prudential regulator and using swaps for hedging could have modest unsecured thresholds
  26. 26. Amending ISDA Master Agreements • ISDA Master Agreements with swap dealers and major swap participants must be amended to comply with CFTC rules (ex: Business Conduct Standards; Swap Data Recordkeeping and Reporting Requirements) • ISDA has launched protocol (the ISDA August 2012 and March 2013 DF Protocols) to facilitate amendments • Structured differently from past protocols • Because compliance requirements vary depending on legal status of each party (ECP, SD, MSP, special entity), structured to allow participants to privately and selectively share information about their legal status with other participants through the exchange of questionnaires • $500 adherence fee
  27. 27. Trade Reporting: Scope Trade reporting requirements apply to all interest rate, currency, equity, credit and other commodity swaps, whether: • cleared or uncleared • executed on a swap execution facility (SEF), designated contract market (DCM) or exchange or entered into bilaterally over-the counter (OTC)
  28. 28. Trade Reporting: Who? If trade is executed on a trading facility, the SEF or DCM will report it. If an off-facility trade is accepted for clearing before the reporting deadline, the DCO will report it. If neither party is a swap dealer or major swap participant and only one party is a US person, the US person reports. Otherwise, the parties must determine who is the “reporting party”: If yes, swap dealer reports. Is only one party a swap dealer? If no, is only one party a major swap participant? If yes, major swap participant reports. If no, is only one party a financial entity? If yes, financial entity reports. If no, parties agree who reports.
  29. 29. Trade Reporting: Where? Trades must be reported to a registered swap data repository (SDR) or, if no SDR is available to accept the data, to the CFTC (for swaps other than security-based swaps)
  30. 30. Trade Reporting: What? • Creation Data – primary economic terms (PET) data and confirmation data • Continuation Data – all changes to the PET data and all valuation data • Additional reporting requirements apply for each trade entered into in reliance on an exception to mandatory clearing • Reporting required on a trade-by-trade basis by reporting party • Reporting party’s obligations are reduced if the electing party has filed an annual report with an SDR providing details of its eligibility to elect the exception
  31. 31. Trade Reporting: When? • PET data: as soon as technologically practicable, but no later than – • cleared swaps: initially 4 hours, reducing to 1 • uncleared swaps: initially 48 business hours, reducing to 24 • Confirmation data: initially 48 business hours, reducing to 24 • Valuation data: quarterly • Other continuation data: initially 2 business days, reducing to 1
  32. 32. Trade Reporting: How? Reporting parties must use facilities, methods, or data standards permitted or required by the SDR Three identifiers will be used: • Unique Swap Identifier (USI) – ID’s transaction • Legal Entity Identifier (LEI) – ID’s counterparty • Unique Product Identifier (UPI) – ID’s transaction type
  33. 33. Non-SD/MSP Reporting Obligations Cleared Swaps Uncleared Swaps • If on SEF or DCM, no reporting requirements • If off-facility and cleared before reporting deadline, no reporting requirements • If off-facility and cleared after reporting deadline, report PET data only • If on SEF or DCM, report only valuation data and other continuation data • If off-facility, report all data (PET, confirmation, valuation, and other continuation data)