OTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond
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OTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond OTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond Presentation Transcript

  • CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond Scott Peterman, CFA Kishore Kumar Ramakrishnan Partner, Sidley Austin, Hong Kong Director, Advisory Services, Ernst & Young Yin Toa Lee, CFA Tate Barnes Partner & Financial Services Leader Vice-President, Institutional Client Group, of Ernst & Young’s Financial Accounting Deutsche Bank, Singapore Advisory Services in the Asia-Pacific Moderators: Samuel Lum, CFA, Director, Private Wealth & Capital Markets, CFA Institute Padma Venkat, CFA, Director, Capital Markets Policy, CFA Institute 20 November 2012
  • Agenda1. Key Imperatives of Dodd Frank Act - Title VII & Global OTC Derivatives Reform (Lee 5min)2. Dodd Frank Act – Extra-territoriality & Cross Border Supervision (Peterman 20min)3. OTC Derivatives Reform – Asia Pacific & Europe Overview (Ramakrishnan 5min)4. OTC Derivatives Ecosystem in the Post-Dodd-Frank Era – Capital, Margin, Clearing & Accounting Implications (Ramakrishnan & Lee 20min )5. OTC Derivatives Reform – Practical Industry Issues (Barnes 15min) 2
  • CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and BeyondKey Imperatives of Dodd Frank Act - Title VII & Global OTCD Reform Yin Toa Lee Partner & Financial Services Leader of Ernst & Young’s Financial Accounting Advisory Services in the Asia-Pacific 20 November 2012 View slide
  • OTC Derivatives & Dodd Frank Act: Beauty lies in the eyes of the beholder! 4 View slide
  • 100 Years of Legislation - Size Matters ? Regulatory Banking / Conventional Customer Permissible BankingFramework / Capital Standards Securities Business Banking Protection Activities Structure Dodd Frank Act Dodd Frank Reforms Process – unprecedented in scope and extent of coverage ! 5
  • Dodd Frank Act: Key Imperatives of Title VII Title Scope of CoverageOf the 16 titles published under Dodd Frank Act I Financial Stability[DFA] - Title VII in particular aims to regulate and II Orderly Liquidation Authoritybring transparency in OTC derivatives [OTCD] Transfer of powers to the Comptroller oftrading which will impact broker-dealers; hedge- III Currencyfunds; mutual funds and any end-user that trade Regulation of Advisers to Hedge funds & IVand clear derivatives. others V Insurance Bank/savings/depository institution VI regulation 2. Central 1. Capital & 3. Reporting VII Wall Street transparency & accountability Clearing Margin [SDR] [DCO] VIII Payment, clearing & settlement provisions Investor protection & improvements to the IX regulation of securities X Bureau of consumer financial protection XI Federal reserve system provisions 4. 5. Cross 6. Electronic Improving access to mainstream financial XII Registration Border Trading institutions [SD/MSP] Implications [SEF/OTF] XIII Pay it back act XIV Mortgage reform & anti-predatory lending act XV Miscellaneous provisions XVI Section 1256 contracts 6
  • CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond Dodd Frank Act – Extra-territoriality & Cross Border Supervision Scott D. Peterman, PhD, CFA Partner Sidley Austin 20 November 2012
  • Introduction & BackgroundAt the G-20 meeting in September 2009, G-20 leaders made thefollowing commitments to regulate standardized over-the-counter(“OTC”) derivatives markets:• All standardized OTC derivative contracts to be traded onexchanges or electronic trading platforms, and cleared throughcentral counterparties by the end of 2012 at the latest;• OTC derivative contracts reported to trade repositories; and• Non-centrally cleared contracts subject to higher capitalrequirements.As a result of these commitments, multiple regulatory reforminitiatives are taking place globally. Many of these initiatives haveextra-territorial effect. For end users with global trading operations,it is possible that difficult compliance and choice-of-law questionswill arise as the new global regulatory landscape for OTCderivatives evolves. 8
  • Extra-territorial Applicability: CFTC-Regulated Swaps• Section 722(d): ‘‘(i) APPLICABILITY.−The provisions of [the Commodity Exchange Act] relating to swaps that were enacted by the Wall Street Transparency and Accountability Act of 2010 (including any rule prescribed or regulation promulgated under that Act), shall not apply to activities outside the United States unless those activities − ‘‘(1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or ‘‘(2) contravene such rules or regulations as the Commission may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act....” 9
  • Extra-territoriality Rule: SEC-Regulation Security-Based Swaps• Section 772: “Rule of Construction. No provision of [the Securities Exchange Act of 1934] that was added by [Title VII of the Dodd-Frank Act], or any rule or regulation thereunder, shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate to prevent the evasion of any provision of this title that was added by [Title VII of the Dodd-Frank Act]. This subsection shall not be construed to limit the jurisdiction of the Commission under any provision of this title, as in effect prior to the date of enactment of [Title VII of the Dodd-Frank Act].’’ 10
  • Cross-Border Regulatory Harmonization / Sanctions• Section 752 requires both the CFTC and SEC to seek harmonization with regulators in other countries by consulting and coordinating “with foreign regulatory authorities on the establishment of consistent international standards” for derivatives regulation.• Section 715 gives both the CFTC and SEC leverage: “. . . if the [relevant Commission] determines that the regulation of swaps or security-based swaps markets in a foreign country undermines the stability of the United States financial system, either Commission, in consultation with the Secretary of the Treasury, may prohibit an entity domiciled in the foreign country from participating in the United States in any swap or security-based swap activities.” 11
  • EU OTC Derivatives Rules –Overview and Extra-territorial ReachIn the EU, the rules requiring OTC derivatives to be centrallycleared and traded on trading platforms are being addressed intwo separate pieces of legislation:1. European Market Infrastructure Regulation (“EMIR”) – EMIRgoverns the central clearing and OTC derivatives data reportingrequirements. EMIR applies from 1 January 2013 onwards.2. MiFID II – “MiFID II” refers to the comprehensive review of theexisting Markets in Financial Instruments Directive (“MiFID”)which, among other things, requires all OTC derivatives to betraded on trading venues. MiFID II is currently going through theEU legislative process (involving the European Parliament andCouncil of the European Union); not expected to apply until early2015. 12
  • International Coordination of OTC Derivatives• Dodd-Frank Act and EMIR/MiFID II anticipate the need for international coordination of OTC derivatives reforms and regulation. EMIR and MiFID II apply to OTC derivative contracts eligible for clearing/trading on trading venues that have a “direct, substantial and foreseeable effect within the EU” or where such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR/MiFID II.• Dodd-Frank where activities relating to CFTC-governed swaps have a “direct and significant connection with activities in, or effect on, commerce of the United States”. 13
  • More Work to Be Done• There is not yet clarity as to the meaning of the words “direct, substantial and foreseeable effect within the EU.”• There is a similar lack of clarity on the analogous Dodd-Frank Act wordings (“direct and significant connection with activities in, or effect on, commerce of the United States” and “without the jurisdiction of the United States”).• Thus U.S. and other non-EU firms face uncertainty in relation to clearing and trading obligations under EMIR and MiFID II, respectively. Conversely, EU firms and other non-U.S. firms face uncertainty under broadly similar provisions in the Dodd- Frank Act.• Is there a need for further rules and amendments to the Dodd- Frank Act and EMIR to close regulatory gaps and avoid arbitrage between the EU, U.S. and other major jurisdictions? 14
  • SEC Enforcement Actions Section 929P explicitly authorizes SEC enforcement actions (but not private actions) involving “conduct within the U.S. that constitutes significant steps in furtherance of a violation” or “conduct occurring outside the U.S. [that] has a foreseeable substantial effect within the U.S.”Note: no comparable statutory provision for CFTC enforcement. 15
  • CFTC Proposed Rules on RegistrationCFTC indicated that a person who “engages in swap dealingactivities and regularly enters into swaps with U.S. persons”would likely be required to register as a swap dealer.Proposed CFTC Rule 1.6 would prohibit activities conductedoutside the U.S., including entering into transactions andstructuring entities, to willfully evade or attempt to evade anyprovision of the federal commodities laws (including rules)enacted under the Dodd-Frank Act and would subject thesetransactions or entities to the swap provisions of the commoditieslaws.Proposed CFTC Rule 1.3(xxx)(6) would permit the CFTC toconsider whether “willfully structured to evade” factors may alsobe considered in determining whether a person is a dealer ormajor participant. “Sham transaction” test, “lack of a legitimatebusiness interest”, intent test. 16
  • Open Questions• When does swap dealing activity by a non-U.S. person with non-U.S. affiliates of U.S. persons or with other non-U.S. persons have a “direct and significant connection” with or effect on U.S. commerce?• What about non-dealing swap transacting activity with non- U.S. affiliates of U.S. persons or with other non-U.S. persons?• Are non-U.S. affiliates of U.S. persons (particularly dealers) treated as U.S. persons when they TRANSACT (or DEAL) with non-U.S. counterparties? 17
  • Foreign Banks’ Perspective• Comment letter February 17, 2011: Permit comprehensively regulated and supervised foreign banks to continue to book their global swaps using a centralized booking model out of a well-capitalized and comprehensively regulated booking center in a non-U.S. jurisdiction.• Swap dealer registration should be through the central booking non-U.S. branch of a foreign bank.• Apply home country regulation for capital and margin requirements for non-cleared swaps. 18
  • Foreign Banks’ PerspectiveApply U.S. transaction requirements to foreign dealer’s swapsactivities with U.S. counterparties, but not to its swaps activitieswith non-U.S. counterparties. Two alternative registrationapproaches suggested:(1)registration and regulation of just the foreign (non-U.S.) branchor separately identified department or division; or(2)registration of a U.S. affiliate of the foreign bank to conductswaps activities with U.S. counterparties; the foreign branch that isthe booking center for swaps with U.S. counterparties but thatdoes not otherwise deal directly with U.S. counterparties couldalso register solely with respect to its acting as a booking centerfor swaps with U.S. counterparties. 19
  • Dual Regulatory Regime in U.S.• Title VII of Dodd-Frank provides for comprehensive regulation of OTC derivatives markets ─ Significant market participants will be required to register with either or both the SEC or the CFTC depending on the categories of OTC derivatives in which they transact• Title VII generally bifurcates regulation of OTC derivatives between the CFTC and the SEC ─ CFTC having jurisdiction over swaps ─ SEC having jurisdiction over security-based swaps ─ Shared jurisdiction over mixed swaps and security-based swap agreements 20
  • Statutory Definitions• Title VII substantially amended the CEA, the 1933 Act and the 1934 Exchange Act ─ Added detailed statutory definitions of “swap,” “security- based swap,” and “mixed swap” ─ Provided interpretation and clarification with respect to various products, including OTC derivatives, Title VII instruments, and non-Title VII instruments ─ The Final Rules clarified the characterization of certain products that would otherwise be uncertain under the statutory definition ─ Characterization is generally made at the inception of the trade, unless the instrument is materially modified 21
  • Elimination of CFMA Regulatory Exemptions• Eliminates almost all exemptions from the U.S. federalsecurities and commodities laws created by the CommodityFutures Modernization Act of 2000 for over-the-counter (“OTC”)derivatives. Permits the filing of petitions to extend CommodityExchange Act (“CEA”) section 2(h) exemptions for 1 year fortransactions in “exempt commodities,” e.g., metals and energyproducts, and electronic commercial markets whose participantsare limited to “eligible commercial entities” and whose products arelimited to exempt commodities.• All of the following discussions of Title VII of DFA areconditioned upon ongoing rulemakings being conducted by theCFTC and SEC. 22
  • Swaps under Title VII of the DFA: SEC/CFTC: Bifurcated Regulation• Creates a two-regulator structure regime for OTC derivatives, OTC market participants and OTC markets based on whether the OTC derivative is a “swap” or a “security-based swap” (an “SB swap”). The CFTC is given jurisdiction over swaps that are not SB swaps. The SEC is given jurisdiction over SB swaps. (Swaps in agricultural commodities are prohibited except to the extent specifically permitted by the CFTC.) Participants in both swap and SB swap markets will therefore be subject to regulation by both the SEC and the CFTC, as in the case of a dually registered broker-dealer/futures commission merchant. The base definition of a “swap” is sufficiently broad to include virtually any OTC derivative with the important exception of options on individual securities or any group or index of securities (whether broad-based or narrow-based) and certain other limited exceptions. 23
  • Treatment of Specific Products 24
  • General Product Characterization 25
  • SwapsTitle VII instruments where the underlying is: 1. “Non-security” assets (commodity, dividend, interest rates, etc.) 2. A broad index of securities or multiple underlying products • Broad index CDS, correlation swap, dividend swap, total return swap, variance swap • Security-based swap agreements 3. A swap itself • Guarantee of swap, options on a swap 4. An exempt security 26
  • Security-Based Swaps1. Title VII products where the underlying is: ─ A security or a narrow security index • Narrow index or single security CDS, correlation swap, dividend swap, total return swap, variance swap, certain contracts for differences • OTC option on a single non-security loan ─ A municipal security2. Definitions of “security” under 1933 Securities Act and 1934 Securities Exchange Act have been amended to include “security-based swaps” 27
  • Mixed Swaps1. Title VII products where the underlying is: ─ Certain CFTC-regulated rates, indices, currencies and commodities will be treated both as swaps and security- based swap ─ Narrowly defined ─ Regulated by both the SEC and the CFTC2. Parties may request a joint CFTC/SEC order permitting compliance with specified provisions of either the Commodity Exchange Act OR the Securities Exchange Act 28
  • CPO Registration Required• Commodity pool operator (“CPO”) essentially means a sponsor or promoter of commodity pool, meaning fund that trades any futures, futures options and (soon) non-securities based swaps and FX contracts.• Applies to managers of funds of funds that invest in pools.• CFTC takes view it has jurisdiction over non-U.S. CPO of any pool sold to U.S. persons.• CFTC has eliminated Rule 4.13(a)(4) sophisticated investor exemption used by most non-U.S. CPOs.• Effective late April for new pools and 31 December 2012 for existing exempt pools. 29
  • Available Registration Exemptions• CFTC Regulation 4.5―Regulated Persons ─ an investment company registered under the U.S. Company Act (i.e., a mutual fund) ─ insurance companies subject to state regulation ─ banks, trust companies and other financial depository institutions subject to state or federal regulation ─ a trustee of, a named fiduciary of or an employer maintaining a pension plan that is subject to ERISA• CFTC Regulation 4.13(a)(3) 30
  • De Minimis Exemption• CPO must satisfy either one of two trading limit tests: ─ the “initial margin” test • aggregate initial margin, option premiums and required minimum security deposit (for retail forex transactions) required to establish commodities interest positions, determined at the time the most recent position was established, does not exceed 5% of the liquidation value ─ “net notional value” test • aggregate net notional value of commodities interest positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into• No hedging exemption 31
  • How to claim a 4.13 exemptionCPO eligible to claim an exemption under Regulation 4.13 must•furnish to prospective participants in the pool ─ a statement that the person is exempt from registration with the CFTC as a commodity pool operator and that therefore, unlike a registered commodity pool operator, it is not required to deliver a disclosure document and a certified annual report to participants in the pool; and ─ a description of the criteria pursuant to which it qualifies for such exemption from registration; and•file a notice of exemption with the NFA, which sets forth basicinformation regarding the commodity pool operator and commoditypool, in each case, no later than the time it delivers a subscriptionagreement 32
  • Limited Relief Available• CFTC Regulation 30.4(c)―Non-U.S. Futures/Options Trading. (1) trading is limited to non-U.S. futures contract or foreign options transaction; (2) trading is for non-U.S. commodity pool whose securities are registered under the Securities Act or otherwise exempt from registration; and (3) no more than 10% of the participants in the commodity pool (determined by value) are held by or on behalf of U.S. persons.• CFTC Regulation 30.5―Non-U.S. CPOs. (1) is located outside U.S.; (2) is otherwise required to be registered with CFTC solely because the CPO trades non-U.S. futures/options; (3) receives confirmation from NFA that Regulation 30.5 exemption applies; (4) engages in all non-U.S. futures/options transactions through registered FCM or a non-U.S. broker with a registration exemption; (5) designates an agent for service of process in U.S.; and (6) provides access to records to the CFTC or U.S. Department of Justice upon demand. 33
  • Alternatives to Registration• Stop trading commodity interests.• Don’t accept U.S. investors -- don’t manage U.S. money.• Only manage U.S. money through true managed accounts and have less than 15 of these.• Don’t trade “Commodity Interests.”• Don’t trade “Commodity Interests” for U.S. investors/clients.• Find a “CPO-for hire” so the non-U.S. adviser can live under the less than 15 CTA client exemption.• Trade “Commodity Interests” only in a way that the 4.13(a)(3) measurement is simpler math.• For pure non-U.S. pools, register and obtain certain relief under Advisory 18-96.• Register and obtain relief under Rule 4.7 (note new annual audit requirement). 34
  • CTA Registration Requirement• Applies to firms that advise others as to futures and (soon) FX and non-securities based swaps.• Jurisdictional analysis same as for CPOs.• CFTC has eliminated portion of 4.14(a)(8) exemption that applies to CTAs that advise 4.13(a)(4) pools and whose advice on commodity interests is solely incidental to advice on securities.• Not as common for CTAs to rely on this exemption as it is for CPOs to use 4.13(a)(4). 35
  • Available Alternatives• Exemption for CTAs that advise fewer than 15 clients in a 12- month period, with a pool counting as a single client and non- U.S. clients not counting for non-U.S. CTAs, and don’t hold themselves out as CTAs in the United States.• Exemption for SEC-registered IAs whose business does not consist primarily of acting as a CTA and do not act as a CTA to a pool that is primarily engaged in trading commodity interests• No CTA registration requirement if advise only pools for which CTA is also the CPO (registered or exempt).• Exemption for CTA which provides advice only to non-U.S. pools whose interests are sold only to non-U.S. persons where no person conducts marketing activities in the U.S. and the advice on commodity interests is solely incidental to advice on securities.• Register as CTA and obtain some relief under Rule 4.7. 36
  • CPOI / CTA Registration Process• Requires Form 7R for firm and Form 8R for each principal and associated person (“AP”).• Electronic filing.• Unlike Form ADV these are not disclosure documents and can be done with limited assistance of counsel.• Testing requirements for APs.• Fingerprint requirement.• Must join National Futures Association (“NFA”). 37
  • Risk Disclosure Requirements• NFA’s Guide for CPOs and CTAs about Disclosure Documents http://www.nfa.futures.org/nfa-compliance/publication- library/disclosure-document-guide.pdf• CPOs under CFTC Rule 4.24(g)• CTAs under CFTC Rule 4.34(g) http://ecfr.gpoaccess.gov/cgi/t/text/text- idx?c=ecfr&rgn=div5&view=text&node=17:1.0.1.1.4&idno=17# 17:1.0.1.1.4.2.7.5 38
  • CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and BeyondOTC Derivatives Reform – Asia Pacific & Europe Overview OTC Derivatives Ecosystem in the Post-Dodd-Frank Era – Capital, Margin, Clearing & Accounting Implications Yin Toa Lee Partner & Financial Services Leader of Ernst & Young’s Financial Accounting Advisory Services in the Asia-Pacific Kishore Kumar Ramakrishnan Director, Advisory Services, Ernst & Young 20 November 2012
  • While aligned to the G20 commitments, theregion’s proposed OTC reform frameworks appear DFA vs. OTCD Reforms in AsiaPacific:to be overly regulated when compared to the This is not “United States of Asia”!maturity & depth of the OTCD markets in eachlocation, with each market adopting a divergent Key Reform Provisions – Coordination Matrixapproach to OTC reform Countries Central Clearing Reporting Execution Capital/Collateral Maturity – OTC Reform vs. OTCD Market Depth Hong Kong No regulations currently Singapore No regulations currentlyReformMaturity 5 Japan 4 Australia Japan Korea No regulations currently Korea Australia No regulations currently 3 Singapore India No regulations currently Taiwan No regulations currently No regulations currently 2 Malaysia India Taiwan Hong Kong Source: Malaysia Analysis No regulations currently FSB Publications, EY No regulations currently 1 2 China Indonesia 3 4 5 China No regulations currently Recent Developments from the US / APAC to consider… Source: EY APAC OTC Regulatory Regime Review 1. Circle sizes represent relative OTCD market size. Currently Asia represents less Market than 10% of the global OTCD market, of which Japan accounts for less than half (~4% of global market size) Maturity Over the last 8 weeks, many regulatory developments Key Observations: • Imbalance between OTC reform framework vs. immaturity of markets in the region ! have unfolded in U.S. and APAC: a.Entity and Product Definitions b.Basel’s Margin Rules, and c.CFTC Cross Border guidance d.CFTC mandatory clearing phase-in rule • Divergent approach of regulators in APAC e.HK – conclusion of consultation published • Proliferation of CCPs f.SG – Margin framework for centrally cleared derivatives • On-shore vs. Off-shore Clearing Models g.AUS – 2 papers published by Treasury/council of regulators h.AUS – consultation on CCP and Securities settlement systems in • SDR: Local vs. Global Infrastructure response to CPSS-IOSCO principles of financial market infrastructure • Inconsistent Basel Capital Considerations 1 Substituted Compliance - Definition Current proposed guidelines under Dodd Frank regarding satisfaction of compliance with a foreign regulatory regime allows for market participants to comply with on-shore requirements on a case-by-case review and approve basis by the CFTC. 40
  • Regulatory alignment – US versus Europe Dodd Frank Overlap EMIR ► Mandatory CCP clearing for eligible products, by standardisation and liquidity ► All standardised derivatives contracts for ‘products eligible for clearing’ to be cleared through High ► Differences in agent vs principal model and related local EU legislationCentral clearing regulated ‘clearing houses’ Some ► New ESMA 2012_600 focus on Indirect clearing model ► Applies for trades between US and non US counterparties ambiguity ► Mandatory clearing of ‘eligible’ derivative contracts for trades between financial counterparts and third party entities. ► Stricter oversight of swap dealers and major participants, including stricter capital and marginNon-cleared ► Bilateral trading on non-cleared trades possible (providing risk management is in place). Likely to hold higher requirements. MediumTrades capital charges and 1-3% risk weighting. ► Transactions between financial and non-financial counterparties not exempt ► Proposed rule: All relevant swaps must be traded on SEFs or exchanges ► MiFID II draft legislation proposes mandatory trading of sufficiently liquid derivatives using regulated venues;Trade Execution Medium ► Best execution with regard to the broader market eg CCP CpR, functionality and im/vm rates. unclear how execution with regard to broader market will be carried out per MTFs/OTFs/platforms. ► Financial and non-financial counterparties must report if they exceed information threshold. Possible for ► Mandatory Trade Reporting - Details of swaps must be reported to a swap data repository as counterparty to report OTC derivatives on behalf of another soon as possible after trade execution and kept updated throughout the life of the swap; Reporting High ► When trade depository is registered by ESMA, reporting must be done within 120 daysTrade Reporting responsibility will depend on hierarchy of counterparties. Some ► EMIR differences around inclusion of ETDs and dual sided reporting. ► All counterparties must obtain a unique identifier and must submit parent and affiliate ambiguity information to the swap data repository. ► Provision for omnibus and individual segregated collateral at CCP and DCM; ► Collateral eligibility restricted to cash and limited securities for im/vm for both cleared and un- MediumCollateral ► LSOC treats all margins as operationally co-mingled but legally segregated to give credit to each customer in cleared swaps; LSOC segregation approach ambiguity case of a member default, but most CCPs not geared up to handle multiple accounts. ► Clearing houses must maintain assets and positions of segregation ► Initial and variation margin required for all swaps transacted with swap dealers, major swap ► Acceptable forms of collateral include cash and government bondsMargin participants and financial end users TBC ► Where derivative contracts are not cleared through a CCP, bilateral collateral requirements will be necessary ►Margin requirements vary depending on type of swap counterparty. for financial counterparties. More standardisation: ►Definitions of standardised OTC Derivatives/participants being updated to match evolving ► EC focus on legal terms of the contract;Standardisation markets. ‘Swap dealer’ and ‘Major swap participant’ are defined terms, as will be ‘Commercial end- Medium ► Standardisation needs to take the form of legal, commercial and operational issues; Capital user’ requirements set by CRD III/IV with specific references to highly-liquid assets, and standards for liquidity. Reduce counterparty risk by: ► Proposing legislation to establish common safety, regulatory and operational standards for CCPs and ► All OTC derivatives dealers and all other major OTC derivatives markets participants will be LowControls and mandate CCP clearing for standardised contracts constrained by regulation, supervision, a capital regime, margin requirements and business Somereducing risk ► Improving collateralisation of bilaterally-cleared contracts conduct rules and tightening of standards of who may participate in those derivatives markets ambiguity ► Substantially raising capital charges for bilaterally-cleared cf. CCP-cleared transactions, ► Exemption for corporates not granted unless ‘objectively measurable as reducing risk related to commercial ►Commercial end users exempt from the need to post margin to meet the clearing requirement. US activity or treasury financing’ Treasury issued a proposed determination that would exempt FX swaps and forwards from the ► Two proportionality tests applied per a clearing thresholdExemptions definition of “swap” for most Dodd-Frank Act purposes, including registration and clearing Low ► Three-year review clause for pension funds under EMIR, but suggestion as of Apr ‘12 that PFs will need to post ► Needs to be re-confirmed post-Aug 2012; Spot FX transactions and certain physically settled collateral if trades are not centrally-cleared commodity transactions exempt. FX options, XCSs and NDFs not exempt. ► Spot FX transactions, commercial forward FX transactions, certain physically settled commodity transactions 41 41 and inter-affiliate trading exemptions exempt. Page 41 "The High-level Impact of Regulatory Reform on the Capital Markets”
  • Regulatory alignment – US versus Europe II Dodd Frank Overlap EMIR ► Transactions between SDs/MSPs and other SDs/MSPs: SD/MSP must execute confirm as soon ► Transactions between SDs/MSPs and other SDs/MSPs: SD/MSP must execute confirm as soon as technologically MediumTrade as technologically possible and by end T+1 (with financial entities) and by end T+2 (with other possible and by end T+1 (with financial entities) and by end T+2 (with other counterparties) - Art 11 RTS SomeConfirmation counterparties) ► Draft EU rules do not address timing requirements for confirmations between an FC/NFC and non-EU entity, and do ambiguity ► CFTC rules do not mandate use of electronic means where available. not address: the treatment of transactions executed anonymously. ► SDs/MSPs must agree in writing on terms of reconciliation with counterparties ; reconciliation ► FCs/NFCs must agree in writing (or other equivalent electronic means) on terms of reconciliation with counterpartiesPortfolio can be performed by a third party High for OTC derivatives not cleared by a CCP.; reconciliation can be performed by a third partyReconciliation ► Covers exchange of trade terms and valuations and reconciliation of discrepancies in material ► Covers reconciliation of key trade terms and valuations attributed under Article 11(2) terms and valuations. ► SDs/MSPs must have policies and procedures for portfolio compression, including policies and ► FCs and NFCs with portfolio of ≥500 outstanding OTC derivatives not cleared by a CCP must have procedures toPortfolio procedures for periodically terminating fully offsetting swaps and engaging in portfolio compression Low Some analyse possibility of conducting portfolio compression exercises and engage in such exercises.Compression exercises when requested. ambiguity ► No record-keeping requirement. ► Record-keeping requirements apply. ► Documentation between SDs/MSPs and other MSPs or financial entities and requested ► Under Art 14 EMIR draft RTS, FCs/NFCs concluding transactions with each other must agree detailed procedures and SDs/and, if requested, other counterparties must include agreed process for determining the value processes covering: MediumClient of swaps. ►1) Identification, recording and monitoring of disputes relating to recognition or valuation of contract and exchange of SomeDocumentation ► Documentation must include: 1) Status disclosure on SD/MSP (e.g. whether insured depository collateral. ambiguity institution); 2) Notice about effect of acceptance of a swap for clearing by a DCO. Record keeping ►2) Resolution of disputes in a timely manner, with a specific process for those disputes that are not resolved within 5 requirements apply. business days. ► FCMs, SDs and MSPs must appoint a CCO reporting to its board/senior officer, who must among ► Authorised firms are required to maintain a permanent and effective compliance function that operatesDesignation of other things submit an annual report to the CFTC on the firm’s policies and procedures and Medium independently, but neither the proposed EMIR measures (post-trade) nor the proposed MiFID Review measures (pre-the CCO compliance with the CEA and CFTC regulations (after review by the board/senior officer). 17 CFR ambiguity trade) stipulate the specific need for a CCO function. §3.3. ► SDs/MSPs must establish and maintain business continuity and disaster recovery plans (and ►Authorised firms are required to establish, implement and maintain an adequate business continuity policy aimed at specifies the components of that plan and procedures for its testing and maintenance). There areBCP High ensuring the preservation of essential data and functions and maintenance of investment services and activities (or requirements to notify the CFTC of disruptions and to provide emergency contacts. Plans to be tested where not possible timely recovery). annually by an independent internal or external party. 17 CFR §23.603 ► Per CP12/22, the FSA proposes to introduce ‘client money sub-pools’ into the CASS regime featuring legally and ► Safeguarding and verification of client assets is referred to at a high level. operationally separate client money sub-pools comprising the margin held in a particular net client transaction accountSafeguarding ► Could include verification of assets by independent public accountant. Medium at a CCP and the client money the clearing member holds in relation to that transaction account.Client Assets ►§763 features detailed stipulations on how client assets should be treated for security-based ambiguity ► If the clearing member became insolvent and a CCP ported the positions to a backup clearing member, the swaps, featuring conditions where segregation is required and prohibition of co-mingling. insolvency practitioner would be able to make the margin that the insolvent clearing member held as client money in relation to the transaction. ► Data transfer to third countries outside the EU can only take place in compliance with the Data Protection Law, and provided the recipient state ensures an adequate level of protection. ► SDs/MSPs must give advance disclosure to counterparties of: the material risks of the Low ► The adequacy of a non-EU states level of protection must be assessed in light of all circumstances surrounding theDisclosures transaction; the material characteristics of the particular swap; and material incentives/conflicts of Some data transfer operations in force in that state and its professional rules and security measures, such as 1) the nature of interest (including price and mid-market price). ambiguity the data; 2) the purpose and duration of the proposed processing operation or operations.; 3) the country of origin and country of final destination; 4) rules of law, both general and sectoral. ►Third country ‘mutual recognition’/Member State of Reference approach based on satisfying various tests, e.g.: ►§722(d)/§772(c) - the provisions of the DFA relating to swaps shall not apply to activities outside ►1) Appropriate regulatory cooperation arrangements are in place; the US unless those activities; 1) have a direct and significant connection with activities in, or effect LowExtra- ►2) Third country where the non-EU AIFM is established is not listed as a Non-Cooperative Country and Territory by FATF 42 on, commerce of the US; or 2) to prevent the evasion of any provision of the DFA. Someterritoriality requirements on money laundering and terrorist financing; ►CFTC is proposing ‘Substituted Compliance’, based upon mutual recognition on an authority-by- ambiguity ►3) Third country fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on authority basis and broad comparability of regimes. Income and Capital .
  • DFA vs. OTCD Reforms in Europe** Source: ISDA 43
  • OTC Ecosystem in the post Dodd Frank reforms eraGlobal OTC derivative reforms has resulted in the creation of a completely newOTC market landscape comprising of a new infrastructure and service offering #1; 2 : New Market Participants 1.Swap Dealers [SD] 2. Major Swap Participant 8. Post Trade Reporting [MSP] #6; 7; 8 : New Risk Mgmt Approaches 7. Collateral / Margin OTC Derivatives Market 3. CCP’s Requirements Microstructure 6. Capital Requirements 4. SEF’s #3; 4; 5 : New Market Entities 5. SDR’s 44
  • OTCD Reforms – Key Challenges to Buy Side Overview of buy-side response to swaps reforms Buy-Side ► Analysis of executing and clearing brokers and clearing houses: • Determine execution venue ► Questionnaires and comparisons of services to be offered • New Legal Framework ► Level of required margin (initial and variation) • Reconcile internal valuations ► Collateral eligibility with external broker / CCP’ Default waterfall modelPre-Trade ► • Assess total cost of trade [capital; clearing; electronic connectivity] ► Operating model ► Identify changes to current processes and new processes • Trade on single / multiple SEF’s ► Identify data requirements and gaps across the business • Leverage electronic trading ► Develop IT design and estimate cost for budget provision methods viz., CLOB, RFQ, Trade • Identify new data requirements for risk capture/assessment ► Conducting readiness assessments including: ► Analysis of existing positions / clearing eligibility ► Analysis of future plans for OTC usage and clearing ability • Margin management with CCP ► Review of margin requirements • Intraday margin calculations ► Evaluation of counterparty risk and resulting changes to business / • Clearing broker relationship operating model Assessing impact of and performing gap assessments on proposedPost-Trade management ► and final rules • Increase in collateral for OTCs not centrally cleared 45
  • Risk Management in the Post Dodd-Frank Era – Capital & Margin Framework for Cleared vs. Un-cleared Swaps p g pDangerous Intersection of Basel, Dodd Frank and Prudential Regulatory regimes 1. Dodd Frank Act [DFA] sets up separate margin rules for uncleared swaps and allows CCPs to set up initial and variation margin rules approved by CFTC / SEC 2. Prudential regulators [federal reserve, federal deposit insurance corp (FDIC) and office of the comptroller of the currency(OCC)] have proposed a set of rules on margin for uncleared trades applicable for banks including bank holding companies[BHCs]. In fact, for banks and BHCs - prudential authority rules override the DFA rules. a. For high risk counterparties - margin requirements [both initial and variation margins - IM and VM] are set out using a table or through regulator-approved formula established by the bank b. For low risk financial counterparties such as pension funds -> no margin is required until the banks exposure to each counterparty is less than or equal to USD 30 million or 0.2% of the banks tier-1 capital and margin rules come into effect only to the extent the exposure exceeds the limit. c. For low risk non-financial counterparties such as end users - no IM or VM is ever required 3. Basel capital rules related to OTC derivative transactions a. Basel rules require that a regulated entity to hold capital to cover counterparty credit risk on a CCP both for: (a) its trade exposure to CCP (b) its default fund contribution to a CCP b. Basel capital rules for trade exposure to CCP offer multiple risk weights: i. Qualifying CCP – 2% capital charges if collateral is segregated from client, CM and double default scenario ii. Qualifying CCP – 4% capital charges if collateral is not segregated against joint default of CM and other clients of CM iii. Non-Qualifying CCP – 20% capital charges i.e., if non-qualifying CCP is a bank iv. Non-Qualifying CCP – 100% capital charges i.e., if non-qualifying CCP is a corporate financial institution Additionally, CM will have to apply a risk weight of 1250% [broadly equivalent to one-to-one for deduction] to their default fund contributions (both funded and unfunded) 46
  • Risk Management in Post Dodd-Frank Era – CFTC Margin Requirements for Un-cleared Swap Trades Type of Counterparty Proposed Rule Swap Entity [SD/MSP] Financial End-User Non-Financial End-userInitial Margin Zero: Swap entity is not allowed to a. High Risk – Zero a. CFTC – no specificThreshold establish an initial margin threshold b. Low-Risk – Lesser of requirement; threshold amount for other swap entities and IM between $15-$45 million and per credit support must be collected at or before the 0.1% - 0.3% of Tier-1 arrangement execution of any un-cleared swap regulatory capital b. Prudential Regulator – subject to MTA $100,000. credit exposure limit set by swap entityVariation Margin Zero Same as above Same as aboveThresholdFrequency of At least once per business day At least once per business day Same as abovecollection of variationmarginSegregation of IM Independent [non-affiliated] third party Not mandatory but can request Not mandatory but can custodian request 47
  • Risk Management in Post Dodd-Frank Era –International Working Group on Margin Requirements Proposal – July 2012 [Basel; IOSCO; CPSS] Proposed Rule Proposed Rule Summary ► All derivatives not centrally cleared covered under this proposal ► Exempt FX swaps and forwards with maturity less than 1 month to 1 year?Scope of coverage ► Full – two way margining with zero thresholds– Products covered ► Two way margining with single threshold/ scope of ► Two way margining with higher threshold for transactions b/w prudentially regulated entitiesapplicability ► Two way margining with three threshold covering system ► Cash / Gold ► High quality government and central bank securities ► High quality corporate bondsEligible Collateral / ► High quality covered bondsTreatment of ► Equities included in major stock indicescollected margin ► IM – to be collected on a gross basis; cash and non-cash collateral collected as IM should not be re-hypothecated or re-used ► Full variation margin should be collected b/w a firm and its affiliates ► Overseas branch treated as equivalent to legal entity as the headquarter and hence margin requirements of headquarter jurisdiction is applicable to its branches ► US bank vs. UK bank -> respective home country margin rule applicableCross border ► US bank vs. UK subsidiary of Swiss bank -> respective home country margin rule applicableimplications ► UK subsidiary of US bank vs. UK bank -> UK margin rules applicable ► UK subsidiary of US bank vs. UK subsidiary of Swiss bank -> UK margin rules applicable 48
  • Cleared vs. Bilateral Trade - A Case in Point Margin Implication for a Margin Implication for a sample Initial Margin Asset Product Type sample un-cleared Cleared Transaction Remarks Requirement (% of Class notional exposure) transactionCredit: 0-2 year 2 Swap clear requires only 1.8% of the However, the proposed margin grid from BCBSduration IRS [2-year swap] 1% – 2% in Initial Margin notional exposure for a swap of the does not recognize netting, so the marginCredit: 2-5 year same tenor schedule for uncleared swaps on active accounts 5 will end up becoming relatively more expensivedurationCredit 5+ year A buy-side firm looking to 10duration trade an uncleared CDS A buy-side firm looking to trade CDS product would require to that is centrally cleared at ICE would a. Basel proposal on margin requirements forCommodity 15 post 10% of the notional indicatively need: uncleared swaps does not distinguish upfront towards Initial a. 2.8% of the notional for the protection between index-linked vs. single name CDS 5 year CDSEquity 15 Margin for buy side buyer [i.e., $280,000] b. Also it does not differentiate on the margin b.while it charges 4.5% towards initial requirements between the protection buyer e.g., 5 year $10 million margin for the protection seller [i.e., vs. protection sellerForeign notional CDS would cost $1 $450,000]ExchangeCurr 6 million towards initial marginencyInterest Rate:0-2 year 1duration Implications of differential treatment of margin requirements between cleared and un-cleared swap trades:Interest Rate: a.Not differentiating between seller and buyer of credit protection could be a major oversight. For e.g., if one buys a protection on2-5 year 2 using 5 year CDS at 200 bps – the “MOST” the counterparty loses would be 2% * 5% = 10% of the trade notional while theduration protection seller of the CDS transaction defaults – I could be down under by more than 90% of the notional – hence, its important to differentiate between the margin requirements for protection seller vs. protection buyerInterest Rate: b.Low risk counterparties have a definite advantage while entering into an uncleared swap trade with banking counterparty [as5+ year 4 opposed to a non-banking counterparty]– as banking regulations have a much lower IM and VM requirements than DFA does.durationOther 15 49
  • Accounting offsetting criteria IFRS U.S. GAAP Two condition must exists to offset a  A right of offset exists when all of the following General Criteria financial assets and a financial liability: conditions are met: Each of two parties owes the other determinable  A legally enforceable right of set‐off exists  amounts in all circumstances; and The reporting party has the right to offset the  There is an intent to settle net or  amount owed by the other party simultaneous settlement The reporting party intends to offset (exception   provided when  there is a  MNA) The right of offset is enforceable by lawAccounting Policy Offsetting is not optional; therefore it is not  A debtor having a legal right of offset has  an accounting policy option. Offsetting is  the option to offset the related asset and  required when the conditions are met liability and report the net amount. The  accounting policy must be applied  consistently to the same class of  transactions.Number of Counterparties Two or more Only twoRights to set‐off Unconditional  ConditionalFocus Gross fair values Net  fair values 50
  • Key accounting differencesThe key differences between the modelsrelate to:• Conditional right to set-off (under a master netting agreement) criterion under U.S. GAAP• Existing US GAAP ‘exception’ for derivatives in relation to the intent criterion between the two models 51
  • Industry Response to OTCD Reforms: Picking the right battles Dodd Frank [DF] Effective areas of engagement in harnessing and delivering valuable and Response Dimensions sustainable business transformation Re-evaluate ► Text Assess the impact of DF legislation across the balance sheet covering each business line; region and customer segment business strategy and seize new ► Revise the business approach by refining the revenue model including pricing revenue and value proposition to the client e.g., client clearing, collateral opportunities transformation, asset securitization ► Reallocate capital to businesses by aligning to risk-adjusted profitability and in Optimal capital the process effectively manage economic and regulatory capital allocation allocation & capital ► Incorporate economic and regulatory capital allocation into business processes management as one of the proxies for performance measurement coupled with ► Reduce the trapped liquidity pools by reconfiguring the funding approach and aggressive cost thereby enabling the businesses in meeting the new requirements – i.e. LCR management – key etc., to navigating ► Rationalize costs by either “eliminating,” “streamlining,” or “re-distributing” regulatory tsunami costs along the business-line; corporate center and support functions ► Streamline and simplify the legal structure in the context of Dodd-Frank where Enhance risk and feasible regulatory compliance ► Automate manual risk management and regulatory compliance processes capabilities by where possible by integrating data from different sources and eventually ensuring “customer- develop a comprehensive view of risk as an enabler of effective response first” theme is ► Fortify dynamic risk reporting capabilities with appropriate detail within specific embedded in the risk lines of business & compliance ► Enhance the capability to access “data” swiftly and accurately that will dimension eventually pay off in the form of improved risk transparency 52
  • Industry Response to OTCD Reforms – getting ready for the new normal 53
  • CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond OTC Derivatives Market Reform: Practical Industry Issues Tate Barnes Vice-President, OTC Derivatives Clearing, Institutional Client Group Deutsch Bank, AG (Singapore) 20 November 2012
  • The Business of Clearing (1)• Major Investment required for a global OTC clearing provider: Connectivity to CCPs, n x Guarantee Fund contributions.• Profitability of clearing houses: CCPs are not government owned utilities, they have a profit motive. Fragmentation of CCPs across Asia-Pac and limited demand from non-members (i.e. end clients) could mean that not all CCPs offer ‘client clearing’.• Profitability of client clearing for direct clearing members: Estimates of the fee pool vary wildly, however the experience of market participants is that clients are very price sensitive and that the fee pool will be relatively small. 55
  • The Business of Clearing (2)• Return on investment: The investment that direct members are making in people and infrastructure suggest that it will take many years for OTC clearing businesses to be profitable after costs.• Barriers to entry to offering OTC clearing services will likely be high for a number of reasons: ─ Utility like pricing is a natural barrier to new entrants entering the market. ─ The long term return on investment profile of being a global OTC clearing provider is a disincentive to new entrants. ─ Client demand for experienced in-country support across the Asia-Pacific region means that unless a clearing broker has critical mass in a particular country, providing local support will not be cost effective (most dealers are off-shoring support functions to low cost regional hubs).• For the reasons noted above, only a limited number of global OTC clearing providers will be eventually exist. 56
  • Competitive Environment:Controlling risks or creating them? (1) • Whilst OTC clearing creates some standardisation (e.g. zero thresholds for mark to market payments), the key commercial and risk terms are still negotiated between clearing members and their clients. • As with other business lines, clients negotiate heavily with clearing members on commercial and legal terms. Unlike other business lines, however, where an appropriate balance of risk between client and dealer has emerged in the market over time (through experience of defaults, etc), no such balance has been found for OTC clearing. Clients are taking advantage of this to extract favourable terms from their clearers. 57
  • Competitive Environment:Controlling risks or creating them? (2) • Is there a land grab going on amongst OTC clearing providers, or are market participants simply reacting to a massive amount of client demand for the service? Either way, clients ability to negotiate heavily with clearing providers has the potential to expose clearing members to liquidity and other risks. • Clearing providers willingness to provide guaranteed portability to clients has the potential to destabilise non- defaulting clearing members in a default scenario. 58
  • Legal Resources (1)• There is a massive demand for professional legal services with experience in negotiating OTC clearing related documentation.• As some elements of the legal documentation and the regulations are completely new to clients (e.g. LSOC), the legal negotiation process often involves a lot of education which extends the time required to negotiate the documentation.• The phasing of mandatory clearing has not resulted in a phasing of demand for legal services. No one wants to clear first, no one wants to clear last… everyone wants to be ‘in the middle’. 59
  • Legal Resources (2)• Across the market, there is active legal negotiation taking place with over a hundred clients globally, with several hundred more to begin formal legal negotiation during 2013.• Whilst the number of clients which are ultimately expected to implement client clearing runs into the hundreds, the number of individual funds runs into the thousands. 60
  • Small OTC Derivative Market Participants (1)• There are a large number of clients who trade clearable OTC derivatives in very small volumes which makes finding a clearer difficult (clearing brokers will often have a minimum overall clearing fee which would be uneconomic for occasional users of OTC products).• Where infrequent users of OTC derivatives can find a clearer, they will usually only appoint one (because it wouldn’t be economic to pay two clearers’ minimum fees).• With no ‘guaranteed portability’ in the event of the default of their clearing member, clients with only a single clearer face the prospect of their positions being unwound by the CCPs, potentially exposing them to losses. 61
  • Small OTC Derivative Market Participants (2)• Some clients may stop using OTC derivatives and hedge using exchange traded instruments instead. Gap risk from hedging with imprecise instruments may expose clients to increased risks.• Will some clients cease to hedge altogether, resulting in greater volatility of earnings? 62