Legal Regulatory Issues OTC Derivatives APAC 2014

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LEGAL AND REGULATORY ISSUES - OTC
DERIVATIVES IN APAC
THE IMPACT OF NEW US AND EU
REGULATIONS
Presented by Gareth Pyburn, Esq.
gmpyburn@insightlegalasia.com
May 26 – 27, 2014
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Day One
1. Overview: The challenges and limits of standardization
2.  ISDA Master Agreement – key differences between 1992 and
2002 versions
3.  Key negotiated provisions in the Master Agreement
4.  Key provisions for specific asset classes: FX, equity and
credit
3

The Limits of Standardization
Regulatory objectives
•  To reduce systemic risk post-GFC, regulators worldwide strive
to standardize derivative transactions and trade, clear and
settle trades via central counterparties (CCPs)
•  Trading, clearing and settlement via CCPs involves a high
degree of transactional standardization, which for certain
transactions/asset classes is not practicable (as we discuss in
detail on Day Two)
•  These obligations only apply to the extent that CCPs offer
trading and clearing to any given type of transactions
4

The Limits of Standardization
Techniques
•  Dodd-Frank (DF), EMIR and other legislative initiatives are
primarily aimed at reducing systemic risk, enhancing the
transparency of OTC derivatives (via trade reporting
repositories) and segregating high risk trading from banks into
non-bank entities
•  This imposes higher margin, collateral and other regulatory
costs for non-cleared trades
•  “Substituted compliance” may apply to certain regulatory
regimes that are substantially similar to the US and EU are
recognized (e.g., Singapore and Hong Kong)
5

ISDA Master Agreement
Section overview
•  Comparative analysis of key material provisions in the 1992 and 2002
Master Agreements
•  Analysis of key negotiated provisions of 2002 ISDA Master Agreement (i.e.,
Schedule Section 13); further, select provisions drawn from particular asset
classes (equity--including “closed market” provisions--and credit)
•  Objective: protection of organization against potential problem areas such
as Events of Default, Termination Events, regulatory change and tax
6

ISDA Master Agreement – Key Differences
between 1992 and 2002
Key differences
•  The main differences can be categorized as follows:
–  differences in the Payments Upon Early Termination;
–  differences in the Events of Default and Termination
Events; and
–  addition of Set-off to the 2002 ISDA
7

Payments Upon Early Termination
•  Inclusion of “Close-out Amount” in 2002, a provision
that sets out a single measure of damages where
trades are being terminated as a result of an “Event or
Default” or a “Termination Event”
•  In the 1992 ISDA, the parties may elect between two
different measures of damages, “Market Quotation” or
“Loss”
8

Payments Upon Early Termination (continued)
•  “Close-out Amount” was developed to offer greater
flexibility to the party determining the amount due
upon termination of their trades under an ISDA
and to address some of the perceived
weaknesses of Market Quotation that were
highlighted during periods of market stress in the
late 1990s
9

between 1992 and 2002• 
Market Quotation
•  Market Quotation is a payment measure
determined on the basis of quotations obtained
from leading dealers in the relevant market
selected by the party terminating the trades
(unless a Termination Event has occurred in which
there are two affected parties, for example a Tax
Event (as defined in the ISDA), in which case both
parties make the relevant determinations)
10

Market Quotation (continued)
•  The dealer quotations will be for the replacement
cost of the relevant terminated transactions
•  If three or more quotations are provided, the
Market Quotation will be the arithmetic mean of
those quotations, without reference to the highest
and lowest quotations
11

•  If only three quotations are provided, the highest and
lowest quotations will be disregarded and the
remaining one will be the Market Quotation
•  If less than three quotations are provided (i.e., a
Market Quotation cannot be determined), or if the
party making the determination does not reasonably
believe that Market Quotation would produce a
commercially reasonable result, then Loss will apply
12

•  Typically entities that believe they are more likely
to be the party subject to an Event of Default or a
Termination Event will negotiate for the
applicability of Market Quotation in a 1992 ISDA in
order to gain transparency in the calculation of the
settlement amount
13

Loss
•  Loss is a payment measure based on the principles of general
indemnification
•  The party terminating the ISDA will reasonably determine in
good faith its total losses and gains in connection with the
terminated transactions
•  The terminating party’s Loss may, but need not, be based on
quotations obtained from leading dealers in the relevant
markets
14

Loss (continued)
•  Typically entities that believe they are less
likely to be the party subject to an Event of
Default or a Termination Event will negotiate
for the applicability of Loss in a 1992 ISDA in
order to gain flexibility in the calculation of the
settlement amount
15

Close-Out Amount
•  In an illiquid market, market quotations could be widely
divergent
•  Close-out Amount balances the need for increased
flexibility (lacking in Market Quotation) while incorporating
certain objectivity and transparency requirements (lacking
in Loss)
16

Close-Out Amount (continued)
•  In determining the Close-out Amount, the party terminating the transactions
may consider, without limitation, one or more of the following three
categories of information:
–  (i) quotations, either firm or indicative, from third parties (which may
include dealers, end-users, information vendors and other sources);
–  (ii) relevant market data (e.g., yields, yield curves, volatilities, spreads
and correlations); and
–  (iii) information from internal sources of the type described in clauses (i)
and (ii)
17

Close-Out Amount (continued)
•  The definition of Close-out Amount clarifies that the
determining party will consider quotations and market data
provided by third parties unless it reasonably believes in good
faith that such quotations or relevant market data are not
readily available or would not produce a commercially
reasonable result
•  When markets are functioning in a normal manner, the
expectation is that third-party (as opposed to internal) sources
should be considered in calculating the Close-out Amount
18

Events of Default and Termination Events
•  Section 5 addresses Events of Defaults and Termination
Events and the 2002 ISDA introduced various changes into
this section
•  The most noteworthy of these changes are:
–  (i) a reduction in the applicable grace or cure periods;
–  (ii) an expansion of the definition of “Specified Transaction”; and
–  (iii) the addition of Force Majeure as a Termination Event
19

Reduction of Cure Periods
•  In the 1992 ISDA, more lenient cure periods are provided than in the
2002 ISDA
•  Under the 1992 ISDA, a failure to pay or make a delivery under a
transaction only crystallizes into an Event of Default if such failure is
not cured within three Local Business Days after notice of such
failure has been given by the non-defaulting party
•  Under the 2002 ISDA, the cure period is one Local Business Day (or
one Local Delivery Day in the case of delivery failures)
20

Reduction of Cure Periods (continued)
•  Similarly, where a “Specified Transaction” is not subject to a
cure period under the terms that govern it directly, a cure
period is granted through the ISDA
•  That period is three Local Business Days under the 1992
ISDA and one Local Business Day under the 2002 ISDA
•  Additionally, involuntary insolvency filings and enforcement
actions are subject to a 30-day cure period under the 1992
ISDA, but only fifteen days in the 2002 ISDA
21

Expansion of the Definition of “Specified Transaction”
•  Section 5(a)(v) of the ISDA, sometimes described as
a limited cross-default provision, provides that an
Event of Default will occur if a party to the ISDA
defaults under a “Specified Transaction” with the
other party (subject to any cure periods provided for
under such Specified Transaction)
22

Expansion of the Definition of “Specified Transaction” (continued)
•  Under the 1992 ISDA, “Specified Transaction” is defined as a
derivative transaction entered into between the parties to the
ISDA that is a rate swap, basis swap, forward rate, commodity
swap/option, equity or equity index swap/option, bond option,
interest rate option, foreign exchange transaction, cap
transaction, floor transaction, collar transaction, currency
swap transaction, cross-currency rate swap transaction,
currency option or any other similar transaction or any
combination of these transactions
23

•  The 2002 ISDA expands the definition of Specified Transactions
to include the following transactions: swap option, credit
protection transaction, credit swap, credit default swap/option,
total return swap, credit spread transaction, repurchase
transaction, reverse repurchase transaction, buy/ sell back
transaction, securities lending transaction, weather index
transaction or forward purchase or sale of a security, commodity
or other financial instrument or interest
24

•  Thus, the 2002 ISDA includes any transaction that is similar to
the specifically enumerated transactions “that is currently, or in
the future becomes, recurrently entered into in the financial
markets and which is a forward, swap, future, option or other
derivative on one or more rates, currencies, commodities, equity
securities or other equity instruments, debt securities or other
debt instruments, economic indices or measures of economic
risk or value, or other benchmarks against which payments or
deliveries are to be made”
25

•  The expansion of the definition of Specified Transaction effectively
brings within the scope of this limited cross-default provision the
parties’ re-purchase (repos), securities lending, and securities
forward transactions
•  In adding repos, securities lending and securities forward
transactions as potential triggers for an Event of Default under the
ISDA, the 2002 ISDA also addresses delivery failures which as a
practical matter, may occur due to administrative errors, settlement
system problems or scarcity of the underlying security
26

•  Section 5(a)(v) of the 2002 ISDA clarifies that where repos,
securities lending and securities forward transactions are subject
to a master agreement, a failure to deliver a security under such
agreement will only trigger an Event of Default under the ISDA if
all transactions under the relevant master agreement are
accelerated or terminated
27

Force Majeure
•  The 2002 ISDA introduces the Force Majeure (or impossibility) Termination
Event in Section 5(b)(ii), which may be triggered if by reason of a force majeure
event or act of state that is beyond the control of a party (or its credit support
provider):
–  (i) the office through which a party (or its credit support provider) is acting is prevented from
making or receiving payments or deliveries or complying with any other material obligation
under the ISDA or a credit support document or it becomes impossible or impracticable for
that office to make or receive payments or deliveries or comply with any other material
obligation under the ISDA or a credit support document;
–  (ii) such party (or credit support provider) could not overcome the force majeure event using
reasonable efforts; and
–  (iii) a waiting period of eight business days has elapsed (unless the force majeure event
affects a payment or delivery or the ability to comply under a credit support document, in
which case there is no waiting period).
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Force Majeure (continued)
•  The Force Majeure provision is rarely negotiated, but
there are a few important points to note about the
provision
•  There is no definition of “force majeure”, other than that it
is a force majeure or act of state that prevents or makes
it impossible to make or receive payments or deliveries
or comply with obligations under the ISDA or credit
support document
29

Force Majeure (continued)
•  Additionally, although a party (or its credit support provider) is
required to attempt to overcome the force majeure event using
reasonable efforts, such party need not incur a loss in doing so
•  Finally, only the party affected by the Force Majeure event is the
“Affected Party,” and therefore, it is the party that determines the
Close-out Amount (based on mid-market values)
30

Set-off
•  The 2002 ISDA standardized set-off language that prior to 2002 was
often incorporated by participants in the Schedule to the 1992 ISDA
is based on language suggested in the User’s Guide to the 1992
ISDA
•  Often market participants seek to expand the set-off right to include
amounts owed under agreements with affiliates
31

Set-off (continued)
•  Section 6(f) permits the non-defaulting party, upon the termination of
all transactions due to the occurrence of an Event of Default or a
Termination Event where all outstanding transactions are
terminated, to offset any amount owed under the ISDA against other
amounts owed under other agreements between the parties
(whether mature or contingent)
32

•  Q&A
33

ISDA Master Agreement –
Key Negotiated Provisions
Credit
•  Some of the most significant negotiating points relate to a
party’s ability to declare an Event of Default (EOD) or
Termination Event (TE), which grants the right to terminate all
transactions under the ISDA and potentially triggering defaults
under other agreements that the defaulting party has in place
•  More creditworthy counterparty will seek to broaden the EOD
and to shorten the cure periods to maximize its ability to
terminate the trades under the Agreement promptly
34

Cross-Default
•  Section 5(a)(vi) provides that an EOD will occur if a party
defaults on a third-party obligation and the default or the
obligation is in excess of a specified Threshold Amount
•  The third-party obligation must be an obligation in
respect of borrowed money (whether present or future,
contingent or otherwise) and is referred to as “Specified
Indebtedness”
35

Cross-Default (continued)
•  The negotiation of the Cross-Default provision typically
revolves around the following three points:
–  amendment of the provision to provide for cross-
acceleration and the addition of an administrative error
carve-out;
–  expansion of the definition of Specified Indebtedness; and
–  agreement on a Threshold Amount
36

Cross Acceleration and Administrative Error Carve-Out
•  Corporate and buy-side participants often seek to delay or
eliminate the application of the Cross-Default provision
•  With respect to the first prong of the Cross-Default provision
(clause (1)), which addresses any type of default having
occurred under Specified Indebtedness, they require that in
order to trigger an EOD not only must the default have
occurred under the Specified Indebtedness, but the creditor
must have also chosen to demand payment of the obligation
(“cross acceleration”)
37

Cross Acceleration and Administrative Error Carve-Out (continued)
•  Under the second prong of the Cross-Default provision (clause
(2)), which addresses payment defaults under the Specified
Indebtedness, they require that a payment default will not trigger
an EOD if the failure to pay was due to an administrative or
operational error, the party had the funds necessary to make the
payment and the payment is cured within a certain period of time,
usually between one and three Local Business Days
(“administrative error carve-out”)
38

Expanding the Definition of Specified Indebtedness
•  Sell-side participants sometimes seek to expand the definition of Specified
Indebtedness to include Specified Transactions (and to expand the
definition of Specified Transactions to include transactions with third parties)
•  Participants are most likely to request this change from counterparties that
have little in the way of “borrowed money” (mainly loans)
•  Thus, if a counterparty defaults on an obligation under a derivative or
securities transaction with a third-party in excess of the Threshold Amount
(and where cross-acceleration applies such obligation is accelerated), the
non-defaulting party may declare an EOD
39

Expanding the Definition of Specified Indebtedness
(continued)
•  Thus, if a counterparty defaults on an obligation under
a derivative or securities transaction with a third-party
in excess of the Threshold Amount (and where cross-
acceleration applies such obligation is accelerated),
the non-defaulting party may declare an EOD
40

Threshold Amount
•  A party to an ISDA will attempt to negotiate a size-able
Threshold Amount for itself to prevent an EOD from
being triggered by a default on a de minimus loan
obligation or payment
•  On the other hand, parties will want to keep their
counterparties’ Threshold Amount as low as possible
in order to allow for greater opportunities to declare an
EOD
41

Threshold Amount
•  Parties often agree to asymmetrical Threshold Amounts which are fair to
each party as they are set at either:
–  (i) a percentage of an entity’s shareholders’ equity or members’
capital, for corporations or limited liability companies, or net asset
value, for investment funds (3% is typical);
–  (ii) a fixed dollar amount which makes sense for each party based
on their borrowed money; or
–  (iii) the lesser of (i) and (ii)
42

Default Under Specified Transaction
•  Certain parties prefer the 2002 ISDA because of its expanded
definition of “Specified Transaction,” which affords more
opportunities to declare an EOD
•  It is not uncommon for parties negotiating a 1992 ISDA to
incorporate the 2002 ISDA definition of “Specified Transaction”
•  Some parties push for an even broader definition of Specified
Transaction to pull in the parties’ obligations under prime brokerage
agreements
43

Additional Termination Events
•  Section 5(b)(v) provides for either or both parties to specify
“Additional Termination Events” (ATEs) applicable to a party (the
“Affected Party”), which will entitle the other party (also referred to
as the non-affected party) to terminate the transactions under the
ISDA
•  ATEs are intended to be early indicators of the deteriorating credit
condition of the Affected Party
•  ATEs provide the non-affected party an opportunity to get out of its
trades before the counterparty’s problems lead it to default
44

Additional Termination Events (continued)
•  ATEs are specifically tailored to the type of entities
involved, such as:
–  (i) a private corporation; and
–  (ii) a rated entity
45

Additional Termination Events – Private Corporations
•  “Maintenance of Ownership” provision
–  When entering into an ISDA with a subsidiary of a customer
(e.g., a bank entering into a swap with a subsidiary of its debtor),
a sell-side participant will want to ensure that the subsidiary’s
ownership, if its credit relationship is really with the parent, does
not change
–  For instance, it may provide that an ATE occurs if the parent
entity fails to own either directly or indirectly more than 51% of
the voting securities of its counterparty
46

Additional Termination Events – Rated Entity
•  A “credit rating downgrade” ATE is often requested from a
counterparty that is a rated entity or that is guaranteed by a rated
entity
•  The ATE can be drafted in numerous different ways, but the upshot
is that should such rated entity, or its guarantor, suffer a downgrade
in its credit-rating (e.g., below investment grade or higher), the other
party will be entitled to terminate all the outstanding transactions
under the ISDA
•  The utility of a credit-rating downgrade ATE hinges on the accuracy*
of the ratings published by the rating agencies
47

Cure Periods
•  Under the 1992 ISDA, the most commonly negotiated cure period is
failure to pay or deliver
•  If the parties agree to reduce the cure period for this EOD from three
Local Business Days to one, they will also likely amend the corollary
EOD in the Credit Support Annex (failure to deliver margin) and
reduce the cure period specified there from two Local Business
Days down to one Local Business Day
•  The standard 2002 ISDA provides for cure periods of one day for
failure to pay or deliver
48

Counterparty Credit Risk
•  In order to mitigate counterparty credit risk, parties enter into a
CSA
•  The CSA provides a contractual framework for the posting of
collateral to secure a party’s “Exposure”
•  For any given day, Exposure is the net amount that one party
would pay to the other based on the mid-market replacement
value of all transactions between the parties, as if they were to
be terminated on that day
49

Counterparty Credit Risk (continued)
•  The form CSA provides that: on every valuation day
(defined in Paragraph 13 – usually every business
day) the party that is in-the-money (the “Secured
Party”) may make a demand for collateral (a
“collateral call”) to the other party (the “Pledgor”),
who will have to transfer collateral (“variation
margin”) within the amount of time specified in the
agreement
50

Counterparty Credit Risk (continued)
•  If the market moves in favor of the Pledgor and the
Secured Party is over collateralized, the Pledgor may
make a collateral call and the Secured Party will return
collateral to the Pledgor
•  Either party can be the Pledgor or the Secured Party
depending on which party is in-the-money
51

Segregation of Independent Amounts
•  If parties choose to collateralize their obligations under the CSA,
one party may be required to post an “Independent Amount”
•  The Independent Amount--or initial margin--has historically been
an amount required by sell-side participants to guard against
credit exposure that may arise between the demand for and the
delivery of variation margin including movements in value
occurring between the time a party defaults and the time the non-
defaulting party designates a termination date
52

Segregation of Independent Amounts (continued)
•  The Independent Amount is posted in addition to the
daily variation margin requirements in the CSA
•  A dealer may hold a significant amount of assets as
Independent Amounts for a single trading counterparty
depending on the size of its OTC trading portfolio
53

Segregation of Independent Amounts (continued)
•  When the dealer becomes a credit-risk and enters insolvency proceedings,
as was the case with Lehman, the counterparty’s claim for a return of its
Independent Amounts becomes a general unsecured claim
•  Since Lehman’s insolvency, many buy-side participants have requested that
their Independent Amounts be held with a third-party custodian in order to
ensure that the collateral posted to cover their Independent Amount is held
with a bankruptcy-remote entity from which it is more readily recoverable
•  Segregation of Independent Amounts can be a costly proposition, both in
terms of the upfront legal and other fees required to set-up the relationship
as well as the ongoing fees to the custodian
54

Eligible Collateral
•  In Paragraph 13 of the CSA, parties specify the forms of “Eligible
Collateral” that may be delivered as collateral
•  The most common forms of Eligible Collateral are U.S. dollars and
U.S. treasuries
•  Parties agree on the class and maturities of the assets that would be
considered Eligible Collateral, as well as the discount (a.k.a. a
“haircut”) that applies to the valuation of the assets in determining
how much collateral has been posted
55

Transfer Timing
•  “Transfer Timing” refers to the period within which
collateral called for under the CSA must be
transferred
•  A failure to transfer within that period will give rise to
a Potential Event of Default
56

Transfer Timing (continued)
•  The standard CSA provides that if a collateral call is made
before the notification time (a time agreed by the parties), then
the collateral must be transferred by close of business on the
next Local Business Day
•  If the collateral call is made after the notification time, then the
collateral must be transferred by close of business on the
second Local Business Day
57

Transfer Timing (continued)
•  Current market practice calls for collateral demands to be satisfied within one
business day
•  Therefore, parties will often seek to reduce the transfer timing such that if a call
is made before the notification time, then the collateral must be transferred by
close of business on the same day, otherwise the transfer must be made by
close of business on the next Local Business Day
•  Whether this timeframe is operationally feasible for a trading entity often
depends on the notification time (in particular where counterparties are in
different time zones)
58

Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii)
•  Section 2(a)(iii)(1) of the ISDA provides that each obligation of a
party to make each payment or delivery specified in a confirmation is
subject to the condition precedent that no Event of Default or
Potential Event of Default with respect to the other party has
occurred and is continuing
•  Accordingly, if an Event of Default or Potential Event of Default has
occurred with respect to a party (the defaulting party), the other
party (the non-defaulting party) at its option may either (i) designate
an Early Termination Date under the agreement, or (ii) cease making
any payment or delivery obligations to the non-defaulting party in
reliance on Section 2(a)(iii)(1)
59

Flawed Asset Provision - Limitation on Reliance on Section 2(a)
(iii) (continued)
•  Paragraph 4(a)(i) of the CSA provides the non-defaulting party
a corresponding right to cease transferring collateral upon the
occurrence and continuance of an Event of Default, Potential
Event of Default or Specified Condition
•  The non-defaulting party may choose not to terminate its
trades under the ISDA, perhaps because it is net out-of-the-
money on all trades, and yet may cease performing in reliance
on these provisions
60

Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii)
(continued)
•  In the meantime, the defaulting party is still required to make timely
payments, deliveries and margin transfers to the non-defaulting
party
•  Section 2(a)(iii)(1) allows the non-defaulting party to game the
market by refusing to terminate its transactions under the Agreement
until it is beneficial for it to do so, or when the market swings in its
favor
61

Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued)
•  The negative consequences to the defaulting party can be significant
•  Excess collateral and settlement payments owed to the defaulting party may
be withheld by the non-defaulting party, thereby creating or further
deepening the defaulting party’s credit problems
•  This lack of liquidity may cause the defaulting party to default on its
obligations with other trading counterparties, triggering a wave of defaults
that leads to the defaulting party’s demise
62

Flawed Asset Provision - Limitation on Reliance on Section 2(a)(iii) (continued)
•  In order to prevent this result, parties will often negotiate a limitation on the
right to rely on Section 2(a)(iii)(1) in not making any payment or delivery
obligations, by providing that the non-defaulting party may only cease to
perform for a certain number of days after the occurrence of the Event of
Default that gave rise to such right
•  Typically the parties agree to anywhere between 30 and 90 days, the
rationale being that such number of days is sufficient time for the non-
defaulting party to decide if it will continue performing to the defaulting party
(thereby preserving the trading relationship), or terminate the trades under
the ISDA
63

“Fish or Cut Bait”
•  A related but different legal limitation is commonly referred
to as the “fish or cut bait” or “use it or lose it” provision
•  This term provides that upon the occurrence and
continuance of an Event of Default or Termination Event,
the non-defaulting party or non-affected party will have to
terminate its trades under the ISDA within a certain number
of days or forever waive its right to terminate the trades
based on such event
64

“Fish or Cut Bait” (continued)
•  The “fish or cut bait” is negotiated principally to
address the occurrence of misrepresentations,
which do not have a cure period, as well as
ATEs that either cannot be cured or may take
some time to cure
65

Ring-fencing Issues
•  ‘Ring fencing’ protects foreign counterparty from
convertibility and transferability issues at settlement
•  Ring-fencing to cover political events, currency
controls and other “closed market” issues
•  Include all transactions or only particular types of
transactions?
66

Ring-fencing Issues (continued)
•  All obligations (ISDA 2(a)(i)) or only net payments (ISDA
6(e))?
•  Does ring-fencing survive insolvency proceedings,
whereby branch non-payment would be included in 6(e)
calculation of Unpaid Amounts?
67

Close-out netting
•  Close-out netting is a central pillar of ISDA
Master Agreement for both risk mitigation (credit
risk exposure) and cost reduction (reserves)
•  Upon default all transactions taken into account
to determine single net amount
68

Close-out netting (continued)
•  Is netting agreement enforceable?
•  Recognized netting agreements (such as ISDA)
allow OTC transactions to be treated on a net basis
for capital adequacy purposes
•  Close-out netting concerned with accounting
between parties, not set-off since no accrued debt
exists prior to determination of net amount
69

•  Single agreement provision (ISDA 1(c)) and the
flawed asset provision (ISDA 2(a)(iii))
•  Payment netting important in FX transactions
since ‘daylight risk’ further mitigated (ISDA 2(c))
70

•  Post-insolvency distinction between contingent
and executory contracts
•  Contingent debts are accelerated but executory
debts are not
71

Automatic Early Termination (AET)
•  All transactions automatically terminate upon
occurrence of specified events within the bankruptcy
event of default immediately prior to winding-up
petition (ISDA 6(a))
•  Removes need for non-defaulting party to serve
termination notice
•  All transactions terminate and non-defaulting party
uses close-out netting provisions immediately
72

AET (continued)
•  Disadvantages of AET is that non-defaulting party loses
right to determine when to terminate
•  Non-defaulting party may not be aware that termination
has occurred and make payments outside the ISDA
architecture
73

Disruption Events
•  Examples of Disruption Events
–  natural disasters
–  social events
–  changes in law
74

Disruption Events
•  Capital/exchange controls may impose restrictions
on currency convertibility and transferability making
it:
–  Illegal
–  Impossible
–  Impractical
to perform obligations under a Transaction
75

Disruption Events (continued)
•  Such controls often used to protect currencies and local
markets during crises, but…
•  Have the potential to adversely impact counterparties
and pose potential systemic risk to the broader market
76

•  Documentation should address:
–  (a) Whether a Disruption Event constitutes a
Termination Event (TE)?
–  (b) Primacy in the event of any inconsistency
between a Confirmation and an ISDA (e.g.,
Illegality TE) as to whether a TE has occurred?
77

•  Trade association (eg., ISDA) involvement often
includes non-binding recommendations to
resolve market-wide issues following Disruption
Events
78

Issue: undocumented trades
•  Undocumented trades with no long-form Confirmation
(e.g., only deal tickets or phone recordings) with pricing
terms but no express standard or bespoke credit or legal
terms
–  Boilerplate provisions missing (e.g., governing law?)
79

Repudiatory breach?
•  Is repudiatory breach available in that the non-defaulting
party has the right to terminate and net all transactions
with a defaulting counterparty?
•  In the absence of any specific contractual right, the
solvent party may be required by a liquidator to pay the
insolvent party (a.k.a. ‘cherry picking’)
80

Non-ISDA Transactions
•  Be careful to include a ‘sweeper’ clause in your ISDA
Schedule so that all transactions (including deal tickets)
are deemed Transactions covered by ISDA termination
and netting provisions
81

•  Exercise date(s) depend on option type
–  American (exercisable at any time until maturity)
–  European (only exercisable at maturity)
–  Bermudan (exercisable on certain defined dates, similar to
a series of Europeans)
–  Asian (exercisable according to an average market price
over a defined option period rather than one date and time)
82

•  Q&A
83

From Specific Asset Classes
Analysis of advanced issues from specific asset classes
•  FX/Currency
•  Equity
•  Credit
84

Currency Derivatives Issues
FX Risk Mitigation
•  FX settlement risk (‘daylight’ risk) is the primary
risk in OTC FX transactions:
–  Post-trade risk that one party goes insolvent (or
unable to perform) after other party settles
–  Risk increases with time between trading and
settlement
85

FX Risk Mitigation
•  Potential systemic risk if large counterparty defaults?
•  Solution: clearinghouse stands between counterparties and
becomes a central counterparty (CCP) guaranteeing
contractual performance (through novation and collateral)
—pre-cursor to today’s broader CCP requirements for other
asset classes
•  E.g., CLS – multilateral payment netting and payment
versus payment (simultaneous settlement)
86

Non-convertibility
•  FX derivative markets initially developed to address delivery
and settlement issues around non-convertibility (‘soft’
currencies)
•  A non deliverable forward (NDF) is a synthetic forward
contract enabling hedging and position taking in countries
subject to currency regulations and/or high political risk
•  Singapore and HK developed as main APAC trading hubs for
NDFs
87

Equity Derivatives Key Provisions
Equity Swaps
Total Return Swaps (“TRS”) and other ‘delta one’ structures
transfer economic performance of underlying asset to
investors
Party A
(Equity Amount
Payer)
Party B
(Equity Amount
Receiver)
Equity Amount
Floating Amount
Shares
Pass-though economic
performance and dividends
88

Variance Swaps
Pay-offs vary according the volatility (up or down) of a
share or index
•  EAP amount is volatility of underlying asset (variance
from initial price) in either direction
Party
A
Party
B
89
EAP amount
Floating amount

Equity Options
Right, but not obligation, to sell (put) or buy (call) underlying at
pre-determined price
–  Party A writes an option and is paid a premium upfront
–  Party B only exercises if option is in-the-money (“ITM”) at the
exercise date(s) (subject to any barrier or cap/floor/collar
features in the case of exotic equity options)
Party A Party B
(writes option/pay-out if ITM)
(buys option/pays premium)
90

Forwards
•  One party buys shares at the forward price and (if physically-settled)
such shares are delivered at maturity (or cash-settled economic
equivalent)
•  In the case of cash-settled forwards, the economic equivalent
(positive or negative amount over or below the forward price) is paid
to ITM party by non-ITM party
91
Party
A
Party
B
(pays/delivers shares if ITM)
(pays/delivers shares if OTM)

Benefits of equity derivatives over cash positions
•  exposure to equity with lower transaction costs
•  avoidance of capital gains tax
•  monetization and financing structures
•  market access
•  greater returns (eg., though use of multipliers/leverage)
•  hedges against adverse movements in cash positions
•  fewer disclosure requirements in many markets
92

Valuation
•  Fundamental to determine payout of
transactions:
–  Scheduled Trading Day
–  Disrupted Day/Market Disruption Event
93

Adjustment Events (Article 11)
•  Potential Adjustment Events
•  Adjustments to Indices
94

Extraordinary Events (Article 12)
•  Merger Events/Tender Offers
•  Nationalization/Insolvency/De-listing
95

Additional Disruption Events (Article 12.9)
•  Change in Law (illegal to deal in share)
•  Failure to Deliver (due to illiquidity)
•  Insolvency Filing (proceeding commence)
•  Hedging Disruption (unable to hedge price risk)
•  Increased Cost of Hedging (material increase)
•  Loss of Stock Borrow (unable to borrow)
•  Increased Cost of Stock Borrow
96

Negotiating Closed Market
Provisions
•  Different documentation for “open” versus “closed”
markets
•  A closed market is a local equity market—Malaysia--
where certain shares are restricted to onshore
investors and therefore not directly available to
offshore investors
•  Asia-ex Japan closed markets include India,
Indonesia, Korea, Malaysia, Taiwan and Thailand
97

Negotiating Closed Market Provisions
•  Market access products enable investors that are not
able to directly invest in closed market shares (or
indices) to gain synthetic economic exposure
•  Transfer of economic exposure to local shares or indices
is done via an equity derivative with a Qualified Foreign
Institutional Investor (QFII)
98

Provisions
•  Market access products can either be bilaterally
negotiated (i.e., OTC format) or in securitized format with
standardized terms and conditions
•  Exchange traded funds (“ETFs”) may also be used to
transfer economic exposure to local equity indices
99

Provisions
100
QFII Buyer
(1. premium paid upfront)
1. premium
proceeds
(1. sell ZEPO)
1.  buy closed market shares at trade date
2.  sell closed market shares at exercise date
2. share sale
proceeds
(2. share sale proceeds)
ZEPO = Zero Exercise Price Option

Provisions
•  ‘Delta-one’ products have a price/pay-out
structure that closely tracks the price of the
underlying asset and risk free rate
•  Delta-one products may be ‘perfectly hedged’ if
the seller holds 100% of underlying shares (but
not required)
101

Provisions
•  Delta (Δ) is the rate of change of the
option price with respect to the underlying
Option
price
A
B
Slope = Δ = 0.6

Stock price
102

Provisions
•  Examples of securitized delta-one products
–  Low exercise price warrants (“LEPW”)
–  Participatory Notes (“P-Notes”)
–  Certificates
103

Provisions
•  Participatory Note (P-Note) example above is a fully-funded
securitized structure whereby a purchase price equal to the share
price at issue date is paid by the Buyer (plus a built-in fee) to the
QFII
104
QFII Buyer
(1. P-Note purchase price
plus fee)
1. P-Note
proceeds
(1. sell P-Note)
1.  buy closed market shares at issue date
2.  sell closed market shares at maturity date
2. share sale
proceeds
(2. share sale proceeds)

Provisions
•  Market access products are always cash-settled
and denominated in a convertible currency
•  FX risk of local currency is typically borne by the
investor (but can be mitigated with a Quanto or
other FX derivative)
105

Provisions
•  Market access products risks include
– Market risk
– Political risk
– Currency risk
– Basis risk
106

Provisions
•  MAP risks are heavily negotiated between buyers and
sellers in the OTC market
•  Buyer wants same risk/benefit profile as if directly
purchasing underlying
•  Seller is acting as a neutral intermediary and therefore
wants to allocate all risks to buyer
107

Provisions
•  Final price determination
–  Objective (good for buyer)
–  Actual (good for seller)
–  Hypothetical broker dealer (compromise)
108

Closed Market Provisions
•  Optional early termination
– By buyer
– By seller
109

Taxation
•  All taxes (especially dividend and capital gains)
are typically borne by buyer
•  Greater tax complexity, uncertainty and potential
retroactivity in closed markets
•  Tax indemnity from buyer to seller as a form of
‘claw-back’
110

Provisions
Additional Disruption Events
•  Seller keen to remain economically neutral and pass
all risks related to hedge position to buyer
•  Hedging Disruption and Increased Cost of Hedging
provisions may need to be extended to cover
currency and dividend risks
•  Difficult to foresee all risks and draft such protection
into market access products
111

•  Example: PRC market access products
representations to be obtained from buyer
•  We can see from the text in the PRC example
that the primary concern is that onshore
investors do not purchase offshore interests
(directly or indirectly) in underlying shares
•  Similar concerns for regulators in other closed
markets
112

Corporate Derivatives Legal Issues
Overview
•  What is a corporate derivative and what makes
them unique?
– An equity derivative over shares of a listed
company (“ListCo”) with a shareholder,
director or ListCo itself
113

Corporate Derivatives Legal
Issues
Transactions with shareholder
•  Shareholder with a large position seeks to
monetize stake (lock-in price) in ListCo without
disposing of shares
•  Shareholder cannot dispose of shares but
wishes to lock-in current price (via collar)
114

Transactions with shareholder (continued)
Monetization structure
115
Shareholder Bank
Shares
Securities
Lender
Securities
Market
sell call / buy put lend shares
return shares
sell shares
Payment of strike price
delivers shares

Transactions with shareholder (continued)
•  Alternatively, shareholder wishes to raise finance
without disposing of existing stake as seen in
this example of a Financing structure
116

Financing structure
117
Shareholder Bank
Shares
Payment of premium
Cash settlement of option
Zero strike call option
Equity swap
floating amount payments
Payments of excess share
value over premium amount
Payments of excess share
value under premium amount
shares as collateral
return of collateral

Problem areas
•  Insider trading (for shareholder and bank)
•  Market misconduct
•  Disclosure
118

Corporate Derivatives Legal
Issues
Insider trading
•  Is the bank a ‘connected’ person that may have
access to material information re ListCo shares?
•  Large shareholder is going to be connected and
may well possess material non-public information
•  Is there ‘equality of information’ between
shareholder and bank?
119

Insider trading (continued)
•  Bank should seek representation from
Shareholder that it is not in possession of
material non-public information
•  Is the derivative transaction itself material
information (i.e., likely to affect ListCo’s share
price)?
120

Insider trading (continued)
•  Bank is acting as neutral intermediary (for a
spread) and merely hedging its position, not
seeking to profit or avoid loss
•  Bank should create a ‘Chinese wall’ internally so
team in possession of material non-public
information is kept separate from team entering
into hedging transaction
121

Market misconduct
•  Does transaction effect market price?
•  False trading: intent (or recklessness) as to the
effect of creating misleading appearance of
active trading or price
122

Disclosure
•  Do all long and short positions created by
transaction need to be disclosed under any
listing rules?
123

•  Transactions with ListCo directors include similar
insider trading and market misconduct issues
discussed above
–  Additionally, are directors’ duties to ListCo (eg.,
fiduciary duties) being met?
–  Are there any blackout periods during which director
is prevented from transacting (such as quarterly and
annual results reporting)
124

Transactions with ListCo
•  Synthetic buy-backs (cash-settled) may replicate
economic effect without breaching restrictions
applicable to physical buy-backs
•  ListCo cannot be connected with itself so insider
dealing not a concern
•  Market misconduct?
–  Similar analysis as above
125Copyright © Gareth M. Pyburn 2013

Transactions with ListCo (continued)
•  Offer to the public?
–  requires approval by independent shareholders and an offer
document
•  On-market purchase (restrictions and disclosures)
•  Off-market purchase (requires special independent
shareholder resolution at general meeting)
•  Cash-settled derivative may avoid off-market restrictions on ListCo buying
own shares

– Directors’ fiduciary duties to ListCo may be
breached if ListCo buys a put or sells a call
option over own shares (depending on facts
surrounding transaction)
– Also, restrictions on subsidiaries holding
shares in ListCo need to be considered

•  Notifiable transactions
–  acquisition/disposal of assets
–  options to acquire/dispose of assets or securities
–  ListCo providing a guarantee/indemnity/financial
assistance
128

•  Connected transactions (eg., directors, CEOs,
substantial shareholders) may require written
agreement subject to independent non-executive
director review
•  General disclosure obligations regarding
material information to avoid creating a false
market in shares or price
129

2011 Equity Definitions
•  2002 Equity Definitions provide a foundation,
but…
–  Over 50 Master Confirmation Agreements (“MCAs”)
make standardization difficult (low levels of electronic
confirmations for equity products) and greater
transparency is desirable
–  New structure and approach (modular instead of
product specific approach)
130

•  ‘Main Book’ intended to be a universal
framework document containing core definitions
and provisions (300 pages long)
•  ‘Appendix’ designed for further tabular options
and features of new products, or new definitions
not in Main Book
131

•  ‘ISDA Transaction Matrices’ are product specific
spreadsheet-style documents with standardized
elections for trading a product
•  ‘Transaction Supplements’ which set out trade
specific economic terms of a transaction
132

•  Substantive changes from 2002 Equity
Definitions include
–  Cancellation Amount
–  Extraordinary Events
–  Calculation Dispute Resolution Procedure
133

Cancellation Amount
•  Different optional methods of calculating the
transaction value, rather than following a purely
replacement value approach which was appropriate
in all cases
•  Greater detail on how and when Cancellation
Amount is to be determined, data to be taken into
account and how losses/gains from hedge close-
outs are allocated
134

Extraordinary Events
•  More choice as to the consequences of
Extraordinary Events with optional fallbacks
•  Range of automatically applied Extraordinary Events
and optional Additional Disruption Events greatly
expanded and the majority of existing provisions
have been amended
135

Calculation Dispute Resolution Procedure
•  Reflects the less mechanical role played by the
Calculation Agent in equity derivative transactions
and provides procedural options
•  Procedure applies to determinations made by the
Calculation Agent, but also to those made by a party
determining a Cancellation Amount (which may or
may not be the Calculation Agent)
136

•  Implementation
–  Main Book does not affect existing transactions under
2002 Equity Definitions or existing MCAs
–  Expected to be gradual and coincide with the
publication of ISDA Transaction Matrices
137

Equity Derivatives Legal Issues
Insider trading
•  Person connected to issuer who has relevant information
–  deals so as to profit from non-public information
(includes equity derivative transactions)
–  counsels another person to enter into transactions
over shares
–  discloses price-sensitive information to another with
reasonable belief that person will deal/counsel
another to deal
138

Insider trading
•  Obtain representation from counterparty
•  Chinese walls arrangement that divide/segregate
departments with material non-public information (eg.,
corporate finance) from other departments (eg., sales and
trading desks, especially prop trading) can be an effective
defense for banks
–  physically measures such as segregating departments, security
codes, support staff and machines
–  compliance procedures documenting non-physical segregation
measures, enforcement of procedures, dealing rules, restricted
lists, control of communications between departments
139

Market Misconduct
•  Actions that affect normal dealings in shares or
have effect on shares price such as ‘false
trading’
– misleading appearance of active trading
– creating/maintaining artificial price
140

Market Misconduct (continued)
•  Hedging transactions typically not false trading
•  Advisable to obtain representation that
counterparty to the equity derivative transaction
(and any related hedging transaction) has no
intention (and is not reckless) to create a false
market
141

Market Misconduct (continued)
•  Price rigging (‘wash sales’ that cause change in value of
listed shares)
•  Market manipulation (two or more transactions likely to
increase or decrease value of shares with intent to
induce another person to buy, sell or refrain from trading
shares)
142

Takeovers
•  Use of cash or physically-settled derivatives by offerors
to obtain exposure to target company shares
–  does derivative transaction constitute an ‘offer’ (i.e.,
does offeror have firm intent to offer) and need to be
announced?
–  disclosure of interests in derivative positions?
–  do restrictions on dealing apply?
143

Short Selling
•  Short seller must have presently exercisable and
unconditional right to vest the shares with buyer
–  stock borrowing and lending agreement
–  title to securities that are convertible into shares
–  option to acquire shares
–  subscription rights or warrants over shares
–  right to return of shares under title transfer CSA
•  Uptick restrictions
144

•  Q&A
145

Credit Derivatives Key Provisions
•  Significant development of credit derivatives in APAC,
but…
•  Volume and complexity of some structured credit
products in APAC has dropped since the financial crisis
–  Synthetic collateralized debt obligations (“CDOs”)
–  Synthetic securitizations, CDO squared (and cubed)
–  Constant credit proportion portfolio insurance (“CPPI”)
146

Market
•  Large institutional market with inter-bank trades and non-
bank end-users
–  Insurance companies
–  Hedge funds
–  Asset managers
–  Corporates
•  Also, retail expansion of credit derivatives via private
banking and wealth management products
147

Credit Derivatives Key
Provisions
Assets
•  Main types of credit derivative underlying assets
(i.e., Reference Entities)
–  Corporates
–  Sovereigns
–  SPVs
–  Single name
–  Baskets
–  CDX indices
148

•  Reference Obligations include corporate bonds
and loans, asset-backed securities (ABS),
leveraged loans and…
•  CDS indices such as Markit iTraxx Asia ex-
Japan IG
149

Credit default swap (CDS)
(physically settled)
150
Party A
(protection
buyer)
Party B
(protection
seller)
(protection premium)
(physical settlement amount)
Delivery of deliverable obligations
upon credit event

Credit-linked notes (CLNs)
•  Noteholder (protection seller) makes an upfront
payment to purchase CLN and receives
enhance coupon (CDS premium from issuer)
until maturity unless a credit event occurs
•  If credit event occurs issuer (protection buyer)
redeems the CLN at a reduced value
151

On balance-sheet CLN
152
Party A
(protection buyer)
Party B
(protection seller)
(CLN purchase price)
(CLN redeemed at par if no
credit event; if credit event
occurs redemption amount
reduced by fall in market value)
(enhanced yield on coupon)

Off-balance sheet CLN structure
153
Party A
Collateral
Party BSPV
(CDS protection
premium)
(settlement under
CDS)
(CLN with enhanced
coupon)
(CLN purchase price)
(collateral purchase price)(interest income from collateral)

Total return swap
154
Asset
Party A Party B
(coupon on asset plus
increase in market value)
(payment plus plus decrease in
market value)

Credit-linked loan
•  Funded structure documented in loan rather than
CLN format
•  Borrower is protection buyer and lender is protection
seller
•  Borrower repays principal at maturity unless a credit
event occurs, in which case borrower repays a
lesser amount early by delivering obligations to
lender (or cash-settled equivalent)
155

Credit-linked deposit
•  Similar to CLN but documented in form of a deposit
•  Bank is protection buyer (over reference entity) and
customer is protection seller
•  Customer receives higher interest rate (similar to CDS
premium) and deposit amount at maturity
•  If credit event occurs, bank delivers obligations (or cash-
settled equivalent) to customer
156

Credit spread option
•  Differs from CDS in that no credit event needs to occur
for payout
•  Option buyer gets credit protection in relation to credit
spread between one reference entity and another
highly rated third party (bps spread b/w A and B)
•  If spread between entities diverge to strike level,
option buyer is in-the-money
157

Contingent credit default swap (CCDS)
•  Uses a variable notional amount based on marked-
to-market value at termination of a ‘hypothetical
derivative transaction’
•  If credit event occurs in relation to reference entity,
credit protection amount crystalizes
•  Credit protection amount more closely reflects actual
loss of protection buyer
158

Documentation (2003 Credit
Definitions)
•  The 2003 ISDA Credit Derivative Definitions
(“2003 Credit Definitions”) are widely used in a
broad range of credit derivatives
•  Designed for OTC credit derivative transactions,
but typically incorporated into securitized and
other credit risk delivery formats mentioned
above
159

Definitions)
•  ‘Reference Entity’ over which protection is bought
–  Corporate
–  Sovereign
–  SPV
–  Basket
–  CDS index
•  …includes any ‘Successor’ (merger, consolidation,
and other)
160

Definitions)
•  ‘Obligations’ of Reference Entity over which
protection is bought
– Includes direct obligations such as bonds or
loans
– May include indirect obligations such as
guarantees
161

Definitions)
•  ‘Reference Obligation’ that is being hedged
by credit derivative transaction
•  ‘Deliverable Obligations’ of Reference Entity
to be delivered upon physical settlement
162

Definitions)
•  ‘Credit Events’ refer to deterioration of
creditworthiness of Reference Entity
–  Bankruptcy
–  Failure to pay (above de minimus threshold)
–  Restructuring
–  Repudiation/Moratorium
–  Obligation Acceleration
–  Obligation Default
163

Definitions)
•  Conditions to Settlement
–  Credit Event Notice
–  Notice of Publicly Available Information
–  Notice of Physical Settlement
164

Definitions)
Physical settlement
•  Not subject to debate over Calculation Agent’s
valuation or methods
•  Often difficult to acquire Deliverable Obligations
in which case protection buyer loses economic
benefit of protection
165

Definitions)
Cash settlement
•  No need for protection buyer to actually acquire
Deliverable Obligations
•  Calculation Agent has discretion in valuation
process that may disadvantage counterparty
166

Definitions)
Auction-based settlement
•  Industry forms determinations committees and
protection amount is determined by auction
•  Avoids difficulties of acquiring Deliverable
Obligations after Credit Event of major Reference
Entity and…
•  Valuation is standardized and less unpredictable
in a distressed market
167

Definitions)
•  Initially auction-based settlement was voluntary
•  Big Bang and Small Bang Protocols replaced
prior practice of voluntary committees
•  Protocols allow all existing and future
transactions to be subject to Credit Derivatives
Determinations Committees
168

Definitions)
•  Determination Committees look at publicly
available information (factual) and provisions of
standard CDS contracts to determine
•  whether Credit Event has occurred
•  whether auction should be held to determine the
final price for CDS settlement
•  which obligations should be delivered or valued in
the auction
169

Definitions)
•  Determination Committee Rules published alongside Big
Bang Protocol and March 2009 Supplement
•  DCs are structured to represent a variety of market
perspectives and to ensure that each DC member has
market expertise
•  Votes process requires deliberation and must represent
protection buyers and sellers
170

Definitions)
•  Determinations requiring interpretation of 2003 Credit
Definitions need 80% supermajority to ensure protection
buyers and sellers treated fairly
•  If an 80% supermajority is not achieved the question
proceeds to External Review
171

Definitions)
•  Standardization and the reduction of basis risk
–  Legal/Interpretation Basis Risk (uniform contractual
terms and determinations of material provisions)
–  Economic Basis Risk (uniform settlement method)
172

Definitions)
•  Under adverse economic conditions borrowers
may try to buy-back debt inexpensively via
‘synthetic buy-back’
•  Provide exposure to own indebtedness and the
Reference Entity is also the protection seller
173

Definitions)
•  Protection buyer requires a funded structure
(with upfront payment by seller such as a CLN)
to address credit risk of protection seller if Credit
Event occurs
•  Funded structures could also include
collateralized OTC CDS, credit-linked loans and
credit-linked deposits
174

Definitions)
•  CLN issuer’s payment obligations of interest and
principal at par upon maturity if no Credit Event
occurs in relation to Reference Entity
•  If Credit Event occurs, issuer no longer obligated
to pay principal and interest; instead,…
•  Issuer delivers Deliverable Obligations to
Noteholder
175

Credit Derivatives Legal Issues
•  Re-characterization risk that credit derivative will
be deemed by regulators to be something else
•  For example, guarantees or risk sub-
participations will be treated differently from a
legal or regulatory standpoint
176

Credit Derivatives Legal Issues
•  If credit derivative seen as means of by-passing
regulatory obstacles the regulator could ‘look
through’ formal structure and deem it to be
another type of financial instrument
177

Credit Derivatives: Advanced
Structures
Synthetic CDOs/securitizations
•  Cash CDO is a debt security backed by a pool of
underlying debt obligations (loans, bonds…)
•  Synthetic CDO uses a credit derivative (CDS) to
transfer credit risk off-balance sheet for
regulatory capital purposes (or for arbitrage
opportunities in credit spreads)
178

Structures
Equity default swap (EDS)
•  Hybrid concept similar to CDS except that the
triggering event is an ‘equity event’ such as a
steep fall in Reference Entity’s shares
•  EDS is basically a deeply out-of-the-money
equity barrier put option
•  If equity event occurs, protection seller pays
settlement amount to protection buyer
179

Structures
Onshore/offshore structures
•  Synthetically work around restrictions on capital
flows
•  Credit risk of on-shore loan transferred offshore
by way of a CDS (embedded in a CLN) offshore
180

Structures
On-shore/off-shore structure
181
Offshore
Branch
Onshore
Subsidiary
Onshore
Branch
3rd Party
Investors
Offshore
Parent
USD
Local
currency loan
USD
Bonds
CLN referencing
onshore subsidiary
Onshore
Offshore

Negotiated Credit Derivative
Provisions
•  Q&A
182

LEGAL AND REGULATORY ISSUES - OTC
DERIVATIVES IN APAC
THE IMPACT OF NEW US AND EU REGULATIONS
Presented by Gareth Pyburn, Esq.
gmpyburn@insightlegalasia.com
Kuala Lumpur
May 26 – 27, 2014
183

DAY TWO
1.  US regulatory framework
2.  Dodd-Frank Act and the Volcker Rule
3. ISDA Protocols Part A: Dodd-Frank Protocols
4.  ISDA Protocols Part B – EMIR Protocol
5.  Central counterparties (CCPs) and comparative
analysis of US and EU clearing obligations
6. FATCA: A new global risk
7. OTC Legal and regulatory trends in APAC: predictions
184

US Regulatory Framework
Section overview
•  Commodities and Futures Trade Commission (CFTC)
•  Securities and Exchange Commission (SEC)
•  Dealers' response to Dodd-Frank and industry-led
lawsuit against CFTC
•  US extraterritoriality and the impact on APAC
185

CFTC
•  Primary regulatory ambit for all swaps, except for
“security-based” swaps which fall to the SEC
•  Drafts proposed and final rules pursuant to DF and also
acts as the enforcement wing for most derivatives activity
•  “Swap” are defined very broadly and captures most
derivative transactions
186

SEC
•  Primary regulator for all securities, but also responsible
for “security-based swaps” that have single stocks, share
baskets or share indices as the underlying
•  Limited rule-making authority under DF, which is specific
to security-based transactions (primarily equity
derivatives)
187

Other Regulatory Entities
Beyond the CFTC, SEC and Federal Reserve itself:
•  Comptroller of the Currency
•  Federal Deposit Insurance Corporation (the “FDIC”)
188

Dealers' response to Dodd-Frank and industry-led lawsuit
against CFTC
•  SIFMA and ISDA took legal action against the CFTC after it issued
its guidance in July 2013, claiming that CFTC’s Chairman Gary
Gensler was acting by individual fiat by using guidance and staff
advisory documents, rather than formal CFTC commissioned rules:
–  “The commission attempted to excuse itself from those
[rulemaking] requirements by issuing a sweeping, international
compliance directive that it characterized as mere guidance”
189

against CFTC (continued)
•  Plaintiffs argued that Gensler was unlawfully
circumventing procedures, failing to conduct legally
required cost benefit analysis and imposing rules that
were contrary to international co-operation
•  The EU concurred that the CFTC had over-reached by
requiring foreign market participants to follow the US rule
book if they trade with a US counterparty
190

against CFTC (continued)
•  Lobbying groups seek to apply pressure on CFTC to
draft clear rules that industry participants can
understand/comply with
•  EU also criticized these CFTC rules on extraterritoriality
“…which seem to us to go against both the letter and
spirit..” of the division of oversight agreement Gensler
hammered out with the EU
191

•  Q&A
192

The Dodd-Frank Act
Overview
•  Dodd Frank is an overarching reform of Wall Street that targets
swaps, prop trading and other activity deemed too risky for Fed
“insured” banks
•  DF rolls back many of the Graham-Bleach-Liley Act’s amendments
made during the 1990s allowing banks to engage in market
activities, thereby re-introducing certain Glass-Steagall era divisions
that segregated credit and market risk in the 1930s (i.e., lending and
trading activities kept separate)
•  Beyond the transactional level, DF also puts in place many risk
management safeguards focused on business conduct and risk
management
193

The Dodd-Frank Act
Jurisdictional responsibilities
•  The CFTC has gained considerable power post-GFC
and is the primary regulator for most DF reforms
•  CFTC has defined “swaps” very broadly
•  The SEC retains its bailiwick vis-à-vis “security-based
swaps”
194

The Dodd-Frank Act
CFTC and/or SEC registration requirements
•  Registration requirements revolve around certain key
terms:
–  Swap dealer (SD)
–  Major swap participant (MSP)
–  Swap Exchange Facility (SEF)
–  Derivatives Clearing Organization (DCO)
195

The Dodd-Frank Act
Derivative clearing organizations (DCOs)
•  Central counterparties (CCPs) seek to transfer and
minimize counterparty credit risk through the use of the
novation concept
–  Counterparty risk is transferred to the CCP so that each side to
trade faces the credit of the CCP, not the economic counterparty
directly
196

The Dodd-Frank Act
The swap push-out rule
•  Restricts the derivatives trading activities of all FDIC-
insured institutions
•  Large components of the detailed Volcker Rule are
derived from the push-out rule, which has fundamentally
changed what types of trading banks can engage in
197

The Dodd-Frank Act
The Volcker Rule: Overview
•  Extraterritorial impact of the Final Rule on non-U.S. banks
•  Ends prop trading within banks, with exceptions for hedges
aligned to actual proprietary positions (must be able to match
trade to underlying position being hedged)
•  The Volcker Rule constrains the worldwide activities of
virtually all internationally active non-U.S. banks and their
affiliates
198

The Dodd-Frank Act
The Volcker Rule’s Effect
•  In the absence of an exception, both proprietary trading in
most financial instruments and sponsorship of and investment
in alternative funds will be prohibited
199

The Dodd-Frank Act
Volcker Rule: Exemptions
•  The worldwide market making, underwriting and hedging
activity of affected banks may be exempt from the
prohibition on proprietary trading, but these exemptions
are narrowly defined
•  Any bank with substantial trading activity can only rely on
these exceptions if it has implemented an elaborate
compliance program and reports a number of detailed
“metrics” to U.S. regulators
200

The Dodd-Frank Act
Volcker Rule: Exemptions (continued)
•  Under the critical SOTUS exception, the Final Rule
allows non-U.S. banking entities to trade with some U.S.
counterparties, subject to certain execution and other
requirements that will require trading arrangements to be
re-examined and conformed
201

The Dodd-Frank Act
Volcker Rule Exemptions (continued)
•  The Final Rule permits any non-U.S. bank to trade in its
home country’s sovereign debt, without regard to where
the trading activity is conducted or booked
•  It also permits a licensed and regulated non-U.S.
subsidiary (but not a foreign branch) of a U.S. bank to
trade in the sovereign debt of the country in which the
non-U.S. subsidiary is organized
202

The Dodd-Frank Act
Volcker Rule: Exemptions (continued)
•  The Final Rule continues to bar most investments by
non-U.S. banks in “covered funds,” but, in an important
development, exempts any private fund organized
outside of the United States with no U.S. investors from
the “covered fund” ban on investments by these banks
•  The Final Rule exempts UCITS and similar public funds,
and covered bond vehicles, from the reach of the Volcker
Rule
203

The Dodd-Frank Act
Volcker Rule Proprietary trading ban
•  Proprietary trading under the Final Rule is defined as trading
activity in “financial instruments” (a term that includes
securities, options and derivatives (including FX swaps and
forwards), but which does not include spot FX and currency
transactions) that falls within any of the following buckets:
–  trading with the principal purpose of short-term resale,
benefiting from short-term price changes, realizing short-
term arbitrage profits or hedging any such positions;
204

Legal Regulatory Issues OTC Derivatives APAC 2014

Legal Regulatory Issues OTC Derivatives APAC 2014

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