Financially Traded Products Readings PDF

2014 Energy Risk Professional
ERP Exam Course Pack
READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE

In addition to the published readings listed, the Financially Traded Energy Products and Structured
Transactions section of the 2014 ERP Study Guide includes several additional readings from online
sources that are freely available on the GARP website (link to 2014 Online Readings). These readings
include learning objectives that cover specialized topics or current trends dealing with financial
transactions that are unavailable in traditional text books.
The 2014 ERP Examination will include questions drawn from the following AIMs for each reading:
Readings for Financially Traded Energy Products and Structured Transactions
Energy Derivatives: Overview of Products, Market Mechanics and Applications

1. IEA, “The Mechanics of the Derivatives Markets: What They Are and How They
Function.” (Special Supplement to the Oil Market Report, April 2011).
• Understand the role of hedgers, speculators, and arbitrageurs in a derivatives market.
• Compare and contrast forward and futures contracts and understand how they are
applied.
• Understand the mechanics of a futures position and calculate the margin requirements
and profit on an open futures contract.
• Explain the circumstances under which you would be required to post additional
margin (a “margin call”).
• Differentiate and apply market, limit and stop-loss orders.
• Construct a hedge for a commodity position or an obligation to buy or sell a
commodity by using long or short positions in futures contracts.
• Explain how basis risk can arise in a hedging transaction.
• Describe the mechanics of swaps and explain the function of the swap counterparty,
including swap dealers.
• Calculate a periodic swap settlement payment for a multiyear energy commodity
swap given forward prices and interest rates.
• Explain how the market value of a swap changes over time and describe factors
affecting a swap's market value.
• Explain how an implicit lending agreement is contained in a swap and describe how
the interest rate is derived from an interest rate forward curve.
• Understand the differences between American, European and Bermudan options.
• Define plain vanilla options; understand the mechanics and payoff profiles of call and
put options.
• Understand what it means for an option contract to be in, at, or out of the money.
© 2014 Global Association of Risk Professionals. All rights reserved.

Energy Commodity Exchanges and OTC Derivative Trade Process

2. OTC Commodity Derivatives Trade Processing Lifecycle Events. (ISDA Working Paper,
April 2012).
• Understand the key features of the OTC commodity derivatives market.
• Summarize the steps involved in processing an OTC trade and understand the action
required in each step (Trade Capture, Controls Processing, etc.).
• Identify the market pricing services used to settle OTC energy contracts (i.e. PlattsGas
Daily) and understand how physical delivery may impact the settlement value.
• Explain the importance of automation (i.e. "straight-through-processing") in clearing
OTC energy trades; describe the benefits and weaknesses of a settlement matching
process.
• Describe how OTC clearing affects market transparency.
Global Regulatory Developments

3. Rajarshi Aroskar. OTC Derivatives: A Comparative Analysis of Regulation in the United
States, European Union, and Singapore.
• Describe the function and benefits of a trade repository as it relates to OTC market
participants.
• Compare the regulatory requirements and regulatory authority in the United States,
European Union, and Singapore with respect to: the central clearing of OTC deriva-
tives, requirements of central counterparties, margin requirements for uncleared
OTC derivatives, trading, and back-loading of existing OTC contracts.
• Describe the requirements for reporting derivative transactions to trade repositories
in the United States, European Union and Singapore.
4. Cleary and Gottlieb. “Navigating Key Dodd-Frank Rules Related to the Use of Swaps by
End Users.” (April 9, 2013).
• Define the terms: swap dealers, major swap participants, and end users; understand
how entities are assigned to these categories under Dodd-Frank.
• Understand the role of a derivatives clearing organization and describe the process
for clearing a swap.
• Understand the requirements for clearing a swap transaction, including swap report-
ing requirements.
• Explain the circumstances under which an end-user exemption may be granted to a
swap participant.

5. Gordon Goodman. “Swaps: Dodd-Frank Memories.” (July 2, 2013)

• Understand the financial limits a party must meet to qualify for the end-user exemption.
• Explain the use of swaps for hedging purposes and how this is affected under
Dodd-Frank.
• Understand the de minimis and major swap participant (MSP) tests, along with other
financial obligations a party must meet to be considered an end-user.
• Understand the reporting process under Dodd-Frank, including which party is
obligated to report a transaction to a swap data repository (SDR).
6. Gordon Goodman. “Dodd-Frank’s Impact on Financial Entities, Financial Activities and

Treasury Affiliates.” (October 23, 2013)
• Explain how a “financial entity” is defined under the Dodd-Frank Act and how this
designation affects mandatory clearing requirements.
• Understand how the end-user exemption may apply to organizations deemed
financial entities.

SPECIAL
SUPPLEMENT
to the April 2011 Oil Market Report
The Mechanics of the

Derivatives Markets
What They Are and How They Function
April 2011

PREFACE

This supplement to the April 2011 OMR is designed as a reference document for member
governments and subscribers. It forms part of an ongoing work programme examining the
mechanics of oil price formation and the interactions between the physical and paper markets.
Further research will be forthcoming in the OMR, the MTOGM and in the form of stand‐alone
papers in months to come. The work programme is being supported by contributions from
member governments, most notably those from Japan and Germany. We are grateful for that
support. Further impetus for this work comes from the joint work programme the IEA is
undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers.
The work is overseen by David Fyfe, and the supplement’s main author is Bahattin Buyuksahin,
to whom all enquiries should be addressed.

TABLE OF CONTENTS
1. INTRODUCTION TO DERIVATIVES ................................................................................................... 4

1.1 Basics of Derivatives ............................................................................................................................. 5
1.2 Types of Derivatives ............................................................................................................................. 6
1.3 History of Derivatives Markets .......................................................................................................... 6
1.4 The Markets ........................................................................................................................................... 7
1.5 Types of Market Participants in Derivatives Markets ................................................................... 8
1.5.1 Hedgers ............................................................................................................................................ 8
1.5.2 Speculators ...................................................................................................................................... 9
1.5.3 Swap Dealers and Commodity Index Traders ...................................................................... 10
2. FORWARDS AND FUTURES................................................................................................................ 12

2.1 Forward Contracts ............................................................................................................................. 12
2.2 Futures ................................................................................................................................................... 14
2.2.1 Contract Specifications............................................................................................................... 15
Box 1: Grade and Quality Specifications of WTI Contract ........................................................... 16
2.2.2 The Clearinghouse Margins ....................................................................................................... 17
2.2.3 Settlement Price, Volume and Open Interest in Futures Markets ................................... 19
2.2.4 Types of Orders........................................................................................................................... 20
2.3 Hedging Using Futures Contracts ................................................................................................... 20
2.4 Basis Risk ............................................................................................................................................... 22
3. SWAPS ......................................................................................................................................................... 23
3.1 Mechanics of Swaps ............................................................................................................................ 26
4. OPTIONS .................................................................................................................................................... 28
4.1 Call Option ........................................................................................................................................... 29
4.2 Put Option ............................................................................................................................................ 32
4.3 “Moneyness” of Options ................................................................................................................... 33
4.4 Hedging Using Options ...................................................................................................................... 34
5. REFERENCES.............................................................................................................................................. 35
6. GLOSSARY OF THE DERIVATIVES MARKET TERMS....................................................................... 36

1. I NTRODUCTION TO D ERIVATIVES I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
1. INTRODUCTION TO DERIVATIVES

In the last thirty years, the world of finance and capital markets has experienced a quite spectacular
transformation in the derivatives markets. Futures, options and swaps, as well as other structured
financial products, are now actively traded on many exchanges and over‐the‐counter (OTC) markets
throughout the world, not only by professional traders but also by retail investors, whose interest in
these derivatives has increased.

Derivatives are financial instruments whose returns are derived from those of another financial
instrument. As opposed to spot (cash) markets, where the sale is made, the payment is remitted, and the
good or security is delivered immediately or shortly thereafter, derivatives are markets for contractual
instruments whose performance depends on the performance of another instrument, the so‐called
underlying instrument. For example, a crude oil futures is a derivative whose value depends on the price
of crude oil.

Derivatives contracts play a very important role in managing the risk of underlying securities such as
commodities, bonds, equities and equity indices, currencies, interest rates or liability positions.
Commodity derivatives are traded in agricultural products (corn, wheat, soybeans, soybean oil), livestock
(live cattle, pork bellies, lean hogs); precious metals (gold, silver, platinum, palladium); industrial metals
(copper, zinc, aluminum, tin, nickel); soft commodities (cotton, sugar, coffee, cocoa); forest products
(lumber and pulp); and energy products (crude oil, natural gas, gasoline, heating oil, electricity). Financial
derivatives, where in many cases no delivery of the physical security is involved, are traded on stocks and
stock indices (single stocks, S&P 500, Dow Jones Industrials); government bonds (US Treasury bonds,
US Treasury notes); interest rates (EuroDollars) and foreign exchanges (Euro, Japanese Yen,
Canadian Dollar). In recent years, new derivatives instruments have been devised, which are different
from the more traditional instruments, as the underlying asset of these derivatives is no longer
necessarily a liquid, marketable good. For example, derivatives trading has begun on weather and
credit risk.

The derivatives market as a whole, and over‐the‐counter markets in particular, has recently attracted
more attention after the onset of the financial crisis in 2008. In this report, we will look at the main
building blocks of derivatives markets, including forwards, futures, swaps and options markets.

4 A PRIL 2011
I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 1. I NTRODUCTION TO D ERIVATIVES
1.1 Basics of Derivatives

Derivatives contracts get their name from the fact that they are “derived from” some other “underlying”
claim, contract, or asset. For instance, a crude oil forward contract is “derived from” the underlying
physical asset—crude oil. Derivatives are also called “contingent claims.” This term reflects the fact that
their payoff—the cash flow—is contingent upon the price of something else. Going back to the crude oil
forward contract example, the payoff to a crude oil forward contract is contingent upon the price of
crude oil at the expiration of the contract.

Hedgers, speculators and arbitrageurs use derivatives instruments for different purposes. Hedgers use
derivatives to eliminate uncertainty by transferring the risk they face from potential future movement in
prices of the underlying asset. In this regard, derivatives serve as an insurance or risk management tool
against unforeseen price movements. Speculators, on the other hand, use these instruments to make
profits by betting on the future direction of market prices of the underlying asset. Therefore, derivatives
can be used as an alternative to investing directly in the asset without buying and holding the asset itself.
Arbitrageurs use derivatives to take offsetting positions in two or more instruments to lock in a profit.

In addition to risk management, derivatives markets play a very useful economic role in price discovery.
Price discovery is the process of which market participants (buyers and sellers) uncover an asset’s full
information or permanent value, and then disseminate those prices as information throughout the
market and the economy as a whole. Thus, market prices are important not only for those buying and
selling the asset or commodity but also for the rest of the global market’s participants (consumers or
producers) who are affected by the price level.

In summary, two of the most important functions of derivatives markets are the transfer of risk and price
discovery. In a well‐functioning futures market, hedgers, who are trying to reduce their exposure to price
risk, will trade with someone, generally a speculator, who is willing to accept that risk by taking opposing
positions. By taking the opposing positions, these traders facilitate the needs of hedgers to mitigate their
price risk, while also adding to overall trading volume, which contributes to the formation of liquid and
well‐functioning markets.

A PRIL 2011 5
1.2 Types of Derivatives

There are four major types of derivatives instruments. In some respects, these may be regarded as
building blocks and can be categorised as follows:
• Forwards
• Futures
• Swaps
• Options
Each instrument has its own characteristics, which offers advantages in using them, but also brings
disadvantages, which are discussed later in the text.

1.3 History of Derivatives Markets
Although derivatives are frequently considered to be something new and exotic, they have been around
for millennia. There are examples of derivative contracts in Aristotle’s works and the Bible. It is true,
however, that the use of financial derivatives has been growing since 1980s.

The origins of derivatives trading dates back to 2000 B.C. when merchants, in what is now called Bahrain

in the Middle East, made consignment transactions for goods to be sold in India. Derivatives contracts,
dating back to the same era, have also been found written on clay tablets from Mesopotamia, when
farmers borrowed barley from the King’s daughter by promising to return it at harvest time. This trade
can either be considered as a commodity loan or as a short‐selling operation. It is a commodity loan
because farmers borrowed barley in order to use it for planting the crop and they promised to return it
after harvesting. Of course, it is a short‐selling trade since farmers do not have any barley at the time of
contract agreement.1

A more literary reference comes some 2 350 years ago from Aristotle, who discussed a case of
manipulation call option style investment on olive oil presses. In Politics, Aristotle told the story of a
trader, who buys exclusive right to use olive oil presses in the upcoming harvest from the owners of this
equipment. The trader paid some down payment for this right. During the harvesting season, the
demand for olive oil presses rose as predicted by the trader and he sold his right to use this equipment
to other parties. In the meantime, the trader made a profit without actually being in the olive oil
production business. The trader’s trade carried only his down‐payment (option premium) as a risk; on
the other hand, owners of olive oil presses transferred some of the risks associated with the possibility of
a bad crop season to the trader.
1
See Weber (2008) for a detailed excellent review of the history of derivatives markets.

6 A PRIL 2011
Derivatives trading in an exchange environment and with trading rules can be traced back to Venice in

the 12th century. Forward and options contracts were traded on commodities, shipments and securities

in Amsterdam after 1595. The first standardised futures contract can be traced to the Yodoya rice market
in Osoka, Japan around 1700. In the US, forward and futures contracts of agricultural products such as
wheat and corn have been formally traded on the Chicago Board of Trade2 (CBOT) since 1848. The CBOT
initially offered forward contracts on agricultural commodities. In 1865, the first standardised futures
contracts were introduced on the CBOT floor. The Chicago Mercantile Exchange (CME) was established in
1919 to offer futures contracts on livestocks and agricultural products. The CME has increased the
number of contracts listings over time and is now best known worldwide for its financial products,
including its flagship Eurodollar contract.

1.4 The Markets
There are basically two types of markets in which derivatives contracts trade. These are exchange traded
markets and over‐the‐counter (OTC) markets. Regulated exchanges, since their inception in the
mid‐1800s until recently, have been the main venue on which producers and large‐scale consumers of
commodities hedge their risk against fluctuations in market prices, while allowing speculators to make
profits by anticipating these fluctuations. Exchange‐traded derivatives are fully standardised and their
contract terms are designed by derivatives exchanges.

However, due to standardisation and fixed contract specifications in exchange‐traded contracts, financial
institutions began to develop non‐exchange‐traded (or over‐the‐counter, OTC) derivatives contracts.
Instruments in the OTC markets are generally privately negotiated between market makers (or so‐called
swap dealers) and their clients. Unlike exchange traded products, OTC instruments can be customised to
fit clients’ needs. These instruments, like standardised futures contracts, can be used by hedgers to
hedge their exposure to the physical asset itself, or by speculators to make speculative profits if prices of
the underlying asset move in an expected direction.

According to the latest Bank of International Settlements (BIS) survey, the total notional value of all OTC
derivatives reached $583 trillion at end‐June 2010, of which $2.85 trillion (0.5%) was in commodity‐
related derivatives. At their peak in end‐June 2008, the total notional value of commodity‐related
derivatives had reached $13 trillion, or 2% of the total market. The total notional value of all exchange‐
traded derivatives contracts exceeded $90 trillion at that time.

2
CBOT merged with CME in 2007.
A PRIL 2011 7
Figure 1: Size of Over‐the‐Counter and Exchange Traded Derivatives Markets
800
Size of Markets ($ trillion)
700
600
500
400
OTC
300
200 Exchange
100
0

1.5 Types of Market Participants in Derivatives Markets
Trading participants in derivatives markets can be placed into three basic categories as we mentioned
earlier: (1) hedgers (2) speculators and (3) arbitrageurs. In addition to these three broad categories, swap
dealers and commodity index traders are important types of market participants and have been
centre‐stage during the recent debate on financial regulations. We discuss swap dealers and their
business in details in Section 3.

1.5.1 Hedgers
Hedgers use derivatives markets to offset the risk of prices moving unfavourably for their ongoing
business activities. Hedgers, including both producers (oil producers, farmers, refiners, etc) and
consumers (airlines, refiners, etc), hold positions in both the underlying commodity and in the futures (or
options) contracts on that commodity. A long futures hedge is appropriate when you know you will
purchase an asset in the future and want to lock in the price. A short futures hedge is appropriate when
you know you will sell an asset in the future and want to lock in the price. By hedging away risks that you
do not want to take, you can take on more risks that you want to take while maintaining desired/target
aggregate risk levels.

For example, an oil producer can hedge against declines in oil price by selling an oil futures contract (taking
a short position) on the exchange in light of its oil position, which is naturally long, in the physical market. If
the price of oil increases over time, the profits from the actual sale of oil are offset by losses from holding
the futures contract. On the other hand, if prices decline over time, oil producers can offset their losses
from the actual sale of oil from selling their short position in the futures market. Basically, whatever
happens to prices, hedgers are guaranteed to have constant profit.

8 A PRIL 2011
Hedgers, who hold short positions in the physical market, take long positions in the paper market to limit
the risk associated with fluctuations in underlying asset prices. For example, an airline company can
hedge against a rise in oil prices by buying oil futures contracts (taking a long position) on the exchange
for the oil required to operate its business activities (the airline company position is short in the
physical market).

Some hedgers might be both producers and consumers in some related commodities. For example,
refiners use crude oil to produce petroleum products. Crude oil is refined to make petroleum products,
in particular heating oil and gasoline. The split of oil into its different components is frequently achieved
by a process known as “cracking”, hence the difference in price between crude oil and equivalent
amounts of heating oil and gasoline is called a crack spread. Therefore, refiners can take positions in
crack spreads.3

1.5.2 Speculators
Speculators, on the other hand, use derivatives to seek profits by betting on the future direction of
market prices of the underlying asset. Hedge funds, financial institutions, commodity trading advisors,
commodity pool operators, associate brokers, introducing brokers, floor brokers and traders are all
considered to be speculators. In the CFTC’s Commitment of Traders report, hedge funds, commodity
pool operators, commodity trading advisors and associate persons constitute managed money traders.
Speculators use derivatives instruments to make profits by betting on the future direction of market
prices of the underlying asset. Traditional speculators can be differentiated based upon the time
horizons during which they operate. Scalpers, or market makers, operate at the shortest time horizon –
sometimes trading within a single second. These traders typically do not trade with a view as to where
prices are going, but rather ‘make markets’ by standing ready to buy or sell at a moment’s notice. The
goal of a market maker is to buy contracts at a slightly lower price than the current market price and sell
3
The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk
Management in the Petroleum, Natural Gas, and Electricity Industries.
“Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because
refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a
given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put
options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden,
NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the
purposes of establishing margin requirements. The crack spread contract helps refiners to lock‐in a crude oil price and heating oil and unleaded
gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three
crude oil futures (30 000 barrels) with the sale a month later of two unleaded gasoline futures (20 000 barrels) and one heating oil future
(10 000 barrels). The 3‐2‐1 ratio approximates the real‐world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil
from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not
deal with individual margins for the underlying trades. An average 3‐2‐1 ratio based on sweet crude is not appropriate for all refiners, however,
and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils,
while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader’s portfolio is close
to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients’ situations and the
exchange standards.”
A PRIL 2011 9
them at a slightly higher price, perhaps at only a fraction of a cent profit on each contract. Skilled market
makers can profit by trading hundreds or even thousands of contracts a day. Market makers provide
immediacy to the market. Without a market maker, another market participant would likely have to wait
longer until the arrival of a counterparty with an opposite trading interest.

Other types of speculators take longer‐term positions based on their view of where prices may be
headed. “Day traders” establish positions based on their views of where prices might be moving within
minutes or hours, while “trend followers” take positions based on price expectations over a period of
days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets.
Through their efforts to gather information on underlying commodities, the activity of these traders
serves to bring information to the markets and aid in price discovery.

1.5.3 Swap Dealers and Commodity Index Traders
Instruments in the OTC markets are generally privately negotiated between market makers (or so‐called
swap dealers) and their client. The party offering the swap, or swap dealer, takes on any price risks
associated with the swap and thus must manage the risk of the commodity exposure. The counter‐
parties to swap dealers are generally hedgers, speculators or commodity index traders.

Investor interest in commodities, including oil, has risen quite dramatically over the last decade and
commodities have become a new asset class in institutional investors’ portfolio. Partly, this development
is due to diversification benefits. In addition, the development of new investment vehicles, such as
exchange‐traded funds, has allowed individual investors to get exposure to movements in commodity
prices. Due to the storage and trading costs associated with direct physical investment in commodities,
the main vehicle used by investors to gain exposure to commodities is via commodity indices (baskets of
short‐maturity commodity futures contracts that are periodically rolled as they approach expiry),
exchange‐traded funds or other structured products. These instruments provide generally long‐only
exposure to commodities. The vast majority of commodity index trading by principals is conducted off‐
exchange using swap contracts.

The main goal of commodity index funds is to track the movement of commodity prices. There exist
several major commodity indices as well as sub‐indices. Standard and Poors’ GSCI (formerly the Goldman
Sachs Commodity Index) is the oldest and most widely tracked index in the market. The S&P GCSI, first
10 A PRIL 2011

created in 1991, covers 24 commodities but is heavily tilted toward energy because its weights reflect
world production figures. For example, in 2010, energy markets received almost 72% weight.

Investors are exposed to three sources of returns in total‐return commodity index investments. The first
type is the yield on the underlying commodity futures. The second type is the roll return, which is
generated from the rolling of nearby futures into first deferred contracts. Depending on whether the
forward curve is in contango (when longer‐dated futures prices are higher than nearby contracts) or,
conversely, in backwardation (when nearby prices are higher than longer‐dated futures prices), the roll
yield is either negative (in contango) or positive (in backwardation). The third type is the T‐bill return,
which is the return on collateral. Historically, the roll return has constituted the largest contributor in
total return. However, the roll return component has been negative since 2005 for the S&P GSCI Total
Return Index due to the contango market we observe in crude oil futures markets.

Institutional investors generally gain exposure to commodity prices through their investment in a fund
that tracks a popular commodity index. The fund managers themselves either directly offset their
resulting short positions by going long in futures markets or by entering swap agreements with a swap
dealer. In turn, swap dealers in the OTC market generally go long or short in the futures market to offset
their net long (or short) position. Of course, the client base of swap dealers also includes
traditional hedgers.
A PRIL 2011 11

2. F ORWARDS AND F UTURES I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
2. FORWARDS AND FUTURES

2.1 Forward Contracts
A forward contract is an OTC agreement between two parties to exchange an underlying asset:
• for an agreed upon price (the forward price or the delivery price)
• at a given point in time in the future (the expiry date or maturity date)
Since it is traded between two parties in the over‐the‐counter market, there is a small possibility that
either side can default on the contract. Therefore, forward contracts are mainly between big institutions
or between a financial institution and one of their clients. Forward contracts are most popular in
currency and interest rates markets.

The party that has agreed to buy the underlying asset has a long position. The party that has agreed to
sell the underlying asset has a short position. By signing a forward contract, one can lock in a price
ex ante for buying or selling a security. Ex post, whether one gains or loses from signing the contract
depends on the spot price at expiry. If the price of the underlying asset rises, then the party who has a
long position in the contract gains while the party who has a short position loses.

Example 1: A commodity contract
Trader A agrees to sell to Trader B one million barrels of WTI crude oil at the price of $100/bbl
with delivery in six months. In this forward contract, WTI crude oil is the underlying asset. Trader
A is said to be short the contract, since he must deliver oil in six months. Trader B is said to be
long the contract, since he receives the delivery of oil in six months.

If at the end of six months the price of oil is at $110, then the trader with a long position has a
profit of $10 000 000 and the trader with a short position loses $10 000 000. On the other hand,
if the price of oil is $95 at the end of six months, then the trader with a long position loses
$5 000 000 and the one with a short position has a profit of $5 000 000.

Example 2: A foreign exchange contract
On 18 February 2011, Party A signs a forward contract with Party B to sell one million
British pounds (GBP) at $1.6190 per GBP six months later.
Today (18 February 2011), sign a contract, shake hands. No money changes hands.
Party A entered a short position and Party B entered a long position on GBP.
12 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 2. F ORWARDS AND F UTURES
But since it is on exchange rates, we can also say: Party A entered a long position
and Party B entered a short position on USD.
18 August 2011 (the expiry date), Party A pays one million GBP to Party B, and
receives 1.6190 million USD from Party B in return.
Currently (18 February, the spot price for the pound (the spot exchange rate) is
1.6234. Six months later (18 August 2011), the exchange rate can be anything
(unknown).
$1.6190 per GBP is the forward price.

The forward price for a contract is the delivery price that would be applicable to the contract if it
were negotiated today. It is the delivery price that would make the contract worth exactly zero.

In the previous example, Party A agrees to sell one million pounds at $1.6190 per GBP at expiry.
If the spot price is $1.61 at expiry, what is the profit and loss (P&L) for party A?
On 18 August 2011, Party A can buy one million GBP from the market at the spot
price of $1.61 and sell it to Party B per forward contract agreement at $1.6190.
The net P&L at expiry is the difference between the strike price (K = 1.6190) and
the spot price (ST = 1.61), multiplied by the notional value (one million). Hence,
the profit is $9 000.

The primary use of a forward contract is to lock in the price at which one buys or sells a
particular good in the future. This implies that the contract can be utilised to manage price risk.
Forward contracts can be used to hedge against unforeseen movement in market prices.
Consider an airline company which is going to buy 100 000 barrels of oil one year from today.
Suppose that forward price for delivery in one year is $100/bbl. Suppose that the yield on a one‐
year and zero‐coupon bond is 5%. The airline company can use a forward contract to guarantee
the cost of buying oil for the next year. The present value of this cost will be 100/1.05=95.24. The
airline company could invest this amount to buy oil in one year or it could pay an oil supplier
$100 at the delivery of the oil. If the spot price at the end of one year is above the agreed
forward price, the airline company gains from this hedging. If the spot price at maturity is below
the forward price, it would lead to the airline company to pay more than the market price of oil.
Regardless of the spot price at the delivery, the airline company protects itself from potential
loss and eliminates uncertainty regarding price movements.

A PRIL 2011 13

2.2 Futures
Like a forward contract, a futures contract is a binding agreement between a seller and a buyer to make
(seller) and to take (buyer) delivery of the underlying commodity (or financial instrument) at a specified
future date with agreed upon payment terms. Unlike forward contracts:
• Futures contracts are standardised and exchange‐traded.
• Default risk is borne by the exchange clearinghouse.
• Traders are allowed to reverse (‘offset’) their positions, so that physical delivery is rare (futures
can be used to trade in the risk, not the commodity). This is true because most hedgers are not
dealing in the commodity deliverable against the futures contract. For instance, an airline
company is not going to use WTI crude oil in Cushing, Oklohama, for its operation, but may use
the WTI futures contract as a hedge. That is, most hedgers are “cross hedgers”. Similarly,
speculators are just betting on price movement, and have no interest in owning the physical oil.
Therefore, most hedgers and speculators reverse their position prior to delivery.
• Value is marked to market daily.
• Different execution details also lead to pricing differences, e.g., effect of marking to market on
interest calculation.

Table 2.1 : Comparison Between Forward and Futures Contracts
FORWARDS FUTURES
Private contracts between two parties Exchange traded
Non‐standard contract Standard contract
Usually one specified delivery date Range of delivery dates
Settled at the end of the contract Settled daily
Delivery or final cash settlement usually occurs Delivery is rare, usually parties offset their
position before maturity
Some credit risk Virtually no credit risk

The fact that futures contracts terms are standardised is important because it enables traders to focus
their attention on one variable, namely price. Standardisation also makes it possible for traders
anywhere in the world to trade in these markets and know exactly what they are trading. This is in sharp
contrast to the cash forward contract market, in which changes in specifications from one contract to
another might cause price changes from one transaction to another.
14 A PRIL 2011

2.2.1 Contract Specifications

One of the main differences between forward contracts and futures contracts is the fact that futures
contracts are standardised. When an exchange introduces a new contract, it has to specify in some detail
the exact nature of the asset, the contract size, delivery point, delivery time, and settlement type
(physical delivery or cash settlement).

The underlying asset in the futures contract can be anything, ranging from commodities to stock indices,
equities, bond, foreign exchange, interest rate, and so on. However, the exchange has to specify the
exact terms in identifying the contract. The financial assets in futures contracts are well defined and
there is no ambiguity. However, in the case of commodities, there may be quite a variation in the quality
of what is available in the marketplace. When the asset is specified, the exchange has to specify in detail
grade or grades of commodity that are acceptable for delivery. For example, the Chicago Mercantile
Exchange (CME) deliverable grade specification of the WTI futures contract is presented in Box 1.

Standardisation of futures contracts also requires the specification of the delivery point and the contract
size (amount of asset that has to be delivered under one contract). For example, under the WTI futures
contracts traded on the CME, delivery can be made F.O.B. at any pipeline or storage facility in Cushing,
Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing
storage. The contract size, on the other hand, is 1 000 US barrels (42 000 US gallons) of WTI crude oil.

Futures contracts are also standardised with respect to the delivery month. The exchange must specify
the precise period during the month when delivery can be made. The exchange also specifies when
trading in a particular month’s contract will begin, the last day on which trading can take place for a
given contract as well as the delivery months. For example, CME WTI crude oil futures are listed nine
years forward using the following listing schedule: consecutive months are listed for the current year and
the next five years; in addition, the June and December contract months are listed beyond the sixth year.
Additional months will be added on an annual basis after the December contract expires, so that an
additional June and December contract would be added nine years forward, and the consecutive months
in the sixth calendar year would be filled in.

Even though physical delivery does not occur on most contracts, delivery is important nonetheless.
Delivery ties the price of the expiring futures to the price of the physical commodity at delivery.
Nonetheless, cash settlement can be considered another way to tie the futures and cash markets
together. In a cash‐settled contract, at expiration the buyer pays the seller the difference between the
fixed price established in the contract and the reference price prevailing on payment.

A PRIL 2011 15


Box 1: Grade and Quality Specifications of WTI Contract (Source CME)
Light sweet crude oil meeting all of the following specifications and designations shall be
deliverable in satisfaction of futures contract delivery obligations under this rule:
(A) Domestic Crudes, (Deliverable at Par)
• Deliverable Crude Streams
West Texas Intermediate
Low Sweet Mix (Scurry Snyder)
New Mexican Sweet
North Texas Sweet
Oklahoma Sweet
South Texas Sweet
Blends of these crude streams are only deliverable if such blends constitute a
pipeline's designated “common stream” shipment which meets the grade and
quality specifications for domestic crude. TEPPCO Crude Pipeline, L.P.'s and
Equilon Pipeline Company LLC's Common Domestic Sweet Streams that meet
quality specifications in Rule 200.12(A)(2‐7) are deliverable as Domestic Crude.
• Sulfur: 0.42% or less by weight as determined by A.S.T.M. Standard D‐4294, or its
latest revision; (3) Gravity: Not less than 37 degrees API, nor more than 42
degrees API as determined by A.S.T.M. Standard D‐287, or its latest revision;
• Viscosity: Maximum 60 Saybolt Universal Seconds at 100 degrees Fahrenheit as
measured by A.S.T.M. Standard D‐445 and as calculated for Saybolt Seconds by
A.S.T.M. Standard D‐2161;
• Reid vapor pressure: Less than 9.5 pounds per square inch at 100 degrees
Fahrenheit, as determined by A.S.T.M. Standard D‐5191‐96, or its latest revision;
• Basic Sediment, water and other impurities: Less than 1% as determined by
A.S.T.M. D‐96‐88 © or D‐4007, or their latest revisions;
• Pour Point: Not to exceed 50 degrees Fahrenheit as determined by A.S.T.M.
Standard D‐97.
(B) Foreign Crudes
• Deliverable Crude Streams
U.K.: Brent Blend (for which seller shall be paid a 30 cent per barrel discount
below the last settlement price)
Nigeria: Bonny Light (for which seller shall be paid a 15 cent per barrel
premium above the last settlement price)
Nigeria: Qua Iboe (for which seller shall be paid a 15 cent per barrel premium
above the last settlement price)
Norway: Oseberg Blend (for which seller shall be paid a 55 cent per barrel
discount below the last settlement price)
Colombia: Cusiana (for which seller shall be paid 15 cent per barrel premium
above the last settlement price)
• Each foreign crude stream must meet the following requirements for gravity and
sulfur, as determined by A.S.T.M. Standards referenced in Rule 200.12(A)(2‐3):
Foreign Crude Stream
Minimum Gravity Maximum Sulfur
Brent Blend 36.4 API 0.46%
Bonny Light 33.8 API 0.30%
Qua Iboe 34.5 API 0.30%
Oseberg Blend 35.4 API 0.30%
Cusiana 34.9 API 0.40%
16 A PRIL 2011

2.2.2 The Clearinghouse Margins

Clearing is the process by which trades in futures and options are processed, guaranteed, and settled by
an entity known as a clearing house. A complete clearing house acts as the central counterparty to and
guarantor of all trades that it has accepted for clearing from its clearing members. The clearing house
“becomes the buyer to every seller and the seller to every buyer” through a process known as
“novation.” The exchange clearing house intermediates all futures transactions. The credit status of the
counterparty becomes irrelevant and contracts become fungible. A transactor needs only to worry about
the credit status of the clearing house.

Clearing houses have a legal relationship only with entities that they have been admitted as clearing
members. That is to say, clearing houses have no legal relationship with the customers of their clearing
members. Clearing members are generally institutions such as futures commission merchants and
broker/dealers that have the financial, risk management, and operational capabilities to function as
clearing members.

Clearing houses perform the following duties:
• Match, guarantee, and settle all trades and register positions resulting from such trades.
• Perform mark‐to‐market calculations of all open positions at least once a day and oversee
the resulting cash flows between clearing member firms.
• Manage the risk exposure that clearing firms present to the clearing house.
• Perform the exercise and assignment of options contracts.
• Facilitate, but not guarantee, the delivery of physical commodities.
• Permit multilateral netting of positions and settlement payments.
• Assuming contracts are fungible (interchangeable), clearing houses offset positions.
• Enable clearing members to substitute the credit and risk exposure of the clearing house for
the credit and risk exposure of each other.
• Maintain a package of financial safeguards that are designed to mitigate losses in the event a
clearing member defaults on its obligations to the clearing house.
• In the event of such a default, meet the obligations of the defaulter by first utilising the
collateral pledged to it by the defaulter.
• If such collateral is insufficient to cover the entire amount of the defaulted amount, then
utilise the components of its financial safeguards package to take care of the remaining
defaulted amount.

A PRIL 2011 17

One of the key safeguards in the risk management systems of futures clearing organisations is the
requirement that market participants post collateral, known as margin, to guarantee their performance
on contract obligations. In contrast to the operation of credit margins in the stock market, a futures
margin is not a partial payment for the position being undertaken. Instead, the futures margin is a
performance bond which serves as collateral or as a “good faith” deposit given by the trader to the
broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures
commission merchants (FCM) have the right to demand higher margins from their customers.

In a traditional futures market, contracts are margined under a risk‐based margining system, which is
called SPAN. Portfolio margining systems evaluate positions as a group and determine margin
requirements based on the estimates of changes in the value of the portfolio that would occur under
assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss
generated by a simulation exercise that includes a range of potential market conditions.

Marking to market ensures that futures contracts always have zero value; hence the clearing house does
not face any risk. Marking to market takes place through margin payments. At the inception of the
contract, each party pays an initial margin (typically 10% of the value contracted) to a margin account
held by its broker. Initial margin may be paid in interest‐bearing securities (T‐bills) so there is no interest
cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss
(profit). The broker pays losses from and receives any profits into the parties’ margin accounts on the
morning following trading. Loss‐making parties are required to restore their margin accounts to the
required level during the course of the same day by payment of variation margins in cash; margin in
excess of the required level may be withdrawn by profit‐making parties.

For example, the initial margin for one WTI futures contract is $5 000 and the maintenance margin
requirement is $3 750 per contract. Consider the following example. Trader X bought a
10 September 2011 delivery NYMEX crude oil futures contract. Suppose that the current price is $100
(18 February 2011). The broker will require the investor to deposit an initial margin of $50 000 in the
margin account. At the end of each day, the margin account is adjusted to reflect the investor’s gain or
loss. This practice is known as marking to market the account. Whenever the margin account exceeds or
falls below the maintenance margin ($3 750 in our example), then the customer receives a margin call
from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the
maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of
18 A PRIL 2011

the initial margin and whenever it is below the maintenance level, the customer has to deposit to bring
the margin account to its initial margin level. The extra funds deposited are known as a variation margin.

Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so
called variation margin, to bring the margin account to the initial level. On the other hand, the seller of
the contract account will be credited.

In practice, there is actually a chain of margins. Traders post margins with brokers. Non‐clearing brokers
post margins with clearing brokers. Clearing brokers post margins with the clearinghouses. The margin
posted by clearinghouse members with the clearinghouse is known as a clearing margin. However, in the
case of clearinghouse member, there is an original margin but no maintenance margin.

Table 2.2 : The following table summarises price changes and margin account.
Daily Gain or Cumulative Margin Account
Day Futures Prices of WTI Crude Oil ($/bbl) Margin Call
(loss) Gain (Loss) Balance
18‐Feb 100 50 000

21‐Feb 99.5 ‐5 000 ‐5 000 45 000
22‐Feb 98 ‐15 000 ‐20 000 30 000 20 000
23‐Feb 99 10 000 ‐10 000 60 000
24‐Feb 98.5 ‐5 000 ‐15 000 55 000
25‐Feb 97 ‐15 000 ‐30 000 40 000
28‐Feb 95 ‐20000 ‐50 000 20 000 30 000
01‐Mar 95 0 ‐50 000 50 000
02‐Mar 99 40 000 ‐10 000 90 000
03‐Mar 99 0 ‐10 000 90 000
04‐Mar 100 10 000 0 100 000

2.2.3 Settlement Price, Volume and Open Interest in Futures Markets
The settlement price is the average of the prices at which the contract traded immediately before the
end of trading for the day. The settlement price is very important since it is used to determine margin
requirements and the following day's price limits.

Volume in futures market represents the total amount of trading activity or contracts that have changed
hands in a given commodity market for a single trading day. On the other hand, open interest is the total
A PRIL 2011 19

number of contracts outstanding that are held by market participants at the end of each day. A contract is
created by a seller and buyer of contract, therefore open interest can be calculated as the sum of all the
long positions (or equivalently it is the sum of all the short positions). Open interest will increase by one
contract if both parties to the trade are initiating a new position (one new buyer and one new seller) and
open interest will decrease by one contract if both traders are closing an existing or old position (one old
buyer and one old seller). However, if one old trader is passing off his position to a new trader (one old
buyer sells to one new buyer), open interest will not change.

2.2.4 Types of Orders
The simplest type of order placed with a broker is a market order. A market order is an order to buy or
sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other
trading platform. However, there are many other types of orders. Most commonly used orders are the
limit order, and the stop order or stop‐loss order.

A limit order is an order in which the customer specifies a minimum sale price or maximum purchase
price, as contrasted with a market order, which implies that the order should be filled as soon as possible
at the market price. Thus, if the limit price is $95/bbl for one April WTI contract for an investor wanting
to sell, the order will be executed only at a price of $95/bbl or more. As opposed to a market order, a
limit order will not be executed unless the price reaches $95/bbl.

A stop order or stop‐loss order is an order that becomes a market order when a particular price level is
reached. A sell stop is placed below the market; a buy stop is placed above the market. The purpose of a
stop order is to close out a position if unfavorable price movements take place.

2.3 Hedging Using Futures Contracts 4

Traditionally, many of the market participants in futures markets were hedgers. Hedgers use futures
markets to reduce particular risks arising from fluctuations in the price of the underlying asset. Of course,
it might not be possible to eliminate the risks completely due to basis risk, which we discuss later in the
text. For the time being, we assume the possibility of a perfect hedge, which completely eliminates the
risk. A hedge might involve taking a long position (long hedge) or a short position (short hedge) in the
futures contract.

4
Futures contracts can be used in similar fashion for speculation purposes as well.
20 A PRIL 2011

A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now. For example, an airline company knows that it will require
100 000 barrel of crude oil on 1 July 2011 for its flight operations. The spot price of oil is $95/bbl, and the
future price for July delivery (July is the delivery month for June contract) is $99/bbl. In order to avoid
any risk associated with price change between now and July, the airline company can buy crude oil now
at $95/bbl and store it until July. In this case, the airline company has to pay storage costs as well as
interest costs. Alternatively, it can hedge its position by taking a long position in one hundred CME WTI
June futures contracts (each contract is for delivery of 1 000 barrels of crude oil) and closing its position
before the expiration by selling one hundred such contracts.

Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the future price.
The airline gains from futures contracts approximately
100 000×($102‐$99)=$300 000
In July, the airline pays $102×100 000=$10 200 000 for the crude oil, making the net cost approximately
$9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl, then the airline
company loses from its futures contract approximately
100 000×($99‐$90)=$900 000
and pays $90×100 000=$9 000 000 for the crude oil in the spot market. Again here, the total net cost of
the oil for the airline company would be $9 900 000. No matter what happens to the spot price in July,
entering into a futures contract allows the airline company to fix its net cost to the number of oil barrels
times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the
cost of funding.

A short hedge works in a similar way. Consider an oil producer, who wants to sell again 100 000 barrels
of crude oil in July. Assume that all the above information still holds. Since the oil producer wants to sell
its oil, it can hedge its cash position by taking a short position in one hundred CME WTI June contracts,
which will be delivered in July. The producer again offsets its short position by going long before the
expiration of contract.

Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the futures price.
The producer loses from a futures contract approximately
100 000×($102‐$99)=$300 000
A PRIL 2011 21

In July, the producer gets $102×100 000=$10 200 000 for the crude oil, making a net revenue from its
sales of approximately $9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl,
then the producer company gains from its futures contract approximately
100 000×($99‐$90)=$900 000
and gets $90×100 000=$9 000 000 for the crude oil in spot market. Again here, the total net revenue for
the oil for the producer would be $9 900 000. No matter what happens to the spot price in July, entering
into the futures contract allows the producer to fix its net revenue to the barrel of oil times the price per
barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the revenue.

2.4 Basis Risk

Up until now, we assumed that hedgers can completely eliminate risks by taking futures positions
opposite to their cash positions. However, in reality it is difficult to eliminate all risks. In order to eliminate
all risks associated with cash positions, the hedger must know the precise date in the future when an asset
would be bought or sold. Even if the hedger knows the exact date of purchase or sale, he might have to
close his/her futures position before its delivery month, i.e. there might be a mismatch between the
hedge period and available delivery date. Even then, the hedger would need to find the same asset
underlying the futures contract as the asset s/he is planning to buy or sell. For all these reasons, the
hedger will face basis risk, which can be defined as the difference between the spot price of the asset to
be hedged and the futures price of the contract used.

If the asset to be hedged and the asset underlying the futures contract are the same, then we should
expect the basis risk to be zero at the expiration of the futures contract. Prior to expiration, the basis can
be negative or positive. If the basis is positive, i.e. the spot price is greater than the futures price, the
situation is known as backwardation. If, on the other hand, the basis is negative, i.e. spot price is less
than the futures price, the situation is known as contango.

If, on the other hand, the asset to be hedged and the asset underlying the futures contract are different‐‐
a situation known as cross hedging‐‐then we should expect the basis risk to be different from zero even
at expiration. Sometimes, it is not possible to find futures contracts for some commodities. Consider an
airline company, which is concerned about the future price of jet fuel oil, rather than crude oil. Since
there is no futures contract on jet fuel oil, the airline company tries to find an asset underlying the
futures contract which is highly correlated with the asset to be hedged. High correlation results in low
basis risk and high hedge effectiveness.
22 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 3. S WAPS
3. SWAPS

Forward or futures contracts settle on a single date. However, many transactions occur repeatedly
For example, an airline company buys jet fuel oil on an ongoing basis. If a manager seeking to reduce risk
confronts a risky payment stream, what is the easiest way to hedge this risk? You can enter into a
separate forward contract for each payment you wish to hedge. However, it could be more convenient
and entail lower transaction costs, if there were a single transaction that we could use to hedge a stream
of payments. Swaps serve exactly this purpose.

Swaps are agreements between two companies to exchange cash flows in the future according to a
prearranged formula. Swaps, therefore, may be regarded as a portfolio of forward contracts. Swaps are
traded on over‐the‐counter derivatives markets and are most common in interest rates, currencies and
commodities. They often extend much further into the future than exchange contracts. The parties to a
swap set:
• the notional amount;
• the tenor or maturity of the swap;
• the payment dates;
• the floating price index; and
• the fixed price.

The following discussion on the swap market and development in the swap market excerpts from the
CFTC “Commodity Swap Dealers & Index Traders with Commission Recommendations” report.5

“The first swap contracts were negotiated in 1981. In order to reduce overall funding costs for
both parties, the World Bank and IBM entered into what has become known as a currency swap.
The swap essentially involved a loan in Swiss francs by IBM to the World Bank and a loan in U.S.
dollars by the World Bank to IBM. This structure of swapping cash flows ultimately served as the
template for swaps on any number of financial assets and commodities.

Swaps serve as an effective hedging vehicle in much the same way that financial futures
contracts do. For example, a typical futures contract has many of the same characteristics as a
swap in that it is essentially a contract where the buyer of the contract agrees at the outset to
pay a fixed price for a commodity in return for future delivery of the commodity, which will have
an uncertain or floating value at the time of expiration of the contract.
5
See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf
A PRIL 2011 23

3. S WAPS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
The party offering the swap, typically called a swap dealer, takes on any price risks associated
with the swap and thus must manage the risk of the commodity exposure. In the early
development of swap markets, investment banks often served in a brokering capacity to bring
together parties with opposite hedging needs. The currency swap between the World Bank and
IBM, for example, was brokered by Salomon Brothers. While brokering swaps eliminates market
price and credit risk to the broker, the process of matching and negotiating swaps between
counterparties with opposite hedging needs could be difficult. As a result, swap brokers (who
took on no market risk) evolved into swap dealers (who took the contract onto their books). As
noted, when a swap dealer takes a swap onto its books, it takes on any price risks associated
with the swap and thus must manage the risk of the commodity exposure. In addition, the
counterparty bears a credit risk that the swap dealer may not honour its commitment. This risk
can be significant in the case of a swap dealer because it is potentially entering into numerous
transactions involving many counterparties, each of which exposes the swap dealer to additional
credit risks.

As a result of these risks, there has been a natural tendency for financial intermediaries (e.g.,
commercial banks, investment banks, insurance companies) to become swap dealers. These
firms typically have the capitalisation to support their creditworthiness as well as the expertise
to manage the market price risks that they take on. In addition, for particular commodity classes,
such as agriculture and energy, large commercial companies that have the expertise to manage
market price risks have set up affiliates to specialise as swap dealers for those commodities. The
utility of swap agreements as a hedging vehicle has led to significant growth in both the size and
complexity of the swap market. During the early period in the development of the swap market,
the majority of swap agreements involved financial assets. In fact, even today the vast majority
of swaps outstanding involve either interest rates or currencies.

The OTC swap market has grown significantly because, for many financial entities, the OTC
derivatives products offered by swap dealers have distinct advantages relative to futures
contracts. While futures markets offer a high degree of liquidity (i.e., the ability to quickly
execute trades due to the high number of participants willing to buy and sell contracts), futures
contracts are more standardised, meaning that they may not meet the exact needs of a hedger.
Swaps, on the other hand, offer additional flexibility since the counterparties can tailor the terms
of the contract to meet specific hedging needs.

24 A PRIL 2011

As an example of the flexibility that swaps can offer, consider again the case of an airline wanting
to hedge future jet fuel purchases. Currently there is no jet fuel futures contract available to the
airlines to directly hedge their price exposure. Contracts for crude oil (from which jet fuel is
made) and heating oil (which is a fuel having similar chemical characteristics to jet fuel) do exist.
But while these contracts can be used to hedge jet fuel, the dissimilarities between jet fuel and
crude oil or heating oil mean that the airline will inevitably take on what was referred to above
as basis risk. That is, the price of jet fuel and the prices of these futures contracts will not tend to
move perfectly together, diminishing the utility of the hedge.

In contrast, swap dealers can offer the airline the alternative of entering into a contract that
directly references the cash price for jet fuel at the specific time and location where the product
is needed. By creating a customised OTC derivative product that specifically addresses the price
risks faced by the airline, by taking on the administrative costs associated with managing that
contract over time, and by assuming the price risks attendant to that contract, the swap dealer
facilitates the airline‘s risk management.

When a commercial entity uses a swap to offset its risk, the swap dealer assumes the price risk
of the commodity. For example, if the swap dealer enters into a jet fuel swap with an airline, the
airline agrees to periodically pay a fixed amount on the swap while the swap dealer pays a
floating amount based on a cash market price. At each point in time when the payments are due,
a netting of the obligations takes place and the party responsible for the larger payment pays the
difference to the other party. Thus, if prices rise, the floating payment will be larger than the
fixed price and the swap dealer pays the net amount to the airline. Conversely, if prices fall, the
airline will be required to make a payment to the swap dealer. Recall, however, that when the
airline makes a payment on the swap to the swap dealer, it means that at the same time, it is
paying a lower price to acquire jet fuel in the cash market. The swap dealer, however, has no
natural offsetting transaction to counterbalance the risk. That is why swap dealers will, in turn,
hedge this price risk in the regulated futures markets.

Swap agreements have also become a popular vehicle for noncommercial participants, such as
hedge funds, pension funds, large speculators, commodity index traders, and others with large
pools of cash, to gain exposure to commodity prices. Recently, portfolio managers have sought
to invest in commodities because of the lack of correlation, or even negative correlation, that
commodities tend to have with traditional investments in stocks and bonds. In addition, because
A PRIL 2011 25

3. S WAPS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
of the ability to tailor transactions, swaps can represent a more efficient means by which these
participants can enter the market. Hence, many of the benefits that swap agreements offer
commercial hedgers also attract noncommercial interests to the swap market. Since swap
dealers are willing to enter into swap contracts on either side of a market, at times they will
enter into swaps that create offsetting exposures, reducing the swap dealer‘s overall market
price risk associated with the firm‘s individual positions opposite its counterparties. Since it is
unlikely, however, that a swap dealer could completely offset the market price risks associated
with its swap business at all times, dealers often enter the futures markets to offset the residual
market price risk. As a result of the growth of the swap market and the dealers who support the
market, there has been an associated growth in the open interest of the futures markets related
to the commodities for which swaps are offered, as these swap dealers attempt to lay off the
residual risk of their swap book.

A more recent phenomenon in the derivatives market has been the development of commodity
index funds and exchange‐traded funds for commodities (ETFs) and exchange‐traded notes
(ETNs), which are mainly transacted through swap dealers. Both products are designed to
produce a return that mimics a passive investment in a commodity or group of commodities.
ETFs and ETNs are traded on securities exchanges and are backed by physical commodities or
long futures positions held in a trust. Commodity index funds are funds that enter into swap
contracts that track published commodity indexes such as the S&P Goldman Sachs Commodity
Index or the Dow Jones AIG Commodity Index.”

3.1 Mechanics of Swaps
When two parties enter a swap contract, one party makes a payment to the other depending upon
whether a price turns out to be greater or less than a reference price that is specified in the
swap contract.

For example by entering into an oil swap, an oil buyer confronting a stream of uncertain oil payments
can lock in a fixed price for oil over a period of time. The swap payments would be based on the fixed
price for oil and a market price that varies over time.

Suppose Untied Airlines (UA) is going to buy 100 000 barrels of oil one year from today and two years
from today. Suppose that the forward price for delivery in one year is $75/bbl and in two years is
$90/bbl. Suppose one‐year and two‐year zero coupon bond yields are 5% and 5.5%. UA can use a
26 A PRIL 2011

forward contract to guarantee the cost of buying oil for the next two years. The present value of this cost
will be
$75 $90
$152.29
1.05 1.055

UA could invest this amount to buy oil in one and two years, or it could pay an oil supplier $152.29 who
would commit to delivering one barrel in each of the next two years. This is a prepaid swap. If the
payment is done after two years, this is a postpaid swap.

Typically, a swap will call equal payments in each year, or $82.28/bbl. This is the price of a two‐year
swap. However, any payments that have a present value of $152.29 are acceptable. In exchange, the
swap counterparty delivers 100 000 barrels of crude oil each year. The notional value of the swap can be
calculated by multiplying all cash flows by 100 000.

Instead of delivery, if the swap counterparties settled with cash, the oil buyer, UA, pays the swap
counterparty the difference between $82.28/bbl and the spot price (if the difference is negative, the
counterparty pays the buyer), and the oil buyer then buys the oil in the spot market. For example, if the
spot price is $90/bbl, the swap counterparty pays the buyer
Spot price‐swap price=$90‐$82.28=$7.72
If the spot price is $80/bbl, then oil buyer makes a payment to the swap counterparty
Spot price‐swap price=$80‐$82.28=‐$2.28
Whatever the spot price, the net cost to the buyer is the swap price, $82.28/bbl
Although the swap price is close to the mean of forward prices ($82.50/bbl), it is not exactly the same.
Why? Suppose the swap price is $82.50/bbl, then the oil buyer would then be committing to pay more
than $7.50 more than the forward price the first year and would pay $7.50 less than the forward price
the second year. Thus relative to the forward curve, the buyer would have made an interest‐free loan to
the counterparty.

If the swap price is $82.28, then we are overpaying $7.28 in the first year and underpaying $7.72 in the
second year, relative to the forward curve. The swap is equivalent to being long on the two forward
contracts, coupled with an agreement to lend $7.28 to the counterparty in the first year, and receive
$7.72 in second year.

The interest rate on this loan is $7.72/$7.28‐1=6%. Where does 6% come from? 6% is the one year
implied forward yield from year one to year two.
A PRIL 2011 27

4. O PTIONS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
4. OPTIONS

An option is a contract that gives the option holder the right/option, but no obligation, to buy or sell a
security (or a futures contract) to the option writer/seller at (or up to) a given time in the future (the
expiry date or maturity date) for a pre‐specified price (the strike price or exercise price, K).

The option purchaser (holder) is the person who buys a call or a put option and pays the option
premium, i.e. the person who establishes a long options position. This is the party with the right, but not
the obligation, under the terms of the contract.

The option writer, or grantor, is the person who sells a call or put option and receives the option
premium, i.e. the person who establishes a short position. This party is obligated to perform under the
terms of such an option.

A call option gives the holder the right to buy a security and a put option gives the holder the right to sell
a security. Where the underlying interest is represented by a futures contract, the right to buy is actually
a right to be long on a futures contract at a specified price level. Conversely, the right to sell represents
the right to a short futures position at a specified price level. Options allow one to take advantage of
changes in futures prices without actually having a position in the futures market.

Options can be American, European or Bermudan. American options can be exercised at any time prior
to expiry. European options can only be exercised at the expiry. Bermudan option can only be exercised
during the specified period.

The price at which the futures contract underlying an option can be purchased (if a call) or sold (if a put)
is called the strike price or the exercise price. In the call and put definitions above, this is the
predetermined price.

It is important to note that for every option buyer there is an option seller. At any time before the option
expires, the option buyer can exercise the option. Since the buyer decides whether to exercise, the seller
cannot make money at expiration. To take this risk, the seller is compensated by the option premium,
which is agreed when the contract is signed. The option premium is determined through trading on an
exchange market. Therefore, we should expect to see different option premia for different strike prices.

Effectively, the exercise of a call gives the option purchaser a long position in the underlying futures
contract at the option’s strike price; the exercise of a put option gives the option purchaser a short
futures position at the option’s strike price. The option buyer can also sell the option to someone else or
28 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 5. R EFERENCES
do nothing and let the option expire. The choice of action is left entirely up to the option buyer. The
option buyer obtains this right by paying the premium to the option seller.

A call option buyer will only choose to exercise if the stock price is greater/higher than the strike price. If
the stock price is less than the strike price, the investor would clearly choose not to exercise the option,
and the investor only loses the option premium. On the other hand, a put option buyer will only to
choose to exercise the option when the stock price is less than strike price. If the stock price is more than
the strike price, the investor would clearly choose not to exercise the option and would only lose the
option premium.

What about the option seller? The option seller receives the premium from the option buyer. If the
option buyer exercises the option, the option seller is obligated to take the opposite futures position at
the same strike price. Because of the seller’s obligation to take a futures position if the option is
exercised, an option seller must post a margin and faces the possibility that the margin will be called if
the market moves against his potential futures position.

4.1 Call Option
A call option is a contract where the buyer has the right, but not the obligation, to buy an underlying
security. Since the buyer decides whether or not to buy, the seller cannot make money at expiration. To take
this risk, the seller is compensated by the option premium, which is agreed when the contract is signed.

Consider a call option on the S&R index with six months to expiration and strike price of $1000 and
premium of $93.81.6 And assume that the risk free rate is 2% over six months. Suppose that the index in
six months is $1100. Clearly it is worthwhile to pay the $1000 strike price to acquire the index worth
$1100. If on the other hand the index is $900 at expiration, it is not worthwhile paying the $1000 strike
price to buy the index worth $900. In this case:
• The buyer is not obliged to buy the index and hence will only exercise the option if the payoff is
positive.
Purchased call payoff = max(0,ST‐K)
In our example, K=1000. If S=1100 then the call payoff
Purchased call payoff = max(0,1100‐1000)=$100
If S=900, then the call payoff is
Purchased call payoff = max(0,900‐1000)=$0
6
The discussions on call and put options draws upon McDonald (2006).
A PRIL 2011 29

The payoff does not take into account the initial cost (option premium) of acquiring the position. For a
purchased option, the premium is paid at the time the option is acquired. In computing profit at
expiration, we use the future value of the premium.
Purchased call profit = max(0,ST‐K)‐future value of option premium
Purchased call profit = Purchased call payoff‐future value of option premium
If the index at the expiration is 1100, then profit is
Purchased call profit=max(0, 1100‐1000)‐93.81×1.02=$4.32
If the index at the expiration is 900, then the owner does not exercise the option. The loss
will be future value of option premium. Maximum loss will be the option premium.
Purchased call profit=max(0, 900‐1000)‐93.81×1.02=‐$95.68

The Payoff at Expiration with a Strike Price of $1000
250
200
150
100
50
Payoff ($)
0
‐50
Call Payoff
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

30 A PRIL 2011

Profit at Expiration for Call Option with K=1000 and Long Forward
200
150
100
50
0 Index price=1095.68
Profit ($)
Call Profit
‐50
Long Forward Profit
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

• The option writer (seller of option) has a short position in a call option. The writer receives the
premium for the option and then has an obligation to sell the underlying security in exchange for
the strike price if the option buyer exercises the option.
The payoff and profit to a written call are just the opposite of those for a purchased call.
Written call payoff = ‐max(0,ST‐K) = min(0,K‐ST)
Written call profit = ‐max(0,ST‐K)+future value of option premium
In our example, if S=1100 then the option writer payoff will be ‐$100 and profit will be ‐
$4.32. If on the other hand, S=900, then payoff will be 0 and profit will be the future value of
premium, $95.68.
A PRIL 2011 31

Payoff for Option Writer with Strike Price of $1000
250
200
150
100
Payoff ($)
50
0
‐50
Written Call Payoff
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

Profit for Option Writer with Strike Price of $1000
250
200
150
100
Profit ($)
50 Index Price=1095.68
Written Call Profit
0
‐50 Short Forward
Index Price=
‐100
1020
‐150
‐200
800 850 900 950 1000 1050 1100 1150 1200
S&R Price Index ($)

4.2 Put Option
A put option is a contract where the buyer has the right to sell, but not the obligation. Since the buyer
decides whether to sell, the seller cannot make money at expiration. To take this risk, the seller is
compensated by the option premium, which is agreed when the contract is signed.

Example: Put Option
Consider a put option on the S&R index with six months to expiration and strike price of $1000 and
premium of $74.20. And assume that the risk free rate is 2% over six months. Suppose that the index in
32 A PRIL 2011

six months is $1100. Clearly it is not worthwhile to sell the index worth $1100 for the strike price of
$1000. If on the other hand the index is $900 at expiration, it is worthwhile selling the index for $1000.
• The buyer is not obliged to sell the index and hence will only exercise the option if the payoff is
positive.
Purchased put payoff = max(0,K‐ST)
In our example, K=1000. If S=1100 then the put payoff
Purchased put payoff = max(0,1000‐1100)=$0
If S=900, then the put payoff is
Purchased put payoff = max(0,1000‐900)=$100
The payoff does not take into account the initial cost of acquiring the position. For a purchased option,
the premium is paid at the time the option is acquired. In computing profit at expiration, we use the
future value of the premium.
Purchased put profit = max(0,K‐ST)‐future value of option premium
Purchased put profit = Purchased put payoff‐future value of option premium
If the index at the expiration is 1100, then the option buyer will not exercise his right to sell
and the maximum loss will be the future value of the option premium.
Purchased put profit = max(0,1000‐1100)‐74.2×1.02=‐$75.68
If the index at the expiration is 900, then the owner exercises the option i.e. sells. The profit
will be
Purchased put profit = max(0,1000‐900)‐74.2×1.02=$24.32
• The option writer (seller of option) has a long position in a put option. The writer receives the
premium for the option and then has an obligation to buy the underlying security in exchange for
the strike price if the option buyer exercises the option.
The payoff and profit to a written put are just the opposite of those for a purchased put.
Written put payoff = ‐max(0,K‐ST) = min(0,ST‐K)
Written put profit=‐max(0,K‐ST)+future value of option premium
In our example, if S=1100 then the put buyer will not exercise the put, thus put writer earns
profit, which will be option premium. If, on the other hand, S=900, then the option buyer
exercises the option and the option seller (writer) will lose $24.32 (‐100+$75.68).

4.3 “Moneyness” of Options
Options are generally referred to as in the money, at the money, or out of money. The “moneyness” of
an option depends on the strike price (K) relative to the spot (St)/forward (Ft) price of the
underlying asset.

A PRIL 2011 33

An option is said to be in‐the‐money if the option has positive value if exercised right now:
• St > K for call options and St < K for put options. Sometimes it is also defined in terms of
the forward price at the same maturity (in the money forward): Ft > K for call and Ft < K
for put.
• The option has positive intrinsic value (defined as the maximum of zero and the value the option
would have if it is exercised today) when in the money. The intrinsic value is (St − K)+ for call,
(K − St)+ for put options. We can also define intrinsic value in terms of the forward price.
An option is said to be out‐of‐the‐money when it has zero intrinsic value.
• St < K for call options and St > K for put options. Out‐of‐the‐money forward: Ft < K for
call and Ft > K for put.
An option is said to be at‐the‐money spot (or forward) when the strike is equal to the spot (or forward).

4.4 Hedging Using Options
Options can be used for hedging purposes. Consider a trader (an airline company) who thinks that oil
prices are going to move substantially higher in the near future and wants some protection. In this case,
the trader might buy a call option. Let us assume that it is 11 March and a July call contract with a $100
strike price is at $4 option premium. Assume that the July futures contract is currently trading at $100. If
the trader decides to buy the call option, he has to pay the premium of (1000×4=$4000) per contract. By
purchasing this call option, the trader has the right to buy a July futures contract at $100/bbl. The seller
of the contract receives a $4000 option premium per contract and is obligated to take a short futures
position at $100/bbl in the July contract if the option buyer chooses to exercise his option. Let’s say that
by May the July futures price has risen to $110/bbl. The trader’s July contract has a value of at least $10
($110‐$100). The trader at this point can sell his option to someone else for $10/bbl and be out of the
market. His total profit will be $6000 (1000×(10‐4)) per contract. Or alternatively, he will exercise his
option and he will get one long July futures contract. The hedger in this case limited his risk of a
substantial rise in prices. If, on the other hand, prices decline, the trader will not exercise his option and
he will lose only the premium he paid when he signed the contract.

34 A PRIL 2011

5. REFERENCES

CFTC (2008) “Commodity Swap Dealers & Index Traders with Commission Recommendations.”
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf
McDonald, Robert L. (2006). “Derivatives Markets.” 2nd Edition, Addison Wesley.
Weber, Ernst Juerg (2008). “A Short History of Derivative Security Markets.” Available at SSRN:
http://ssrn.com/abstract=1141689
A PRIL 2011 35

6. G LOSSARY OF THE D ERIVATIVES M ARKET I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
6. GLOSSARY OF THE DERIVATIVES MARKET TERMS7

A
Abandon: To elect not to exercise or offset a long option position.
Accommodation Trading: Non‐competitive trading entered into by a trader, usually to assist another
with illegal trades.
Accumulator: A contract in which the seller agrees to deliver a specified quantity of a commodity or
other asset to the buyer at a pre‐determined price on a series of specified accumulation dates over a
specified period of time. The contract typically has a “knock‐out” price, which, if reached, will trigger the
cancellation of all remaining accumulations. Moreover, the amount of the commodity to be delivered
may be doubled or otherwise adjusted on those accumulation dates when the price of the asset reaches
a specified price different from the knockout price.
Actuals: The physical or cash commodity, as distinguished from a futures contract. See Cash and Spot
Commodity.
Agency Bond: A debt security issued by a government‐sponsored enterprise such as Fannie Mae or
Freddie Mac, designed to resemble a U.S. Treasury bond.
Agency Note: A debt security issued by a government‐sponsored enterprise such as Fannie Mae or
Freddie Mac, designed to resemble a U.S. Treasury note.
Aggregation: The principle under which all futures positions owned or controlled by one trader (or group
of traders acting in concert) are combined to determine reporting status and compliance with
speculative position limits.
Agricultural Trade Option Merchant: Any person that is in the business of soliciting or entering option
transactions involving an enumerated agricultural commodity that are not conducted or executed on or
subject to the rules of an exchange.
Algorithmic Trading: The use of computer programs for entering trading orders with the computer
algorithm initiating orders or placing bids and offers.
Allowances: (1) The discounts (premiums) allowed for grades or locations of a commodity lower (higher)
than the par (or basis) grade or location specified in the futures contract. See Differentials. (2) The
tradable right to emit a specified amount of a pollutant under a cap and trade system.
American Option: An option that can be exercised at any time prior to or on the expiration date. See
European Option.
Approved Delivery Facility: Any bank, stockyard, mill, storehouse, plant, elevator, or other depository
that is authorized by an exchange for the delivery of commodities tendered on futures contracts.
7
Source: CFTC. This glossary is available at http://www.cftc.gov/ucm/groups/public/@educationcenter/documents/file/cftcglossary.pdf
36 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 6. G LOSSARY OF THE D ERIVATIVES M ARKET
Arbitrage: A strategy involving the simultaneous purchase and sale of identical or equivalent commodity
futures contracts or other instruments across two or more markets in order to benefit from a
discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for
profitable arbitrage. See Spread.
Arbitration: A process for settling disputes between parties that is less structured than court
proceedings. The National Futures Association arbitration program provides a forum for resolving
futures‐related disputes between NFA members or between NFA members and customers. Other forums
for customer complaints include the American Arbitration Association.
Artificial Price: A cash market or futures price that has been affected by a manipulation and is thus
higher or lower than it would have been if it reflected the forces of supply and demand.
Asian Option: An exotic option whose payoff depends on the average price of the underlying asset
during a specified period preceding the option expiration date.
Ask: The price level of an offer, as in bid‐ask spread.
Assignable Contract: A contract that allows the holder to convey his rights to a third party. Exchange‐
traded contracts are not assignable.
Assignment: Designation by a clearing organization of an option writer who will be required to buy (in
the case of a put) or sell (in the case of a call) the underlying futures contract or security when an option
has been exercised, especially if it has been exercised early.
Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders,
discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on
behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a
commodity pool operator, or an agricultural trade option merchant.
At‐the‐Market: An order to buy or sell a futures contract at whatever price is obtainable when the order
reaches the trading facility. See Market Order.
At‐the‐Money: When an option's strike price is the same as the current trading price of the underlying
commodity, the option is at‐the‐money.
Auction Rate Security: A debt security, typically issued by a municipality, in which the yield is reset on
each payment date via a Dutch auction.
Audit Trail: The record of trading information identifying, for example, the brokers participating in each
transaction, the firms clearing the trade, the terms and time or sequence of the trade, the order receipt
and execution time, and, ultimately, and when applicable, the customers involved.
Automatic Exercise: A provision in an option contract specifying that it will be exercised automatically on
the expiration date if it is in‐the‐money by a specified amount, absent instructions to the contrary.
A PRIL 2011 37

B
Back Months: Futures delivery months other than the spot or front month (also called deferred months).
Back Office: The department in a financial institution that processes and deals and handles delivery,
settlement, and regulatory procedures.
Back pricing: Fixing the price of a commodity for which the commitment to purchase has been made in
advance. The buyer can fix the price relative to any monthly or periodic delivery using the futures markets.
Back Spread: A delta‐neutral ratio spread in which more options are bought than sold. A back spread will
be profitable if volatility increases. See Delta.
Backwardation: Market situation in which futures prices are progressively lower in the distant delivery
months. For instance, if the gold quotation for January is $960.00 per ounce and that for June is $945.00
per ounce, the backwardation for five months against January is $15.00 per ounce. (Backwardation is the
opposite of contango). See Inverted Market.
Banging the Close: A manipulative or disruptive trading practice whereby a trader buys or sells a large
number of futures contracts during the closing period of a futures contract (that is, the period during
which the futures settlement price is determined) in order to benefit an even larger position in an
option, swap, or other derivative that is cash settled based on the futures settlement price on that day.
Banker's Acceptance: A draft or bill of exchange accepted by a bank where the accepting institution
guarantees payment. Used extensively in foreign trade transactions.
Basis: The difference between the spot or cash price of a commodity and the price of the nearest futures
contract for the same or a related commodity (typically calculated as cash minus futures). Basis is usually
computed in relation to the futures contract next to expire and may reflect different time periods,
product forms, grades, or locations.
Basis Grade: The grade of a commodity used as the standard or par grade of a futures contract.
Basis Point: The measurement of a change in the yield of a debt security. One basis point equals 1/100 of
one percent.
Basis Quote: Offer or sale of a cash commodity in terms of the difference above or below a futures price
(e.g., 10 cents over December corn).
Basis Risk: The risk associated with an unexpected widening or narrowing of the basis (that is, the
difference between the futures price and the relevant cash price) between the time a hedge position is
established and the time that it is lifted.
Basis Swap: A swap whose cash settlement price is calculated based on the basis between a futures
contract (e.g., natural gas) and the spot price of the underlying commodity or a closely related
commodity (e.g., natural gas at a location other than the futures delivery location) on a specified date.
38 A PRIL 2011

Bear: One who expects a decline in prices. The opposite of a bull. A news item is considered bearish if it
is expected to result in lower prices.
Bear Market: A market in which prices generally are declining over a period of months or years. Opposite
of bull market.
Bear Market Rally: A temporary rise in prices during a bear market. See Correction.
Bear Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class
and expiration date, but different strike prices. In a bear spread, the option that is purchased has a lower
delta than the option that is bought. For example, in a call bear spread, the purchased option has a
higher exercise price than the option that is sold. Also called bear vertical spread. (2) The simultaneous
purchase and sale of two futures contracts in the same or related commodities with the intention of
profiting from a decline in prices but at the same time limiting the potential loss if this expectation does
not materialize. In agricultural products, this is accomplished by selling a nearby delivery and buying a
deferred delivery.
Bear Vertical Spread: See Bear Spread.
Bermuda Option: An exotic option which can be exercised on a specified set of predetermined dates
during the life of the option.
Beta (Beta Coefficient): A measure of the variability of rate of return or value of a stock or portfolio
compared to that of the overall market, typically used as a measure of riskiness.
Bid: An offer to buy a specific quantity of a commodity at a stated price.
Bid‐Ask Spread or Bid‐Offer Spread: The difference between the bid price and the ask or offer price.
Binary Option: A type of option whose payoff is either a fixed amount or zero. For example, there could
be a binary option that pays $100 if a hurricane makes landfall in Florida before a specified date and zero
otherwise. Also called a digital option.
Blackboard Trading: The practice, no longer used, of buying and selling commodities by posting prices on
a blackboard on a wall of a commodity exchange.
Black‐Scholes Model: An option pricing model initially developed by Fischer Black and Myron Scholes for
securities options and later refined by Black for options on futures.
Block Trade: A large transaction that is negotiated off an exchange’s centralized trading facility and then
executed on the trading facility, as permitted under exchange rules.
Board Order: See Market‐if‐Touched Order.
Board of Trade: Any organized exchange or other trading facility for the trading of futures and/or
option contracts.
A PRIL 2011 39

Boiler Room: An enterprise that often is operated out of inexpensive, low‐rent quarters (hence the term
“boiler room”), that uses high pressure sales tactics (generally over the telephone), and possibly false or
misleading information to solicit generally unsophisticated investors.
Booking the Basis: A forward pricing sales arrangement in which the cash price is determined either by
the buyer or seller within a specified time. At that time, the previously‐agreed basis is applied to the
then‐current futures quotation.
Book Transfer: A series of accounting or bookkeeping entries used to settle a series of cash market
transactions.
Box Spread: An option position in which the owner establishes a long call and a short put at one strike
price and a short call and a long put at another strike price, all of which are in the same contract month
in the same commodity.
Break: A rapid and sharp price decline.
Broad‐Based Security Index: Any index of securities that does not meet the legal definition of narrow‐
based security index.
Broker: A person paid a fee or commission for executing buy or sell orders for a customer. In commodity
futures trading, the term may refer to: (1) Floor broker, a person who actually executes orders on the
trading floor of an exchange; (2) Account executive or associated person, the person who deals with
customers in the offices of futures commission merchants; or (3) the futures commission merchant.
Broker Association: Two or more persons with exchange trading privileges who (1) share responsibility
for executing customer orders; (2) have access to each other's unfilled customer orders as a result of
common employment or other types of relationships; or (3) share profits or losses associated with their
brokerage or trading activity.
Bucketing: Directly or indirectly taking the opposite side of a customer's order into a broker’s own
account or into an account in which a broker has an interest, without open and competitive execution of
the order on an exchange. Also called trading against.
Bucket Shop: A brokerage enterprise that “books” (i.e., takes the opposite side of) retail customer orders
without actually having them executed on an exchange.
Bull: One who expects a rise in prices. The opposite of a bear. A news item is considered bullish if it is
expected to result in higher prices.
Bullion: Bars or ingots of precious metals, usually cast in standardized sizes.
Bull Market: A market in which prices generally are rising over a period of months or years. Opposite of a
bear market.
Bull Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and
expiration date but different strike prices. In a bull vertical spread, the purchased option has a higher
40 A PRIL 2011

delta than the option that is sold. For example, in a call bull spread, the purchased option has a lower
exercise price than the sold option. Also called bull vertical spread. (2) The simultaneous purchase and
sale of two futures contracts in the same or related commodities with the intention of profiting from a
rise in prices but at the same time limiting the potential loss if this expectation is wrong. In agricultural
commodities, this is accomplished by buying the nearby delivery and selling the deferred.
Bull Vertical Spread: See Bull Spread.
Bust: To cancel a trade that was executed in error.
Buoyant: A market in which prices have a tendency to rise easily with a considerable show of strength.
Bunched Order: A discretionary order entered on behalf of multiple customers.
Bust: An executed trade cancelled by an exchange that is considered to have been executed in error.
Butterfly Spread: A three‐legged option spread in which each leg has the same expiration date but
different strike prices. For example, a butterfly spread in soybean call options might consist of one long
call at a $5.50 strike price, two short calls at a $6.00 strike price, and one long call at a $6.50 strike price.
Buyer: A market participant who takes a long futures position or buys an option. An option buyer is also
called a taker, holder, or owner.
Buyer’s Call: A purchase of a specified quantity of a specific grade of a commodity at a fixed number of
points above or below a specified delivery month futures price with the buyer allowed a period of time
to fix the price either by purchasing a futures contract for the account of the seller or telling the seller
when he wishes to fix the price. See Seller’s Call.
Buyer’s Market: A condition of the market in which there is an abundance of goods available and hence
buyers can afford to be selective and may be able to buy at less than the price that previously prevailed.
See Seller's Market.
Buying Hedge (or Long Hedge): Hedging transaction in which futures contracts are bought to protect
against possible increases in the cost of commodities. See Hedging.
Buy (or Sell) On Close: To buy (or sell) at the end of the trading session within the closing price range.
Buy (or Sell) On Opening: To buy (or sell) at the beginning of a trading session within the open price range.
C
C & F: “Cost and Freight” paid to a point of destination and included in the price quoted; same as C.A.F.
Calendar Spread: (1) The purchase of one delivery month of a given futures contract and simultaneous
sale of a different delivery month of the same futures contract; (2) the purchase of a put or call option
and the simultaneous sale of the same type of option with typically the same strike price but a different
expiration date. Also called a horizontal spread or time spread.
Call: (1) An option contract that gives the buyer the right but not the obligation to purchase a
commodity, security, or other asset or to enter into a long futures position at a given price (the “strike
A PRIL 2011 41

price”) prior to or on a specified expiration date; (2) a period at the opening and the close of some
futures markets in which the price for each futures contract was established by auction; or (3) the
requirement that a financial instrument such as a bond be returned to the issuer prior to maturity, with
principal and accrued interest paid off upon return. See Buyer’s Call, Seller’s Call.
Call Around Market: A market, commonly used for options on futures on European exchanges, in which
brokers contact each other outside of the exchange trading facility to arrange block trades.
Call Cotton: Cotton bought or sold on call. See Buyer’s Call, Seller’s Call.
Called: Another term for exercised when an option is a call. In the case of an option on a physical, the
writer of a call must deliver the indicated underlying commodity when the option is exercised or called.
In the case of an option on a futures contract, a futures position will be created that will require margin,
unless the writer of the call has an offsetting position.
Call Rule: An exchange regulation under which an official bid price for a cash commodity is competitively
established at the close of each day's trading. It holds until the next opening of the exchange.
Cap and Trade: A market based pollution control system in which total emissions of a pollutant are
capped at a specified level. Allowances (or the right to emit a specified amount of a pollutant) are issued
to firms and can be bought and sold on an organized market or OTC.
Capping: Effecting transactions in an instrument underlying an option shortly before the option's
expiration date to depress or prevent a rise in the price of the instrument so that previously written call
options will expire worthless, thus protecting premiums previously received. See Pegging.
Carrying Broker: An exchange member firm, usually a futures commission merchant, through whom
another broker or customer elects to clear all or part of its trades.
Carrying Charges: Also called Cost of Carry. Cost of storing a physical commodity or holding a financial
instrument over a period of time. These charges include insurance, storage, and interest on the
deposited funds, as well as other incidental costs. It is a carrying charge market when there are higher
futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the
holder, it is called “full carry.” See Negative Carry, Positive Carry, and Contango.
Carry Trade: A trade where one borrows a currency or commoidity commodity or currency with a low cost
of carry and lends a similar instrument with a high cost of carry in order to profit from the differential.
Cascade: A situation in which the execution of market orders or stop loss orders on an electronic trading
system triggers other stop loss orders which may, in turn, trigger still more stop loss orders. This may
lead to a very large price move if there are no safety mechanisms to prevent cascading.
Cash Commodity: The physical or actual commodity as distinguished from the futures contract,
sometimes called spot commodity or actuals.
Cash Forward Sale: See Forward Contract.
42 A PRIL 2011

Cash Market: The market for the cash commodity (as contrasted to a futures contract) taking the form
of: (1) an organized, self‐regulated central market (e.g., a commodity exchange); (2) a decentralized
over‐the‐counter market; or (3) a local organization, such as a grain elevator or meat processor, which
provides a market for a small region.
Cash Price: The price in the marketplace for actual cash or spot commodities to be delivered via
customary market channels.
Cash Settlement: A method of settling futures options and other derivatives whereby the seller (or
short) pays the buyer (or long) the cash value of the underlying commodity or a cash amount based on
the level of an index or price according to a procedure specified in the contract. Also called Financial
Settlement. Compare to physical delivery.
CCC: See Commodity Credit Corporation.
CD: See Certificate of Deposit.
CEA: Commodity Exchange Act or Commodity Exchange Authority.
Certificate of Deposit (CD): A time deposit with a specific maturity traditionally evidenced by a
certificate. Large denomination CDs are typically negotiable.
CFTC: See Commodity Futures Trading Commission.
CFTC Form 40: The form used by large traders to report their futures and option positions and the
purposes of those positions.
CFO: Cancel Former Order.
Centralized Counterparty (CCP): See Clearing Organization.
Certificated or Certified Stocks: Stocks of a commodity that have been inspected and found to be of a
quality deliverable against futures contracts, stored at the delivery points designated as regular or
acceptable for delivery by an exchange. In grain, called “stocks in deliverable position.” See
Deliverable Stocks.
Changer: Formerly, a clearing member of both the Mid‐America Commodity Exchange (MidAm) and
another futures exchange who, for a fee, would assume the opposite side of a transaction on MidAm by
taking a spread position between MidAm and the other futures exchange that traded an identical, but
larger, contract. Through this service, the changer provided liquidity for MidAm and an economical
mechanism for arbitrage between the two markets. MidAm was a subsidiary of the Chicago Board of
Trade (CBOT). MidAm was closed by the CBOT in 2003 after MidAm’s contracts were delisted on MidAm
and relisted on the CBOT as Mini contracts. The CBOT continued to use changers for former MidAm
contracts traded on an open outcry platform.
Charting: The use of graphs and charts in the technical analysis of futures markets to plot trends of price
movements, average movements of price, volume of trading, and open interest.
A PRIL 2011 43

Chartist: Technical trader who reacts to signals derived from graphs of price movements.
Cheapest‐to‐Deliver: Usually refers to the selection of a class of bonds or notes deliverable against an
expiring bond or note futures contract. The bond or note that has the highest implied repo rate is
considered cheapest to deliver.
Chooser Option: An exotic option that is transacted in the present, but that at some specified future
date is chosen to be either a put or a call option.
Churning: Excessive trading of a discretionary account by a person with control over the account for the
purpose of generating commissions while disregarding the interests of the customer.
Circuit Breakers: A system of coordinated trading halts and/or price limits on equity markets and equity
derivative markets designed to provide a cooling‐off period during large, intraday market declines. The
first known use of the term circuit breaker in this context was in the Report
of the Presidential Task Force on Market Mechanisms (January 1988), which recommended that circuit
breakers be adopted following the market break of October 1987.
C.I.F: Cost, insurance, and freight paid to a point of destination and included in the price quoted.
Class (of options): Options of the same type (i.e., either puts or calls, but not both) covering the same
underlying futures contract or other asset (e.g., a March call with a strike price of 62 and a May call with
a strike price of 58).
Clearing: The procedure through which the clearing organization becomes the buyer to each seller of a
futures contract or other derivative, and the seller to each buyer for clearing members.
Clearing Association: See Clearing Organization.
Clearing House: See Clearing Organization.
Clearing Member: A member of a clearing organization. All trades of a non‐clearing member must be
processed and eventually settled through a clearing member.
Clearing Organization: An entity through which futures and other derivative transactions are cleared and
settled. It is also charged with assuring the proper conduct of each contract’s delivery procedures and
the adequate financing of trading. A clearing organization may be a division of a particular exchange, an
adjunct or affiliate thereof, or a freestanding entity. Also called a clearing house, multilateral clearing
organization, or clearing association. See Derivatives Clearing Organization.
Clearing Price: See Settlement Price.
Close: The exchange‐designated period at the end of the trading session during which all transactions are
considered made “at the close.” See Call.
Closing‐Out: Liquidating an existing long or short futures or option position with an equal and opposite
transaction. Also known as Offset.
44 A PRIL 2011

Closing Price (or Range): The price (or price range) recorded during trading that takes place in the final
period of a trading session’s activity that is officially designated as the “close.”
Co‐Location: The placement of servers used by market participants in close physical proximity to an
electronic trading facility's matching engine in order to facilitate high‐frequency trading.
Combination: Puts and calls held either long or short with different strike prices and/or expirations.
Types of combinations include straddles and strangles.
Commercial: An entity involved in the production, processing, or merchandising of a commodity.
Commercial Grain Stocks: Domestic grain in store in public and private elevators at important markets
and grain afloat in vessels or barges in lake and seaboard ports.
Commercial Paper: Short‐term promissory notes issued in bearer form by large corporations, with
maturities ranging from 5 to 270 days. Since the notes are unsecured, the commercial paper market
generally is dominated by large corporations with impeccable credit ratings.
Commission: (1) The charge made by a futures commission merchant for buying and selling futures
contracts; or (2) the fee charged by a futures broker for the execution of an order. Note: when
capitalized, the word Commission usually refers to the CFTC.
Commitments of Traders Report (COT): A weekly report from the CFTC providing a breakdown of each
Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the
reporting levels established by the CFTC. Open interest is broken down by aggregate commercial,
non‐commercial, and non‐reportable holdings.
Commitments: See Open Interest.
Commodity: (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural
commodities enumerated in Section 1a(4) of the Commodity Exchange Act, 7 USC 1a(4), and all other
goods and articles, except onions as provided in Public Law 85‐839 (7 USC 13‐1), a 1958 law that banned
futures trading in onions, and all services, rights, and interests in which contracts for future delivery are
presently or in the future dealt in. (2) A physical commodity such as an agricultural product or a natural
resource as opposed to a financial instrument such as a currency or interest rate.
Commodity Credit Corporation: A government‐owned corporation established in 1933 to assist
American agriculture. Major operations include price support programs, foreign sales, and export credit
programs for agricultural commodities.
Commodity Exchange Act: The Commodity Exchange Act, 7 USC 1, et seq., provides for the federal
regulation of commodity futures and options trading and was enacted in 1936.
Commodity Exchange Authority: A regulatory agency of the U.S. Department of Agriculture established
to regulate futures trading under the 1936 Commodity Exchange Act prior to 1975. The Commodity
A PRIL 2011 45

Exchange Authority was the predecessor of the Commodity Futures Trading Commission. Before World
War II, this agency was known as the Commodity Exchange Administration.
Commodity Exchange Commission: A commission consisting of the Secretary of Agriculture, Secretary of
Commerce, and the Attorney General, responsible for administering the Commodity Exchange Act prior
to 1975. Among other things, the CEC was responsible for setting Federal speculative position limits.
Commodity Futures Trading Commission (CFTC): The Federal regulatory agency established by the
Commodity Futures Trading Act of 1974 to administer the Commodity Exchange Act.
Commodity Index: An index of a specified set of (physical) commodity prices or commodity futures prices.
Commodity Index Fund: An investment fund that enters into futures or commodity swap positions for
the purpose of replicating the return of an index of commodity prices or commodity futures prices.
Commodity Index Swap: A swap whose cash flows are intended to replicate a commodity index.
Commodity Index Trader: An entity that conducts futures trades on behalf of a commodity index fund or
to hedge commodity index swap positions.
Commodity‐Linked Bond: A bond in which payment to the investor is dependent to a certain extent on
the price level of a commodity, such as crude oil, gold, or silver, at maturity.
Commodity Option: An option on a commodity or a futures contract.
Commodity Pool: An investment trust, syndicate, or similar form of enterprise operated for the purpose
of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the
business of investing the collective or “pooled” funds of multiple participants in trading commodity
futures or options, where participants share in profits and losses on a pro rata basis.
Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a
syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity
futures contracts or commodity options. The commodity pool operator either itself makes trading
decisions on behalf of the pool or engages a commodity trading advisor to do so.
Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising
others as to the value of commodity futures or options or the advisability of trading in commodity
futures or options, or issues analyses or reports concerning commodity futures or options.
Commodity Swap: A swap in which the payout to at least one counterparty is based on the price of a
commodity or the level of a commodity index.
Confirmation Statement: A statement sent by a futures commission merchant to a customer when a
futures or options position has been initiated which typically shows the price and the number of
contracts bought and sold. See P&S (Purchase and Sale Statement).
Congestion: (1) A market situation in which shorts attempting to cover their positions are unable to find
an adequate supply of contracts provided by longs willing to liquidate or by new sellers willing to enter
46 A PRIL 2011

the market, except at sharply higher prices (see Squeeze, Corner); (2) in technical analysis, a period of

time characterized by repetitious and limited price fluctuations.
Consignment: A shipment made by a producer or dealer to an agent elsewhere with the understanding
that the commodities in question will be cared for or sold at the highest obtainable price. Title to the
merchandise shipped on consignment rests with the shipper until the goods are disposed of according to
agreement.
Contango: Market situation in which prices in succeeding delivery months are progressively higher than
in the nearest delivery month; the opposite of backwardation.
Contract: (1) A term of reference describing a unit of trading for a commodity future or option or other
derivative; (2) an agreement to buy or sell a specified commodity, detailing the amount and grade of the
product and the date on which the contract will mature and become deliverable.
Contract Grades: Those grades of a commodity that have been officially approved by an exchange as
deliverable in settlement of a futures contract.
Contract Market: A board of trade or exchange designated by the Commodity Futures Trading
Commission to trade futures or options under the Commodity Exchange Act. A contract market can allow
both institutional and retail participants and can list for trading futures contracts on any commodity,
provided that each contract is not readily susceptible to manipulation. Also called designated contract
market. See Derivatives Transaction Execution Facility.
Contract Month: See Delivery Month.
Contract Size: The actual amount of a commodity represented in a contract.
Contract Unit: See Contract Size.
Controlled Account: An account for which trading is directed by someone other than the owner. Also
called a Managed Account or a Discretionary Account.
Convergence: The tendency for prices of physicals and futures to approach one another, usually during
the delivery month. Also called a “narrowing of the basis.”
Conversion: A position created by selling a call option, buying a put option, and buying the underlying
instrument (for example, a futures contract), where the options have the same strike price and the same
expiration. See Reverse Conversion.
Conversion Factors: Numbers published by a futures exchange to determine invoice prices for debt
instruments deliverable against bond or note futures contracts. A separate conversion factor is published
for each deliverable instrument. Invoice price = Contract Size × Futures Settlement Price × Conversion
Factor + Accrued Interest.
Core Principle: A provision of the Commodity Exchange Act with which a contract market, derivatives
transaction execution facility, or derivatives clearing organization must comply on an ongoing basis.
A PRIL 2011 47

There are 18 core principles for contract markets, 9 core principles for derivatives transaction execution
facilities, and 14 core principles for derivatives clearing organizations.
Corner: (1) Securing such relative control of a commodity that its price can be manipulated, that is, can
be controlled by the creator of the corner; or (2) in the extreme situation, obtaining contracts requiring
the delivery of more commodities than are available for delivery. See Squeeze, Congestion.
Corn‐Hog Ratio: See Feed Ratio.
Correction: A temporary decline in prices during a bull market that partially reverses the previous rally.
See Bear Market Rally.
Cost of Carry: See Carrying Charges.
Cost of Tender: Total of various charges incurred when a commodity is certified and delivered on a
futures contract.
COT: See Commitments of Traders Report.
Counterparty: The opposite party in a bilateral agreement, contract, or transaction, such as a swap. In the
retail foreign exchange (or Forex) context, the party to which a retail customer sends its funds; lawfully,
the party must be one of those listed in Section 2(c)(2)(B)(ii)(I)‐(VI) of the Commodity Exchange Act.
Counterparty Risk: The risk associated with the financial stability of the party entered into contract with.
Forward contracts impose upon each party the risk that the counterparty will default, but futures contracts
executed on a designated contract market are guaranteed against default by the clearing organization.
Counter‐Trend Trading: In technical analysis, the method by which a trader takes a position contrary to
the current market direction in anticipation of a change in that direction.
Coupon (Coupon Rate): A fixed dollar amount of interest payable per annum, stated as a percentage of
principal value, usually payable in semiannual installments.
Cover: (1) Purchasing futures to offset a short position (same as Short Covering); see Offset, Liquidation;
(2) to have in hand the physical commodity when a short futures sale is made, or to acquire the
commodity that might be deliverable on a short sale.
Covered Option: A short call or put option position that is covered by the sale or purchase of the
underlying futures contract or other underlying instrument. For example, in the case of options on
futures contracts, a covered call is a short call position combined with a long futures position. A covered
put is a short put position combined with a short futures position.
Cox‐Ross‐Rubinstein Option Pricing Model: An option pricing model developed by John Cox, Stephen
Ross, and Mark Rubinstein that can be adopted to include effects not included in the Black‐Scholes
Model (e.g., early exercise and price supports).
CPO: See Commodity Pool Operator.
48 A PRIL 2011

Crack Spread: (1) In energy futures, the simultaneous purchase of crude oil futures and the sale of
petroleum product futures to establish a refining margin. One can trade a gasoline crack spread, a
heating oil crack spread, or a 3‐2‐1 crack spread which consists of three crude oil futures contracts
spread against two gasoline futures contracts and one heating oil futures contract. The 3‐2‐1 crack
spread is designed to approximate the typical ratio of gasoline and heating oil that results from refining a
barrel of crude oil. See Gross Processing Margin. (2) Calculation showing the theoretical market value of
petroleum products that could be obtained from a barrel of crude after the oil is refined or cracked. This
does not necessarily represent the refining margin because a barrel of crude yields varying amounts of
petroleum products.
Credit Default Option: A put option that makes a payoff in the event the issuer of a specified reference
asset defaults. Also called default option.
Credit Default Swap: A bilateral over‐the‐counter (OTC) contract in which the seller agrees to make a
payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of
fixed payments; the most common type of credit derivative; also called credit swap; similar to credit
default option.
Credit Derivative: A derivative contract designed to assume or shift credit risk, that is, the risk of a credit
event such as a default or bankruptcy of a borrower. For example, a lender might use a credit derivative
to hedge the risk that a borrower might default or have its credit rating downgraded. Common credit
derivatives include, credit default swaps, credit default options, credit spread options, downgrade
options, and total return swaps.
Credit Event: An event such as a debt default or bankruptcy that will affect the payoff on a credit
derivative, as defined in the derivative agreement.
Credit Rating: A rating determined by a rating agency that indicates the agency’s opinion of the
likelihood that a borrower such as a corporation or sovereign nation will be able to repay its debt. The
rating agencies include Standard & Poor’s, Fitch, and Moody’s.
Credit Spread: The difference between the yield on the debt securities of a particular corporate or
sovereign borrower (or a class of borrowers with a specified credit rating) and the yield of similar
maturity Treasury debt securities.
Credit Spread Option: An option whose payoff is based on the credit spread between the debt of a
particular borrower and similar maturity Treasury debt.
Credit Swap: See Credit Default Swap.
Crop Year: The time period from one harvest to the next, varying according to the commodity
(e.g., July 1 to June 30 for wheat; September 1 to August 31 for soybeans).
A PRIL 2011 49

Cross‐Hedge: Hedging a cash market position in a futures or option contract for a different but
price‐related commodity.
Cross‐Margining: A procedure for margining related securities, options, and futures contracts jointly
when different clearing organizations clear each side of the position.
Cross Rate: In foreign exchange, the price of one currency in terms of another currency in the market of
a third country. For example, the exchange rate between Japanese yen and Euros would be considered a
cross rate in the U.S. market.
Cross Trading: Offsetting or noncompetitive match of the buy order of one customer against the sell
order of another, a practice that is permissible only when executed in accordance with the Commodity
Exchange Act, CFTC rules, and rules of the exchange.
Crush Spread: In the soybean futures market, the simultaneous purchase of soybean futures and the sale
of soybean meal and soybean oil futures to establish a processing margin. See Gross Processing Margin,
Reverse Crush Spread.
CTA: See Commodity Trading Advisor.
CTI (Customer Type Indicator) Codes: These consist of four identifiers that describe transactions by the
type of customer for which a trade is effected. The four codes are: (1) trading by a person who holds
trading privileges for his or her own account or an account for which the person has discretion;
(2) trading for a clearing member’s proprietary account; (3) trading for another person who holds trading
privileges who is currently present on the trading floor or for an account controlled by such other
person; and (4) trading for any other type of customer. Transaction data classified by the above codes is
included in the trade register report produced by a clearing organization.
Curb Trading: Trading by telephone or by other means that takes place after the official market has
closed and that originally took place in the street on the curb outside the market. Under the Commodity
Exchange Act and CFTC rules, curb trading is illegal. Also known as kerb trading.
Currency Swap: A swap that involves the exchange of one currency (e.g., U.S. dollars) for another
(e.g., Japanese yen) on a specified schedule.
Current Delivery Month: See Spot Month
D
Daily Price Limit: The maximum price advance or decline from the previous day's settlement price
permitted during one trading session, as fixed by the rules of an exchange.
Day Ahead: See Next Day.
Day Order: An order that expires automatically at the end of each day's trading session. There may be a
day order with time contingency. For example, an “off at a specific time” order is an order that remains
50 A PRIL 2011

in force until the specified time during the session is reached. At such time, the order is
automatically canceled.
Day Trader: A trader, often a person with exchange trading privileges, who takes positions and then
offsets them during the same trading session prior to the close of trading.
DCM: Designated Contract Market.
Dealer: An individual or firm that acts as a market maker in an instrument such as a security or
foreign currency.
Dealer/Merchant (AD): A large trader that declares itself a “Dealer/Merchant” on CFTC Form 40, which
provides as examples “wholesaler, exporter/importer, shipper, grain elevator operator,
crude oilmarketer.”
Deck: The orders for purchase or sale of futures and option contracts held by a floor broker. Also
referred to as an order book.
Declaration Date: See Expiration Date.
Declaration (of Options): See Exercise.
Default: Failure to perform on a futures contract as required by exchange rules, such as failure to meet a
margin call, or to make or take delivery.
Default Option: See Credit Default Option.
Deferred Futures: See Back Months.
Deliverable Grades: See Contract Grades.
Deliverable Stocks: Stocks of commodities located in exchange‐approved storage for which receipts may
be used in making delivery on futures contracts. In the cotton trade, the term refers to cotton certified
for delivery. Also see Certificated or Certified Stocks.
Deliverable Supply: The total supply of a commodity that meets the delivery specifications of a futures
contract. See Economically Deliverable Supply.
Delivery: The tender and receipt of the actual commodity, the cash value of the commodity, or of a
delivery instrument covering the commodity (e.g., warehouse receipts or shipping certificates), used to
settle a futures contract. See Notice of Delivery, Delivery Notice.
Delivery, Current: Deliveries being made during a present month. Sometimes current delivery is used as
a synonym for nearby delivery.
Delivery Date: The date on which the commodity or instrument of delivery must be delivered to fulfill
the terms of a contract.
Delivery Instrument: A document used to effect delivery on a futures contract, such as a warehouse
receipt or shipping certificate.
A PRIL 2011 51

Delivery Month: The specified month within which a futures contract matures and can be settled by
delivery or the specified month in which the delivery period begins.
Delivery, Nearby: The nearest traded month, the front month. In plural form, one of the nearer
trading months.
Delivery Notice: The written notice given by the seller of his intention to make delivery against an open
short futures position on a particular date. This notice, delivered through the clearing organization, is
separate and distinct from the warehouse receipt or other instrument that will be used to transfer title.
Also called Notice of Intent to Deliver or Notice of Delivery.
Delivery Option: A provision of a futures contract that provides the short with flexibility in regard to
timing, location, quantity, or quality in the delivery process.
Delivery Point: A location designated by a commodity exchange where stocks of a commodity
represented by a futures contract may be delivered in fulfillment of the contract. Also called Location.
Delivery Price: The price fixed by the clearing organization at which deliveries on futures are invoiced—
generally the price at which the futures contract is settled when deliveries are made. Also called
Invoice Price.
Delta: The expected change in an option's price given a one‐unit change in the price of the underlying
futures contract or physical commodity. For example, an option with a delta of 0.5 would change $.50
when the underlying commodity moves $1.00.
Delta Margining or Delta‐Based Margining: An option margining system used by some exchanges that
equates the changes in option premiums with the changes in the price of the underlying futures contract
to determine risk factors upon which to base the margin requirements.
Delta Neutral: Refers to a position involving options that is designed to have an overall delta of zero.
Deposit: See Initial Margin.
Depository Receipt: See Vault Receipt.
Derivative: A financial instrument, traded on or off an exchange, the price of which is directly dependent
upon (i.e., “derived from”) the value of one or more underlying securities, equity indices, debt
instruments, commodities, other derivative instruments, or any agreed upon pricing index or
arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They are used
to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures,
options, and swaps. For example, futures contracts are derivatives of the physical contract and options
on futures are derivatives of futures contracts.
Derivatives Clearing Organization: A clearing organization or similar entity that, in respect to a contract
(1) enables each party to the contract to substitute, through novation or otherwise, the credit of the
derivatives clearing organization for the credit of the parties; (2) arranges or provides, on a multilateral
52 A PRIL 2011

basis, for the settlement or netting of obligations resulting from such contracts; or (3) otherwise provides
clearing services or arrangements that mutualize or transfer among participants in the derivatives
clearing organization the credit risk arising from such contracts.
Derivatives Transaction Execution Facility (DTEF): A board of trade that is registered with the CFTC as a
DTEF. A DTEF is subject to fewer regulatory requirements than a contract market. To qualify as a DTEF,
an exchange can only trade certain commodities (including excluded commodities and other
commodities with very high levels of deliverable supply) and generally must exclude retail participants
(retail participants may trade on DTEFs through futures commission merchants with adjusted net capital
of at least $20 million or registered commodity trading advisors that direct trading for accounts
containing total assets of at least $25 million). See Derivatives Transaction Execution Facilities.
Designated Contract Market: See Contract Market.
Designated Self‐Regulatory Organization (DSRO): Self‐regulatory organizations (i.e., the commodity
exchanges and registered futures associations) must enforce minimum financial and reporting
requirements for their members, among other responsibilities outlined in the CFTC's regulations. When a
futures commission merchant (FCM) is a member of more than one SRO, the SROs may decide among
themselves which of them will assume primary responsibility for these regulatory duties and, upon
approval of the plan by the Commission, be appointed the “designated self‐regulatory organization” for
that FCM.
Diagonal Spread: A spread between two call options or two put options with different strike prices and
different expiration dates. See Horizontal Spread, Vertical Spread.
Differentials: The discount (premium) allowed for grades or locations of a commodity lower (higher)
than the par of basis grade or location specified in the futures contact. See Allowances.
Digital Option: See Binary Option.
Directional Trading: Trading strategies designed to speculate on the direction of the underlying market,
especially in contrast to volatility trading.
Disclosure Document: A statement that must be provided to prospective customers that describes
trading strategy, potential risk, commissions, fees, performance, and other relevant information.
Discount: (1) The amount a price would be reduced to purchase a commodity of lesser grade; (2)
sometimes used to refer to the price differences between futures of different delivery months, as in the
phrase “July at a discount to May,” indicating that the price for the July futures is lower than that of May.
Discretionary Account: An arrangement by which the holder of an account gives written power of
attorney to someone else, often a commodity trading advisor, to buy and sell without prior approval of
the holder; often referred to as a “managed account” or controlled account.
Distillates: A category of petroleum products that includes diesel fuels and fuel oils such as heating oil.
A PRIL 2011 53

DRT (“Disregard Tape”) or Not‐Held Order: Absent any restrictions, a DRT (Not‐Held Order) means any
order giving the floor broker complete discretion over price and time in execution of an order, including
discretion to execute all, some, or none of this order.
Distant or Deferred Months: See Back Month.
Dominant Future: That future having the largest amount of open interest.
Double Hedging: As used by the CFTC, it implies a situation where a trader holds a long position in the
futures market in excess of the speculative position limit as an offset to a fixed price sale, even though
the trader has an ample supply of the commodity on hand to fill all sales commitments.
DSRO: See Designated Self‐Regulatory Organization.
DTEF: See Derivatives Transaction Execution Facility.
Dual Trading: Dual trading occurs when: (1) a floor broker executes customer orders and, on the same
day, trades for his own account or an account in which he has an interest; or (2) a futures commission
merchant carries customer accounts and also trades or permits its employees to trade in accounts in
which it has a proprietary interest, also on the same trading day.
Dutch Auction: An auction of a debt instrument (such as a Treasury note) in which all successful bidders
receive the same yield (the lowest yield that results in the sale of the entire amount to be issued).
Duration: A measure of a bond's price sensitivity to changes in interest rates.
E
Ease Off: A minor and/or slow decline in the price of a market.
ECN: Electronic Communications Network, frequently used for creating electronic stock or futures
markets.
Economically Deliverable Supply: That portion of the deliverable supply of a commodity that is in
position for delivery against a futures contract, and is not otherwise unavailable for delivery. For
example, Treasury bonds held by long‐term investment funds are not considered part of the
economically deliverable supply of a Treasury bond futures contract.
Efficient Market: In economic theory, an efficient market is one in which market prices adjust rapidly to
reflect new information. The degree to which the market is efficient depends on the quality of
information reflected in market prices. In an efficient market, profitable arbitrage opportunities do not
exist and traders cannot expect to consistently outperform the market unless they have lower‐cost
access to information that is reflected in market prices or unless they have access to information before
it is reflected in market prices. See Random Walk.
EFP: See Exchange for Physical.
EIA: See Energy Information Administration.
54 A PRIL 2011

Electronic Trading Facility: A trading facility that operates by an electronic or telecommunications
network instead of a trading floor and maintains an automated audit trail of transactions.
Eligible Commercial Entity: An eligible contract participant or other entity approved by the CFTC that has
a demonstrable ability to make or take delivery of an underlying commodity of a contract; incurs risks
related to the commodity; or is a dealer that regularly provides risk management, hedging services, or
market‐making activities to entities trading commodities or derivative agreements, contracts, or
transactions in commodities.
Eligible Contract Participant: An entity, such as a financial institution, insurance company, or commodity
pool, that is classified by the Commodity Exchange Act as an eligible contract participant based upon its
regulated status or amount of assets. This classification permits these persons to engage in transactions
(such as trading on a derivatives transaction execution facility) not generally available to non‐eligible
contract participants, i.e., retail customers.
Elliot Wave: (1) A theory named after Ralph Elliot, who contended that the stock market tends to move
in discernible and predictable patterns reflecting the basic harmony of nature and extended by other
technical analysts to futures markets; (2) in technical analysis, a charting method based on the belief that
all prices act as waves, rising and falling rhythmically.
E‐Local: A person with trading privileges at an exchange with an electronic trading facility who trades
electronically (rather than in a pit or ring) for his or her own account, often at a trading arcade.
E‐Mini: A mini contract that is traded exclusively on an electronic trading facility. E‐Mini is a trademark of
the Chicago Mercantile Exchange.
Emergency: Any market occurrence or circumstance which requires immediate action and threatens or
may threaten such things as the fair and orderly trading in, or the liquidation of, or delivery pursuant to,
any contracts on a contract market.
Energy Information Administration (EIA): An agency of the US Department of Energy that provides
statistics, data, analysis on resources, supply, production, consumption for all energy sources. EIA data
includes weekly inventory statistics for crude oil and petroleum products as well as weekly natural
storage data.
Enumerated Agricultural Commodities: The commodities specifically listed in Section 1a(3) of the
Commodity Exchange Act: wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill
feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard,
tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed,
peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice.
Equity: As used on a trading account statement, refers to the residual dollar value of a futures or option
trading account, assuming it was liquidated at current prices.
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ETF: See Exchange Traded Fund.
EURIBOR® (Euro Interbank Offered Rate): The euro denominated rate of interest at which banks borrow
funds from other banks, in marketable size, in the interbank market. Euribor is sponsored by the
European Banking Federation. See LIBOR, TIBOR.Euro: The official currency of most members of the
European Union.
Eurocurrency: Certificates of Deposit (CDs), bonds, deposits, or any capital market instrument issued
outside of the national boundaries of the currency in which the instrument is denominated (for example,
Eurodollars, Euro‐Swiss francs, or Euroyen).
Eurodollars: U.S. dollar deposits placed with banks outside the U.S. Holders may include individuals,
companies, banks, and central banks.
European Option: An option that may be exercised only on the expiration date. See American Option.
Even Lot: A unit of trading in a commodity established by an exchange to which official price quotations
apply. See Round Lot.
Event Market: A market in derivatives whose payoff is based on a specified event or occurrence such as
the release of a macroeconomic indicator, a corporate earnings announcement, or the dollar value of
damages caused by a hurricane.
Exchange: A central marketplace with established rules and regulations where buyers and sellers meet to
trade futures and options contracts or securities. Exchanges include designated contract markets and
derivatives transaction execution facilities.
Exchange for Physicals (EFP): A transaction in which the buyer of a cash commodity transfers to the
seller a corresponding amount of long futures contracts, or receives from the seller a corresponding
amount of short futures, at a price difference mutually agreed upon. In this way, the opposite hedges in
futures of both parties are closed out simultaneously. Also called Exchange of Futures for Cash, AA
(against actuals), or Ex‐Pit transactions.
Exchange of Futures for Cash: See Exchange for Physicals.
Exchange of Futures for Swaps (EFS): A privately negotiated transaction in which a position in a physical
delivery futures contract is exchanged for a cash‐settled swap position in the same or a related
commodity, pursuant to the rules of a futures exchange. See Exchange for Physicals.
Exchange Rate: The price of one currency stated in terms of another currency.
Exchange Risk Factor: The delta of an option as computed daily by the exchange on which it is traded.
Exchange Traded Fund (ETF): An investment vehicle holding a commodity or other asset that issues
shares that are traded like a stock on a securities exchange.
Excluded Commodity: In general, the Commodity Exchange Act defines an excluded commodity as: any
financial instrument such as a security, currency, interest rate, debt instrument, or credit rating; any
56 A PRIL 2011

economic or commercial index other than a narrow‐based commodity index; or any other value that is
out of the control of participants and is associated with an economic consequence. See the Commodity
Exchange Act definition of excluded commodity.
Exempt Board of Trade: A trading facility that trades commodities (other than securities or securities
indexes) having a nearly inexhaustible deliverable supply and either no cash market or a cash market so
liquid that any contract traded on the commodity is highly unlikely to be susceptible to manipulation. An
exempt board of trade’s contracts must be entered into by parties that are eligible contract participants.
Exempt Commercial Market: An electronic trading facility that trades exempt commodities on a
principal‐to‐principal basis solely between persons that are eligible commercial entities.
Exempt Commodity: The Commodity Exchange Act defines an exempt commodity as any commodity
other than an excluded commodity or an agricultural commodity. Examples include energy commodities
and metals.
Exempt Foreign Firm: A foreign firm that does business with U.S. customers only on foreign exchanges
and is exempt from registration under CFTC regulations based upon compliance with its home country’s
regulatory framework (also known as a “Rule 30.10 firm”).
Exercise Price (Strike Price): The price, specified in the option contract, at which the underlying futures
contract, security, or commodity will move from seller to buyer.
Exotic Options: Any of a wide variety of options with non‐standard payout structures or other features,
including Asian options and lookback options. Exotic options are mostly traded in the over‐the‐counter
market.
Expiration Date: The date on which an option contract automatically expires; the last day an option may
be exercised.
Extrinsic Value: See Time Value.
Ex‐Pit: See Transfer Trades and Exchange for Physicals
F
FAB (Five Against Bond) Spread: A futures spread trade involving the buying (selling) of a five‐year Treasury
note futures contract and the selling (buying) of a long‐term (15‐30 year) Treasury bond futures contract.
Fannie Mae: A corporation (government‐sponsored enterprise) created by Congress to support the
secondary mortgage market (formerly the Federal National Mortgage Association). It purchases and sells
residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veteran's
Administration (VA). See Freddie Mac.
FAN (Five Against Note) Spread: A futures spread trade involving the buying (selling) of a five‐year
Treasury note futures contract and the selling (buying) of a ten‐year Treasury note futures contract.
A PRIL 2011 57

Fast Market: An open outcry market situation where transactions in the pit or ring take place in such
volume and with such rapidity that price reporters fall behind with price quotations, label each quote as
“FAST” and show a range of prices. Also called a fast tape.
The Federal Energy Regulatory Commission: (FERC): An independent agency of the U.S. Government
that regulates the interstate transmission of natural gas, oil, and electricity. FERC also regulates natural
gas and hydropower projects.
Federal Limit: A speculative position limit that is established and administered by the CFTC rather than
an exchange.
Feed Ratio: The relationship of the cost of feed, expressed as a ratio to the sale price of animals, such as
the corn‐hog ratio. These serve as indicators of the profit margin or lack of profit in feeding animals to
market weight.
FERC: See Federal Energy Regulatory Commission.
FIA: See Futures Industry Association.
Fibonacci Numbers: A number sequence discovered by a thirteenth century Italian mathematician
Leonardo Fibonacci (circa 1170‐1250), who introduced Arabic numbers to Europe, in which the sum of
any two consecutive numbers equals the next highest number—i.e., following this sequence: 1, 1, 2, 3, 5,
8, 13, 21, 34, 55, and so on. The ratio of any number to its next highest number approaches 0.618 after
the first four numbers. These numbers are used by technical analysts to determine price objectives from
percentage retracements.
Fictitious Trading: Wash trading, bucketing, cross trading, or other schemes which give the appearance
of trading but actually no bona fide, competitive trade has occurred.
Fill: The execution of an order.
Fill or Kill Order (FOK): An order that demands immediate execution or cancellation. Typically involving a
designation, added to an order, instructing the broker to offer or bid (as the case may be) one time only;
if the order is not filled immediately, it is then automatically cancelled.
Final Settlement Price: The price at which a cash‐settled futures contract is settled at maturity, pursuant
to a procedure specified by the exchange.
Financial: Can be used to refer to a derivative that is financially settled or cash settled. See Physical.
Financial Commodity: Any futures or option contract that is not based on an agricultural commodity or a
natural resource such as energy or metals. It includes currencies, equity securities, fixed income
securities, and indexes of various kinds.
Financial Future: A futures contract on a financial commodity.
Financial Settlement: See Cash settlement
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First Notice Day: The first day on which notices of intent to deliver actual commodities against futures
market positions can be received. First notice day may vary with each commodity and exchange.
Fix, Fixing: See Gold Fixing.
Fixed Income Security: A security whose nominal (or current dollar) yield is fixed or determined with
certainty at the time of purchase, typically a debt security.
Floor Broker: A person with exchange trading privileges who, in any pit, ring, post, or other place
provided by an exchange for the meeting of persons similarly engaged, executes for another person any
orders for the purchase or sale of any commodity for future delivery.
Floor Trader: A person with exchange trading privileges who executes his own trades by being personally
present in the pit or ring for futures trading. See Local.
F.O.B. (Free On Board): Indicates that all delivery, inspection and elevation, or loading costs involved in
putting commodities on board a carrier have been paid.
Forced Liquidation: The situation in which a customer's account is liquidated (open positions are offset)
by the brokerage firm holding the account, usually after notification that the account is under‐margined
due to adverse price movements and failure to meet margin calls.
Force Majeure: A clause in a supply contract that permits either party not to fulfill the contractual
commitments due to events beyond their control. These events may range from strikes to export delays
in producing countries.
Foreign Exchange: Trading in foreign currency.
Forex: Refers to the over‐the‐counter market for foreign exchange transactions. Also called the foreign
exchange market.
Forwardation: See Contango.
Forward Contract: A cash transaction common in many industries, including commodity merchandising,
in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods
at a specified future date. Terms may be more “personalized” than is the case with standardized futures
contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be
agreed upon in advance, or there may be agreement that the price will be determined at the time
of delivery.
Forward Market: The over‐the‐counter market for forward contracts.
Forward Months: Futures contracts, currently trading, calling for later or distant delivery. See Deferred
Futures, Back Months.
Forward Rate Agreement (FRA): An OTC forward contract on short‐term interest rates. The buyer of a
FRA is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional
amount that is never actually exchanged. The seller of a FRA agrees notionally to lend a sum of money to
A PRIL 2011 59

a borrower. FRAs can be used either to hedge interest rate risk or to speculate on future changes in
interest rates.
Freddie Mac: A corporation (government‐sponsored enterprise) created by Congress to support the
secondary mortgage market (formerly the Federal Home Loan Mortgage Corporation). It purchases and
sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the
Veterans Administration (VA). See Fannie Mae.
Front Month: The spot or nearby delivery month, the nearest traded contract month. See Back Month.
Front Running: With respect to commodity futures and options, taking a futures or option position based
upon non‐public information regarding an impending transaction by another person in the same or
related future or option. Also known as trading ahead.
Front Spread: A delta‐neutral ratio spread in which more options are sold than bought. Also called ratio
vertical spread. A front spread will increase in value if volatility decreases.
Full Carrying Charge, Full Carry: See Carrying Charges.
Fund of Funds: A commodity pool that invests in other commodity pools rather than directly in futures
and options contracts.
Fundamental Analysis: Study of basic, underlying factors that will affect the supply and demand of the
commodity being traded in futures contracts. See Technical Analysis.
Fungibility: The characteristic of interchangeability. Futures contracts for the same commodity and
delivery month traded on the same exchange are fungible due to their standardized specifications for
quality, quantity, delivery date, and delivery locations.
Futures: See Futures Contract.
Futures Commission Merchant (FCM): Individuals, associations, partnerships, corporations, and trusts that
solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the
rules of any exchange and that accept payment from or extend credit to those whose orders are accepted.
Futures Contract: An agreement to purchase or sell a commodity for delivery in the future: (1) at a price
that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the
contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied
by delivery or offset.
Futures‐equivalent: A term frequently used with reference to speculative position limits for options on
futures contracts. The futures‐equivalent of an option position is the number of options multiplied by the
previous day's risk factor or delta for the option series. For example, ten deep out‐of‐money options with
a delta of 0.20 would be considered two futures‐equivalent contracts. The delta or risk factor used for
this purpose is the same as that used in delta‐based margining and risk analysis systems.
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Futures Industry Association (FIA): A membership organization for futures commission merchants
(FCMs) which, among other activities, offers education courses on the futures markets, disburses
information, and lobbies on behalf of its members.
Futures Option: An option on a futures contract.
Futures Price: (1) Commonly held to mean the price of a commodity for future delivery that is traded on
a futures exchange; (2) the price of any futures contract.
G
Gamma: A measurement of how fast the delta of an option changes, given a unit change in the
underlying futures price; the “delta of the delta.”
Ginzy Trading: A non‐competitive trade practice in which a floor broker, in executing an order—
particularly a large order—will fill a portion of the order at one price and the remainder of the order at
another price to avoid an exchange's rule against trading at fractional increments or "split ticks."
Give Up: A contract executed by one broker for the client of another broker that the client orders to be
turned over to the second broker. The broker accepting the order from the customer collects a fee from
the carrying broker for the use of the facilities. Often used to consolidate many small orders or to
disperse large ones.
Gold Certificate: A certificate attesting to a person's ownership of a specific amount of gold bullion.
Gold Fixing (Gold Fix): The setting of the gold price at 10:30 a.m. (first fixing) and 3:00 p.m. (second
fixing) in London by representatives of the London gold market.
Gold/Silver Ratio: The number of ounces of silver required to buy one ounce of gold at current spot prices.
Good This Week Order (GTW): Order which is valid only for the week in which it is placed.
Good 'Till Canceled Order (GTC): An order which is valid until cancelled by the customer. Unless
specified GTC, unfilled orders expire at the end of the trading day. See Open Order.
GPM: See Gross Processing Margin.
Grades: Various qualities of a commodity.
Grading Certificates: A formal document setting forth the quality of a commodity as determined by
authorized inspectors or graders.
Grain Futures Act: Federal statute that provided for the regulation of trading in grain futures, effective
June 22, 1923; administered by the Grain Futures Administration, an agency of the U.S. Department of
Agriculture. The Grain Futures Act was amended in 1936 by the Commodity Exchange Act and the Grain
Futures Administration became the Commodity Exchange Administration, later the Commodity
Exchange Authority.
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Grantor: The maker, writer, or issuer of an option contract who, in return for the premium paid for the
option, stands ready to purchase the underlying commodity (or futures contract) in the case of a put
option or to sell the underlying commodity (or futures contract) in the case of a call option.
Gross Processing Margin (GPM): Refers to the difference between the cost of a commodity and the
combined sales income of the finished products that result from processing the commodity. Various
industries have formulas to express the relationship of raw material costs to sales income from finished
products. See Crack Spread, Crush Spread, and Spark Spread.
GTC: See Good 'Till Canceled Order.
GTW: See Good This Week Order.
Guaranteed Introducing Broker: An introducing broker that has entered into a guarantee agreement
with a futures commission merchant (FCM), whereby the FCM agrees to be jointly and severally liable for
all of the introducing broker’s obligations under the Commodity Exchange Act. By entering into the
agreement, the introducing broker is relieved from the necessity of raising its own capital to satisfy
minimum financial requirements. In contrast, an independent introducing broker must raise its own
capital to meet minimum financial requirements.
H
Haircut: In computing the value of assets for purposes of capital, segregation, or margin requirements, a
percentage reduction from the stated value (e.g., book value or market value) to account for possible
declines in value that may occur before assets can be liquidated.
Hand Held Terminal: A small computer terminal used by floor brokers or floor traders on an exchange to
record trade information and transmit that information to the clearing organization.
Hardening: (1) Describes a price which is gradually stabilizing; (2) a term indicating a slowly
advancing market.
Hard Position Limit: A Speculative Position Limit, especially in contrast to a position accountability level.
Head and Shoulders: In technical analysis, a chart formation that resembles a human head and shoulders
and is generally considered to be predictive of a price reversal. A head and shoulders top (which is
considered predictive of a price decline) consists of a high price, a decline to a support level, a rally to a
higher price than the previous high price, a second decline to the support level, and a weaker rally to
about the level of the first high price. The reverse (upside‐down) formation is called a head and
shoulders bottom (which is considered predictive of a price rally).
Heavy: A market in which prices are demonstrating either an inability to advance or a slight tendency
to decline.
Hedge Exemption: An exemption from speculative position limits for bona fide hedgers and certain other
persons who meet the requirements of exchange and CFTC rules.
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Hedge Fund: A private investment fund or pool that trades and invests in various assets such as
securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals.
Some commodity pool operators operate hedge funds.
Hedge Ratio: Ratio of the value of futures contracts purchased or sold to the value of the cash
commodity being hedged, a computation necessary to minimize basis risk.
Hedger: A trader who enters into positions in a futures market opposite to positions held in the cash
market to minimize the risk of financial loss from an adverse price change; or who purchases or sells
futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long
cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one
plans on buying the cash commodity in the future).
Henry Hub: A natural gas pipeline hub in Louisiana that serves as the delivery point for New York
Mercantile Exchange natural gas futures contracts and often serves as a benchmark for wholesale
natural gas prices across the U.S.
Hidden Quantity Order: An order placed on an electronic trading system whereby only a portion of the
order is visible to other market participants. As the displayed part of the order is filled, additional
quantities become visible. Also called Iceberg, Max Show.
High Frequency Trading: Computerized or algorithmic trading in which transactions are completed in
very small fractions of a second.
Historical Volatility: A statistical measure (specifically, the annualized standard deviation) of the volatility
of a futures contract, security, or other instrument over a specified number of past trading days.
Hog‐Corn Ratio: See Feed Ratio.
Horizontal Spread (also called Time Spread or Calendar Spread): An option spread involving the
simultaneous purchase and sale of options of the same class and strike prices but different expiration
dates. See Diagonal Spread, Vertical Spread.
Hybrid Instruments: Financial instruments that possess, in varying combinations, characteristics of
forward contracts, futures contracts, option contracts, debt instruments, bank depository interests, and
other interests. Certain hybrid instruments are exempt from CFTC regulation.
IJK
IB: See Introducing Broker.
Iceberg: See Hidden Quantity Order.
Implied Repo Rate: The rate of return that can be obtained from selling a debt instrument futures
contract and simultaneously buying a bond or note deliverable against that futures contract with
borrowed funds. The bond or note with the highest implied repo rate is cheapest to deliver.
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Implied Volatility: The volatility of a futures contract, security, or other instrument as implied by the
prices of an option on that instrument, calculated using an option pricing model.
Index Arbitrage: The simultaneous purchase (sale) of stock index futures and the sale (purchase) of some or
all of the component stocks that make up the particular stock index to profit from sufficiently large
intermarket spreads between the futures contract and the index itself. Also see Arbitrage, Program Trading.
Indirect Bucketing: Also referred to as indirect trading against. Refers to when a floor broker effectively
trades opposite his customer in a pair of non‐competitive transactions by buying (selling) opposite an
accommodating trader to fill a customer order and by selling (buying) for his personal account opposite
the same accommodating trader. The accommodating trader assists the floor broker by making it appear
that the customer traded opposite him rather than opposite the floor broker.
Inflation‐Indexed Debt Instrument: Generally a debt instrument (such as a bond or note) on which the
payments are adjusted for inflation and deflation. In a typical inflation‐indexed instrument, the principal
amount is adjusted monthly based on an inflation index such as the Consumer Price Index.
Initial Deposit: See Initial Margin.
Initial Margin: Customers' funds put up as security for a guarantee of contract fulfillment at the time a
futures market position is established. See Original Margin.
In Position: Refers to a commodity located where it can readily be moved to another point or delivered
on a futures contract. Commodities not so situated are "out of position." Soybeans in Mississippi are out
of position for delivery in Chicago, but in position for export shipment from the Gulf of Mexico.
In Sight: The amount of a particular commodity that arrives at terminal or central locations in or near
producing areas. When a commodity is “in sight,” it is inferred that reasonably prompt delivery can be
made; the quantity and quality also become known factors rather than estimates.
Instrument: A tradable asset such as a commodity, security, or derivative, or an index or value that
underlies a derivative or could underlie a derivative.
Intercommodity Spread: A spread in which the long and short legs are in two different but generally
related commodity markets. Also called an intermarket spread. See Spread.
Interdelivery Spread: A spread involving two different months of the same commodity. Also called an
intracommodity spread. See Spread.
Interest Rate Futures: Futures contracts traded on fixed income securities such as U.S. Treasury issues,
or based on the levels of specified interest rates such as LIBOR (London Interbank Offered Rate).
Currency is excluded from this category, even though interest rates are a factor in currency values.
Interest Rate Swap: A swap in which the two counterparties agree to exchange interest rate flows.
Typically, one party agrees to pay a fixed rate on a specified series of payment dates and the other party
64 A PRIL 2011

pays a floating rate that may be based on LIBOR (London Interbank Offered Rate) on those payment
dates. The interest rates are paid on a specified principal amount called the notional principal.
Intermarket Spread: See Spread and Intercommodity Spread.
Intermediary: A person who acts on behalf of another person in connection with futures trading, such as
a futures commission merchant, introducing broker, commodity pool operator, commodity trading
advisor, or associated person.
International Swaps and Derivatives Association (ISDA): A New York‐based group of major international
swaps dealers, that publishes the Code of Standard Wording, Assumptions and Provisions for Swaps, or
Swaps Code, for U.S. dollar interest rate swaps as well as standard master interest rate, credit, and
currency swap agreements and definitions for use in connection with the creation and trading of swaps.
In‐The‐Money: A term used to describe an option contract that has a positive value if exercised. A call
with a strike price of $390 on gold trading at $400 is in‐the‐money 10 dollars. See Intrinsic Value.
Intracommodity Spread: See Spread and Interdelivery Spread.
Intrinsic Value: A measure of the value of an option or a warrant if immediately exercised, that is, the
extent to which it is in‐the‐money. The amount by which the current price for the underlying commodity
or futures contract is above the strike price of a call option or below the strike price of a put option for
the commodity or futures contract.
Introducing Broker (IB): A person (other than a person registered as an associated person of a futures
commission merchant) who is engaged in soliciting or in accepting orders for the purchase or sale of any
commodity for future delivery on an exchange who does not accept any money, securities, or property
to margin, guarantee, or secure any trades or contracts that result therefrom.
Inverted Market: A futures market in which the nearer months are selling at prices higher than the more
distant months; a market displaying “inverse carrying charges,” characteristic of markets with supply
shortages. See Backwardation.
Invisible Supply: Uncounted stocks of a commodity in the hands of wholesalers, manufacturers, and
producers that cannot be identified accurately; stocks outside commercial channels but theoretically
available to the market. See Visible Supply.
Invoice Price: The price fixed by the clearing house at which deliveries on futures are invoiced—generally
the price at which the futures contract is settled when deliveries are made. Also called Delivery Price.
ISDA: See International Swaps and Derivatives Association.
Job Lot: A form of contract having a smaller unit of trading than is featured in a regular contract.
Kerb Trading or Dealing: See Curb Trading.
Knock‐In: A provision in an option or other derivative contract, whereby the contract is activated only if
the price of the underlying instrument reaches a specified level before a specified expiration date.
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Knock‐Out: A provision in an option or other derivative contract, whereby the contract is immediately
canceled if the price of the underlying instrument reaches a specified level during the life of the contract.
L
Large Order Execution (LOX) Procedures: Rules in place at the Chicago Mercantile Exchange that
authorize a member firm that receives a large order from an initiating party to solicit counterparty
interest off the exchange floor prior to open execution of the order in the pit and that provide for special
surveillance procedures. The parties determine a maximum quantity and an "intended execution price."
Subsequently, the initiating party's order quantity is exposed to the pit; any bids (or offers) up to and
including those at the intended execution price are hit (acceptable). The unexecuted balance is then
crossed with the contraside trader found using the LOX procedures.
Large Traders: A large trader is one who holds or controls a position in any one future or in any one
option expiration series of a commodity on any one exchange equaling or exceeding the exchange or
CFTC‐specified reporting level.
Last Notice Day: The final day on which notices of intent to deliver on futures contracts may be issued.
Last Trading Day: Day on which trading ceases for the maturing (current) delivery month. Latency: The
amount of time that elapses between the placement of a market order or marketable limit order on an
electronic trading system and the execution of that order.
Latency: The amount of time that elapses between the placement of a market order or marketable limit
order on an electronic trading system and the execution of that order.
Leaps: Long‐dated, exchange‐traded options. Stands for “Long‐term Equity Anticipation Securities.”
Leverage: The ability to control large dollar amounts of a commodity or security with a comparatively
small amount of capital.
LIBOR: The London Interbank Offered Rate. The rate of interest at which banks borrow funds
(denominated in U.S. dollars) from other banks, in marketable size, in the London interbank market.
LIBOR rates are disseminated by the British Bankers Association, which also disseminates LIBOR rates for
British pounds sterling. Some interest rate futures contracts, including Eurodollar futures, are cash
settled based on LIBOR. Also see EURIBOR® and TIBOR.
Licensed Warehouse: A warehouse approved by an exchange from which a commodity may be delivered
on a futures contract. See Regular Warehouse.
Life of Contract: Period between the beginning of trading in a particular futures contract and the
expiration of trading. In some cases, this phrase denotes the period already passed in which trading has
already occurred. For example, “The life‐of‐contract high so far is $2.50.” Same as life of delivery or life
of the future.
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Limit (Up or Down): The maximum price advance or decline from the previous day's settlement price
permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the
limit may be expanded or removed during a trading session a specified period of time after the contract
is locked limit. See Daily Price Limit.
Limit Move: See Locked Limit.
Limit Only: The definite price stated by a customer to a broker restricting the execution of an order to
buy for not more than, or to sell for not less than, the stated price.
Limit Order: An order in which the customer specifies a minimum sale price or maximum purchase price,
as contrasted with a market order, which implies that the order should be filled as soon as possible at
the market price.
Liquidation: The closing out of a long position. The term is sometimes used to denote closing out a short
position, but this is more often referred to as covering. See Cover, Offset.
Liquid Market: A market in which selling and buying can be accomplished with minimal effect on price.
Local: An individual with exchange trading privileges who trades for his own account, traditionally on an
exchange floor, and whose activities provide market liquidity. See Floor Trader, E‐Local.
Location: A Delivery Point for a futures contract.
Locked‐In: A hedged position that cannot be lifted without offsetting both sides of the hedge (spread).
See Hedging. Also refers to being caught in a limit price move.
Locked Limit: A price that has advanced or declined the permissible limit during one trading session, as
fixed by the rules of an exchange. Also called Limit Move.
London Gold Market: Refers to the dealers in the London Bullion Market Association who set (fix) the
gold price in London. See Gold Fixing.
Long: (1) One who has bought a futures contract to establish a market position; (2) a market position
that obligates the holder to take delivery; (3) one who owns an inventory of commodities. See Short.
Long Hedge: See Buying Hedge.
Long the Basis: A person or firm that has bought the spot commodity and hedged with a sale of futures is
said to be long the basis.
Lookalike Option: An over‐the‐counter option that is cash settled based on the settlement price of a
similar exchange‐traded futures contract on a specified trading day.
Lookalike Swap: An over‐the‐counter swap that is cash settled based on the settlement price of a similar
exchange‐traded futures contract on a specified trading day.
Lookback Option: An exotic option whose payoff depends on the minimum or maximum price of the
underlying asset during some portion of the life of the option. Lookback options allow the buyer to pay
or receive the most favorable underlying price during the lookback period.
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Lot: A unit of trading. See Even Lot, Job Lot, and Round Lot.
M
Macro Fund: A hedge fund that specializes in strategies designed to profit from expected
macroeconomic events.
Maintenance Margin: See Margin.
Managed Account: See Controlled Account and Discretionary Account.
Managed Money Trader (MMTs): A futures market participant who engages in futures trades on behalf
of investment funds or clients. While MMTs are commonly equated with hedge funds, they may include
Commodity Pool Operators and other managed accounts as well as hedge funds. While CFTC Form 40
does not provide a place to declare oneself a Managed Money Trader, a large trader can declare itself a
“Hedge Fund (H)” or “Managed Accounts and Commodity Pools.”
Manipulation: Any planned operation, transaction, or practice that causes or maintains an artificial price.
Specific types include corners and squeezes as well as unusually large purchases or sales of a commodity
or security in a short period of time in order to distort prices, and putting out false information in order
to distort prices.
Manufacturer (AM): A large trader that declares itself a “Manufacturer” on CFTC Form 40, which
provides as examples “refiner, miller, crusher, fabricator, sawmill, coffee roaster, cocoa grinder.”
Many‐to‐Many: Refers to a trading platform in which multiple participants have the ability to execute or
trade commodities, derivatives, or other instruments by accepting bids and offers made by multiple
other participants. In contrast to one‐to‐many platforms, many‐to‐many platforms are considered
trading facilities under the Commodity Exchange Act. Traditional exchanges are many‐to‐many
platforms.
Margin: The amount of money or collateral deposited by a customer with his broker, by a broker with a
clearing member, or by a clearing member with a clearing organization. The margin is not partial
payment on a purchase. Also called Performance Bond. (1) Initial margin is the amount of margin
required by the broker when a futures position is opened; (2) Maintenance margin is an amount that
must be maintained on deposit at all times. If the equity in a customer's account drops to or below the
level of maintenance margin because of adverse price movement, the broker must issue a margin call to
restore the customer's equity to the initial level. See Variation Margin. Exchanges specify levels of initial
margin and maintenance margin for each futures contract, but futures commission merchants may
require their customers to post margin at higher levels than those specified by the exchange. Futures
margin is determined by the SPAN margining system, which takes into account all positions in a
customer’s portfolio.
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Margin Call: (1) A request from a brokerage firm to a customer to bring margin deposits up to initial
levels; (2) a request by the clearing organization to a clearing member to make a deposit of original
margin, or a daily or intra‐day variation margin payment because of adverse price movement, based on
positions carried by the clearing member.
Market‐if‐Touched (MIT) Order: An order that becomes a market order when a particular price is
reached. A sell MIT is placed above the market; a buy MIT is placed below the market. Also referred to as
a board order. Compare to Stop Order.
Market Maker: A professional securities dealer or person with trading privileges on an exchange who has
an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy
orders. By maintaining an offering price sufficiently higher than their buying price, these firms are
compensated for the risk involved in allowing their inventory of securities to act as a buffer against
temporary order imbalances. In the futures industry, this term is sometimes loosely used to refer to a
floor trader or local who, in speculating for his own account, provides a market for commercial users of
the market. Occasionally a futures exchange will compensate a person with exchange trading privileges
to take on the obligations of a market maker to enhance liquidity in a newly listed or lightly traded
futures contract. See Specialist System.
Market‐on‐Close: An order to buy or sell at the end of the trading session at a price within the closing
range of prices. See Stop‐Close‐Only Order.
Market‐on‐Opening: An order to buy or sell at the beginning of the trading session at a price within the
opening range of prices.
Market Order: An order to buy or sell a futures contract at whatever price is obtainable at the time it is
entered in the ring, pit, or other trading platform. See At‐the‐Market Limit Order.
Mark‐to‐Market: Part of the daily cash flow system used by U.S. futures exchanges to maintain a
minimum level of margin equity for a given futures or option contract position by calculating the gain or
loss in each contract position resulting from changes in the price of the futures or option contracts at the
end of each trading session. These amounts are added or subtracted to each account balance.
Maturity: Period within which a futures contract can be settled by delivery of the actual commodity.
Max Show: See Hidden Quantity Order.
Maximum Price Fluctuation: See Limit (Up or Down) and Daily Price Limit.
Member Rate: Commission charged for the execution of an order for a person who is a member of or
has trading privileges at the exchange.
Mini: Refers to a futures contract that has a smaller contract size than an otherwise identical
futures contract.
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Minimum Price Contract: A hybrid commercial forward contract for agricultural products that includes a
provision guaranteeing the person making delivery a minimum price for the product. For agricultural
commodities, these contracts became much more common with the introduction of exchange‐traded
options on futures contracts, which permit buyers to hedge the price risks associated with such contracts.
Minimum Price Fluctuation (Minimum Tick): Smallest increment of price movement possible in trading a
given contract.
Minimum Tick: See Minimum Price Fluctuation.
MMBTU: Million British Thermal Units, the unit of trading in the natural gas futures market.
MOB Spread: A spread between the municipal bond futures contract and the Treasury bond contract,
also known as munis over bonds.
Momentum: In technical analysis, the relative change in price over a specific time interval. Often
equated with speed or velocity and considered in terms of relative strength.
Money Market: The market for short‐term debt instruments.
Multilateral Clearing Organization: See Clearing Organization
N
Naked Option: The sale of a call or put option without holding an equal and opposite position in the
underlying instrument. Also referred to as an uncovered option, naked call, or naked put.
Narrow‐Based Security Index: In general, the Commodity Exchange Act defines a narrow‐based security
index as an index of securities that meets one of the following four requirements (1) it has nine or fewer
components; (2) one component comprises more than 30 percent of the index weighting; (3) the five
highest weighted components comprise more than 60 percent of the index weighting, or (4) the lowest
weighted components comprising in the aggregate 25 percent of the index’s weighting have an
aggregate dollar value of average daily volume over a six‐month period of less than $50 million
($30 million if there are at least 15 component securities). However, the legal definition in Section 1a(25)
of the Commodity Exchange Act, 7 USC 1a(25), contains several exceptions to this provision. See Broad‐
Based Security Index, Security Future.
National Futures Association (NFA): A self‐regulatory organization whose members include futures
commission merchants, commodity pool operators, commodity trading advisors, introducing brokers,
commodity exchanges, commercial firms, and banks, that is responsible—under CFTC oversight—for
certain aspects of the regulation of FCMs, CPOs, CTAs, IBs, and their associated persons, focusing
primarily on the qualifications and proficiency, financial condition, retail sales practices, and business
conduct of these futures professionals. NFA also performs arbitration and dispute resolution functions
for industry participants.
Nearbys: The nearest delivery months of a commodity futures market.
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Nearby Delivery Month: The month of the futures contract closest to maturity; the front month or
lead month.
Negative Carry: The cost of financing a financial instrument (the short‐term rate of interest), when the
cost is above the current return of the financial instrument. See Carrying Charges and Positive Carry.
Net Asset Value (NAV): The value of each unit of participation in a commodity pool.
Net Position: The difference between the open long contracts and the open short contracts held by a
trader in any one commodity.
NFA: National Futures Association.
Next Day: A spot contract that provides for delivery of a commodity on the next calendar day or the next
business day. Also called day ahead.
NOB (Note Against Bond) Spread: A futures spread trade involving the buying (selling) of a ten‐year
Treasury note futures contract and the selling (buying) of a Treasury bond futures contract.
Non‐Member Traders: Speculators and hedgers who trade on the exchange through a member or a
person with trading privileges but who do not hold exchange memberships or trading privileges.
Nominal Price (or Nominal Quotation): Computed price quotation on a futures or option contract for a
period in which no actual trading took place, usually an average of bid and asked prices or computed
using historical or theoretical relationships to more active contracts.
Notice Day: Any day on which notices of intent to deliver on futures contracts may be issued.
Notice of Intent to Deliver: A notice that must be presented by the seller of a futures contract to the
clearing organization prior to delivery. The clearing organization then assigns the notice and subsequent
delivery instrument to a buyer. Also notice of delivery.
Notional Principal: In an interest rate swap, forward rate agreement, or other derivative instrument, the
amount or, in a currency swap, each of the amounts to which interest rates are applied in order to
calculate periodic payment obligations. Also called the notional amount, the contract amount, the
reference amount, and the currency amount.
NYMEX Lookalike: A lookalike swap or lookalike option that is based on a futures contract traded on the
New York Mercantile Exchange (NYMEX).
O
OCO: See One Cancels the Other Order.
Offer: An indication of willingness to sell at a given price; opposite of bid, the price level of the offer may
be referred to as the ask.
Off Exchange: See Over‐the‐Counter.
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Offset: Liquidating a purchase of futures contracts through the sale of an equal number of contracts of
the same delivery month, or liquidating a short sale of futures through the purchase of an equal number
of contracts of the same delivery month. See Closing Out and Cover.
Omnibus Account: An account carried by one futures commission merchant, the carrying FCM, for
another futures commission merchant, the originating FCM, in which the transactions of two or more
persons, who are customers of the originating FCM, are combined and carried by the carrying FCM.
Omnibus account titles must clearly show that the funds and trades therein belong to customers of the
originating FCM. An originating broker must use an omnibus account to execute or clear trades for
customers at a particular exchange where it does not have trading or clearing privileges.
On Track (or Track Country Station): (1) A type of deferred delivery in which the price is set f.o.b. seller's
location, and the buyer agrees to pay freight costs to his destination; (2) commodities loaded in railroad
cars on tracks.
One Cancels the Other (OCO) Order: A pair of orders, typically limit orders, whereby if one order is filled,
the other order will automatically be cancelled. For example, an OCO order might consist of an order to
buy 10 calls with a strike price of 50 at a specified price or buy 20 calls with a strike price of 55 (with the
same expiration date) at a specified price.
One‐to‐Many: Refers to a proprietary trading platform in which the platform operator posts bids and
offers for commodities, derivatives, or other instruments and serves as a counterparty to every
transaction executed on the platform. In contrast to many‐to‐many platforms, one‐to‐many platforms
are not considered trading facilities under the Commodity Exchange Act.
Opening Price (or Range): The price (or price range) recorded during the period designated by the
exchange as the official opening.
Opening: The period at the beginning of the trading session officially designated by the exchange during
which all transactions are considered made “at the opening.”
Open Interest: The total number of futures contracts long or short in a delivery month or market that
has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. Also
called open contracts or open commitments.
Open Order (or Orders): An order that remains in force until it is canceled or until the futures contracts
expire. See Good 'Till Canceled and Good This Week orders.
Open Outcry: A method of public auction, common to most U.S. commodity exchanges during the
20th century, where trading occurs on a trading floor and traders may bid and offer simultaneously either
for their own accounts or for the accounts of customers. Transactions may take place simultaneously at
different places in the trading pit or ring. At most exchanges been replaced or largely replaced by
electronic trading platforms. See Specialist System.
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Open Trade Equity: The unrealized gain or loss on open futures positions.
Option: A contract that gives the buyer the right, but not the obligation, to buy or sell a specified
quantity of a commodity or other instrument at a specific price within a specified period of time,
regardless of the market price of that instrument. Also see Put and Call.
Option Buyer: The person who buys calls, puts, or any combination of calls and puts.
Option Delta: See Delta.
Option Writer: The person who originates an option contract by promising to perform a certain
obligation in return for the price or premium of the option. Also known as option grantor or
option seller.
Option Pricing Model: A mathematical model used to calculate the theoretical value of an option. Inputs
to option pricing models typically include the price of the underlying instrument, the option strike price,
the time remaining till the expiration date, the volatility of the underlying instrument, and the risk‐free
interest rate (e.g., the Treasury bill interest rate). Examples of option pricing models include
Black‐Scholes and Cox‐Ross‐Rubinstein.
Original Margin: Term applied to the initial deposit of margin money each clearing member firm is
required to make according to clearing organization rules based upon positions carried, determined
separately for customer and proprietary positions; similar in concept to the initial margin or security
deposit required of customers by exchange rules. See Initial Margin.
OTC: See Over‐the‐Counter.
Out of Position: See In Position.
Out‐Of‐The‐Money: A term used to describe an option that has no intrinsic value. For example, a call
with a strike price of $400 on gold trading at $390 is out‐of‐the‐money 10 dollars.
Outright: An order to buy or sell only one specific type of futures contract; an order that is not a
spread order.
Out Trade: A trade that cannot be cleared by a clearing organization because the trade data submitted
by the two clearing members or two traders involved in the trade differs in some respect (e.g., price
and/or quantity). In such cases, the two clearing members or traders involved must reconcile the
discrepancy, if possible, and resubmit the trade for clearing. If an agreement cannot be reached by the
two clearing members or traders involved, the dispute would be settled by an appropriate exchange
committee.
Overbought: A technical opinion that the market price has risen too steeply and too fast in relation to
underlying fundamental factors. Rank and file traders who were bullish and long have turned bearish.
Overnight Trade: A trade which is not liquidated during the same trading session during which it
was established.
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Oversold: A technical opinion that the market price has declined too steeply and too fast in relation to
underlying fundamental factors; rank and file traders who were bearish and short have turned bullish.
Over‐the‐Counter (OTC): The trading of commodities, contracts, or other instruments not listed on any
exchange. OTC transactions can occur electronically or over the telephone. Also referred to as
Off‐Exchange.
P
P&S (Purchase and Sale Statement): A statement sent by a futures commission merchant to a customer
when any part of a futures position is offset, showing the number of contracts involved, the prices at
which the contracts were bought or sold, the gross profit or loss, the commission charges, the net profit
or loss on the transactions, and the balance. FCMs also send P&S Statements whenever any other event
occurs that alters the account balance including when the customer deposits or withdraws margin and
when the FCM places excess margin in interest bearing instruments for the customer’s benefit.
Paper Profit or Loss: The profit or loss that would be realized if open contracts were liquidated as of a
certain time or at a certain price.
Par: (1) Refers to the standard delivery point(s) and/or quality of a commodity that is deliverable on a
futures contract at contract price. Serves as a benchmark upon which to base discounts or premiums for
varying quality and delivery locations; (2) in bond markets, an index (usually 100) representing the face
value of a bond.
Path Dependent Option: An option whose valuation and payoff depends on the realized price path of
the underlying asset, such as an Asian option or a Lookback option.
Pay/Collect: A shorthand method of referring to the payment of a loss (pay) and receipt of a gain
(collect) by a clearing member to or from a clearing organization that occurs after a futures position has
been marked‐to‐market. See Variation Margin.
Pegged Price: The price at which a commodity has been fixed by agreement.
Pegging: Effecting transactions in an instrument underlying an option to prevent a decline in the price of
the instrument shortly prior to the option’s expiration date so that previously written put options will
expire worthless, thus protecting premiums previously received. See Capping.
Performance Bond: See Margin.
Physical: A contract or derivative that provides for the physical delivery of a commodity rather than cash
settlement. See Financial.
Physical Commodity: A commodity other than a financial commodity, typically an agricultural
commodity, energy commodity or a metal.
Physical Delivery: A provision in a futures contract or other derivative for delivery of the actual
commodity to satisfy the contract. Compare to cash settlement.
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Pip: The smallest price unit of a commodity or currency.
Pit: A specially constructed area on the trading floor of some exchanges where trading in a futures
contract or option is conducted. On other exchanges, the term ring designates the trading area for
commodity contract.
Pit Brokers: See Floor Broker.
Point‐and‐Figure: A method of charting that uses prices to form patterns of movement without regard to
time. It defines a price trend as a continued movement in one direction until a reversal of a
predetermined criterion is met.
Point Balance: A statement prepared by futures commission merchants to show profit or loss on all open
contracts using an official closing or settlement price, usually at calendar month end.
Ponzi Scheme: Named after Charles Ponzi, a man with a remarkable criminal career in the early
20th century, the term has been used to describe pyramid arrangements whereby an enterprise makes
payments to investors from the proceeds of a later investment rather than from profits of the underlying
business venture, as the investors expected, and gives investors the impression that a legitimate profit‐
making business or investment opportunity exists, where in fact it is a mere fiction.
Pork Bellies: One of the major cuts of the hog carcass that, when cured, becomes bacon.
Portfolio Insurance: A trading strategy that uses stock index futures and/or stock index options to
protect stock portfolios against market declines.
Portfolio Margining: A method for setting margin requirements that evaluates positions as a group or
portfolio and takes into account the potential for losses on some positions to be offset by gains on others.
Specifically, the margin requirement for a portfolio is typically set equal to an estimate of the largest
possible decline in the net value of the portfolio that could occur under assumed changes in market
conditions. Sometimes referred to as risked‐based margining. Also see Strategy‐Based Margining.
Position: An interest in the market, either long or short, in the form of one or more open contracts.
Position Accountability: A rule adopted by an exchange requiring persons holding a certain number of
outstanding contracts to report the nature of the position, trading strategy, and hedging information of
the position to the exchange, upon request of the exchange. See Speculative Position Limit.
Position Limit: See Speculative Position Limit.
Position Trader: A commodity trader who either buys or sells contracts and holds them for an extended
period of time, as distinguished from a day trader, who will normally initiate and offset a futures position
within a single trading session.
Positive Carry: The cost of financing a financial instrument (the short‐term rate of interest), where the
cost is less than the current return of the financial instrument. See Carrying Charges and Negative Carry.
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Posted Price: An announced or advertised price indicating what a firm will pay for a commodity or the
price at which the firm will sell it.
Prearranged Trading: Trading between brokers in accordance with an expressed or implied agreement
or understanding, which is a violation of the Commodity Exchange Act and CFTC regulations.
Premium: (1) The payment an option buyer makes to the option writer for granting an option contract;
(2) the amount a price would be increased to purchase a better quality commodity; (3) refers to a futures
delivery month selling at a higher price than another, as “July is at a premium over May.”
Price Banding: A CME Group and ICE‐instituted mechanism to ensure a fair and orderly market on an
electronic trading platform. This mechanism subjects all incoming orders to price verification and rejects
all orders with clearly erroneous prices. Price bands are monitored throughout the day and adjusted if
necessary.
Price Basing: A situation where producers, processors, merchants, or consumers of a commodity
establish commercial transaction prices based on the futures prices for that or a related commodity
(e.g., an offer to sell corn at 5 cents over the December futures price). This phenomenon is commonly
observed in grain and metal markets.
Price Discovery: The process of determining the price level for a commodity based on supply and
demand conditions. Price discovery may occur in a futures market or cash market.
Price Movement Limit: See Limit (Up or Down).
Primary Market: (1) For producers, their major purchaser of commodities; (2) to processors, the market
that is the major supplier of their commodity needs; and (3) in commercial marketing channels, an
important center at which spot commodities are concentrated for shipment to terminal markets.
Producer (AP): A large trader that declares itself a “Producer” on CFTC Form 40, which provides as
examples, “farmer” and “miner.” A firm that extracts crude oil or natural gas from the ground would also
be considered a Producer.
Program Trading: The purchase (or sale) of a large number of stocks contained in or comprising a
portfolio. Originally called program trading when index funds and other institutional investors began to
embark on large‐scale buying or selling campaigns or “programs” to invest in a manner that replicates a
target stock index, the term now also commonly includes computer‐aided stock market buying or selling
programs, and index arbitrage.
Prompt Date: The date on which the buyer of an option will buy or sell the underlying commodity (or
futures contract) if the option is exercised.
Prop Shop: A proprietary trading group, especially one where the group's traders trade electronically at a
physical facility operated by the group.
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Proprietary Account: An account that a futures commission merchant carries for itself or a closely
related person, such as a parent, subsidiary or affiliate company, general partner, director, associated
person, or an owner of 10 percent or more of the capital stock. The FCM must segregate customer funds
from funds related to proprietary accounts.
Proprietary Trading Group: An organization whose owners, employees, and/or contractors trade in the
name of accounts owned by the group and exclusively use the funds of the group for all of their
trading activity.
Public: In trade parlance, non‐professional speculators as distinguished from hedgers and professional
speculators or traders.
Public Elevators: Grain elevators in which bulk storage of grain is provided to the public for a fee. Grain
of the same grade but owned by different persons is usually mixed or commingled as opposed to storing
it "identity preserved." Some elevators are approved by exchanges as regular for delivery on futures
contracts, see Regular Warehouse.
Purchase and Sale Statement: See P&S.
Put: An option contract that gives the holder the right but not the obligation to sell a specified quantity
of a particular commodity, security, or other asset or to enter into a short futures position at a given
price (the "strike price") prior to or on a specified expiration date.
Pyramiding: The use of profits on existing positions as margin to increase the size of the position,
normally in successively smaller increments.
QR
Qualified Eligible Person (QEP): The definition of QEP is too complex to summarize here; please see CFTC
Regulation 4.7(a)(2) and (a)(3), 17 CFR 4.7(a)(2) and (a)(3), for the full definition.
Quick Order: See Fill or Kill Order.
Quotation: The actual price or the bid or ask price of either cash commodities or futures contracts.
Rally: An upward movement of prices.
Random Walk: An economic theory that market price movements move randomly. This assumes an
efficient market. The theory also assumes that new information comes to the market randomly.
Together, the two assumptions imply that market prices move randomly as new information is
incorporated into market prices. The theory implies that the best predictor of future prices is the current
price, and that past prices are not a reliable indicator of future prices. If the random walk theory is
correct, technical analysis cannot work.
Range: The difference between the high and low price of a commodity, futures, or option contract during
a given period.
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Ratio Hedge: The number of options compared to the number of futures contracts bought or sold in
order to establish a hedge that is neutral or delta neutral.
Ratio Spread: This strategy, which applies to both puts and calls, involves buying or selling options at one
strike price in greater number than those bought or sold at another strike price. Ratio spreads are
typically designed to be delta neutral. Back spreads and front preads are types of ratio spreads.
Ratio Vertical Spread: See Front Spread.
Reaction: A downward price movement after a price advance.
Recovery: An upward price movement after a decline.
Reference Asset: An asset, such as a corporate or sovereign debt instrument, that underlies a credit
derivative.
Regular Warehouse: A processing plant or warehouse that satisfies exchange requirements for financing,
facilities, capacity, and location and has been approved as acceptable for delivery of commodities against
futures contracts. See Licensed Warehouse.
Replicating Portfolio: A portfolio of assets for which changes in value match those of a target asset. For
example, a portfolio replicating a standard option can be constructed with certain amounts of the asset
underlying the option and bonds. Sometimes referred to as a synthetic asset.
Repo or Repurchase Agreement: A transaction in which one party sells a security to another party while
agreeing to repurchase it from the counterparty at some date in the future, at an agreed price. Repos
allow traders to short‐sell securities and allow the owners of securities to earn added income by lending
the securities they own. Through this operation the counterparty is effectively a borrower of funds to
finance further. The rate of interest used is known as the repo rate.
Reporting Level: Sizes of positions set by the exchanges and/or the CFTC at or above which commodity
traders or brokers who carry these accounts must make daily reports about the size of the position by
commodity, by delivery month, and whether the position is controlled by a commercial or non‐
commercial trader. See the Large Trader Reporting Program.
Resistance: In technical analysis, a price area where new selling will emerge to dampen a continued rise.
See Support.
Resting Order: A limit order to buy at a price below or to sell at a price above the prevailing market that
is being held by a floor broker. Such orders may either be day orders or open orders.
Retail Customer: A customer that does not qualify as an eligible contract participant under Section
1a(12) of the Commodity Exchange Act, 7 USC 1a(12). An individual with total assets that do not exceed
$10 million, or $5 million if the individual is entering into an agreement, contract, or transaction to
manage risk, would be considered a retail customer.
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Retender: In specific circumstances, some exchanges permit holders of futures contracts who have
received a delivery notice through the clearing organization to sell a futures contract and return the
notice to the clearing organization to be reissued to another long; others permit transfer of notices to
another buyer. In either case, the trader is said to have retendered the notice.
Retracement: A reversal within a major price trend.
Reversal: A change of direction in prices. See Reverse Conversion.
Reverse Conversion or Reversal: With regard to options, a position created by buying a call option,
selling a put option, and selling the underlying instrument (for example, a futures contract). See
Conversion.
Reverse Crush Spread: The sale of soybean futures and the simultaneous purchase of soybean oil and
meal futures. See Crush Spread.
Riding the Yield Curve: Trading in an interest rate futures contract according to the expectations of
change in the yield curve.
Ring: A circular area on the trading floor of an exchange where traders and brokers stand while
executing futures trades. Some exchanges use pits rather than rings.
Risked‐Based Margining: See Portfolio Margining.
Risk Factor: See Delta.
Risk/Reward Ratio: The relationship between the probability of loss and profit. This ratio is often used as
a basis for trade selection or comparison.
Roll‐Over: A trading procedure involving the shift of one month of a straddle into another future month
while holding the other contract month. The shift can take place in either the long or short straddle
month. The term also applies to lifting a near futures position and re‐establishing it in a more deferred
delivery month.
Round Lot: A quantity of a commodity equal in size to the corresponding futures contract for the
commodity. See Even Lot.
Round Trip Trading: See Wash Trading.
Round Turn: A completed transaction involving both a purchase and a liquidating sale, or a sale followed
by a covering purchase.
Rules: The principles for governing an exchange. In some exchanges, rules are adopted by a vote of the
membership, while in others, they can be imposed by the governing board.
Runners: Messengers or clerks who deliver orders received by phone clerks to brokers for execution in
the pit.
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S
Sample Grade: Usually the lowest quality of a commodity, too low to be acceptable for delivery in
satisfaction of futures contracts.
Scale Down (or Up): To purchase or sell a scale down means to buy or sell at regular price intervals in a
declining market. To buy or sell on scale up means to buy or sell at regular price intervals as the market
advances.
Scalper: A speculator often with exchange trading privileges who buys and sells rapidly, with small profits
or losses, holding his positions for only a short time during a trading session. Typically, a scalper will
stand ready to buy at a fraction below the last transaction price and to sell at a fraction above, e.g., to
buy at the bid and sell at the offer or ask price, with the intent of capturing the spread between the two,
thus creating market liquidity. See Day Trader, Position Trader, High Frequency Trading.
Seasonality Claims: Misleading sales pitches that one can earn large profits with little risk based on
predictable seasonal changes in supply or demand, published reports or other well‐known events.
Seat: An instrument granting trading privileges on an exchange. A seat may also represent an ownership
interest in the exchange.
Securities and Exchange Commission (SEC): The Federal regulatory agency established in 1934 to
administer Federal securities laws.
Security: Generally, a transferable instrument representing an ownership interest in a corporation
(equity security or stock) or the debt of a corporation, municipality, or sovereign. Other forms of debt
such as mortgages can be converted into securities. Certain derivatives on securities (e.g., options on
equity securities) are also considered securities for the purposes of the securities laws. Security futures
products are considered to be both securities and futures products. Futures contracts on broad‐based
securities indexes are not considered securities.
Security Deposit: See Margin.
Security Future: A contract for the sale or future delivery of a single security or of a narrow‐based
security index.
Security Futures Product: A security future or any put, call, straddle, option, or privilege on any security
future.
Self‐Regulatory Organization (SRO): Exchanges and registered futures associations that enforce financial
and sales practice requirements for their members. See Designated Self‐Regulatory Organizations.
Seller's Call: Seller's call, also referred to as call purchase, is the same as the buyer's call except that the
seller has the right to determine the time to fix the price. See Buyer’s Call.
Seller's Market: A condition of the market in which there is a scarcity of goods available and hence
sellers can obtain better conditions of sale or higher prices. See Buyer's Market.
80 A PRIL 2011

Seller's Option: The right of a seller to select, within the limits prescribed by a contract, the quality of the
commodity delivered and the time and place of delivery.
Selling Hedge (or Short Hedge): Selling futures contracts to protect against possible decreased prices of
commodities. See Hedging.
Series (of Options): Options of the same type (i.e., either puts or calls, but not both), covering the same
underlying futures contract or other underlying instrument, having the same strike price and
expiration date.
Settlement: The act of fulfilling the delivery requirements of the futures contract.
Settlement Price: The daily price at which the clearing organization clears all trades and settles all
accounts between clearing members of each contract month. Settlement prices are used to determine
both margin calls and invoice prices for deliveries. The term also refers to a price established by the
exchange to even up positions which may not be able to be liquidated in regular trading.
Shipping Certificate: A negotiable instrument used by several futures exchanges as the futures delivery
instrument for several commodities (e.g., soybean meal, plywood, and white wheat). The shipping
certificate is issued by exchange‐approved facilities and represents a commitment by the facility to
deliver the commodity to the holder of the certificate under the terms specified therein. Unlike an issuer
of a warehouse receipt, who has physical product in store, the issuer of a shipping certificate may honor
its obligation from current production or through‐put as well as from inventories.
Shock Absorber: A temporary restriction in the trading of certain stock index futures contracts that
becomes effective following a significant intraday decrease in stock index futures prices. Designed to
provide an adjustment period to digest new market information, the restriction bars trading below a
specified price level. Shock absorbers are generally market specific and at tighter levels than
circuit breakers.
Short: (1) The selling side of an open futures contract; (2) a trader whose net position in the futures
market shows an excess of open sales over open purchases. See Long.
Short Covering: See Cover.
Short Hedge: See Selling Hedge.
Short Selling: Selling a futures contract or other instrument with the idea of delivering on it or offsetting
it at a later date.
Short Squeeze: See Squeeze.
Short the Basis: The purchase of futures as a hedge against a commitment to sell in the cash or spot
markets. See Hedging.
A PRIL 2011 81

Significant Price Discovery Contract (SPDC): A contract traded on an Exempt Commercial Market (ECM)
which performs a significant price discovery function as determined by the CFTC pursuant to CFTC
Regulation 36.3 (c). ECMs with SPDCs are subject to additional regulatory and reporting requirements.
Single Stock Future: A futures contract on a single stock as opposed to a stock index. Single stock futures
were illegal in the U.S. prior to the passage of the Commodity Futures Modernization Act in 2000. See
Security Future, Security Futures Product.
Small Traders: Traders who hold or control positions in futures or options that are below the reporting
level specified by the exchange or the CFTC.
Soft: (1) A description of a price that is gradually weakening; or (2) this term also refers to certain “soft”
commodities such as sugar, cocoa, and coffee.
Sold‐Out‐Market: When liquidation of a weakly‐held position has been completed, and offerings become
scarce, the market is said to be sold out.
SPAN® (Standard Portfolio Analysis of Risk®): As developed by the Chicago Mercantile Exchange, the
industry standard for calculating performance bond requirements (margins) on the basis of overall
portfolio risk. SPAN calculates risk for all enterprise levels on derivative and non‐derivative instruments
at numerous exchanges and clearing organizations worldwide.
Spark Spread: The differential between the price of electricity and the price of natural gas or other fuel
used to generate electricity, expressed in equivalent units. See Gross Processing Margin.
SPDC: See Significant Price Discovery Contract.
Specialist System: A type of trading formerly used for the exchange trading of securities in which one
individual or firm acts as a market‐maker in a particular security, with the obligation to provide fair and
orderly trading in that security by offsetting temporary imbalances in supply and demand by trading for
the specialist’s own account. Like open outcry, the specialist system was supplanted by electronic trading
during the early 21st century. In 2008, the New York Stock Exchange replaced the specialist system with
a competitive dealer system. Specialists were converted into Designated Market Makers who have a
different set of privileges and obligations than specialists had.
Speculative Bubble: A rapid run‐up in prices caused by excessive buying that is unrelated to any of the
basic, underlying factors affecting the supply or demand for a commodity or other asset. Speculative
bubbles are usually associated with a “bandwagon” effect in which speculators rush to buy the
commodity (in the case of futures, “to take positions”) before the price trend ends, and an even greater
rush to sell the commodity (unwind positions) when prices reverse.
Speculative Limit: See Speculative Position Limit.
Speculative Position Limit: The maximum position, either net long or net short, in one commodity future
(or option) or in all futures (or options) of one commodity combined that may be held or controlled by
82 A PRIL 2011

one person (other than a person eligible for a hedge exemption) as prescribed by an exchange and/or by
the CFTC.
Speculator: In commodity futures, a trader who does not hedge, but who trades with the objective of
achieving profits through the successful anticipation of price movements.
Split Close: A condition that refers to price differences in transactions at the close of any market session.
Spot: Market of immediate delivery of and payment for the product.
Spot Commodity: (1) The actual commodity as distinguished from a futures contract; (2) sometimes used
to refer to cash commodities available for immediate delivery. See Actuals or Cash Commodity.
Spot Month: The futures contract that matures and becomes deliverable during the present month. Also
called Current Delivery Month.
Spot Price: The price at which a physical commodity for immediate delivery is selling at a given time and
place. See Cash Price.
Spread (or Straddle): The purchase of one futures delivery month against the sale of another futures
delivery month of the same commodity; the purchase of one delivery month of one commodity against
the sale of that same delivery month of a different commodity; or the purchase of one commodity in one
market against the sale of the commodity in another market, to take advantage of a profit from a change
in price relationships. The term spread is also used to refer to the difference between the price of a
futures month and the price of another month of the same commodity. A spread can also apply to
options. See Arbitrage.
Squeeze: A market situation in which the lack of supplies tends to force shorts to cover their positions by
offset at higher prices. Also see Congestion, Corner.
SRO: See Self‐Regulatory Organization.
Stop‐Close‐Only Order: A stop order that can be executed, if possible, only during the closing period of
the market. See also Market‐on‐Close Order.
Stop Limit Order: A stop limit order is an order that goes into force as soon as there is a trade at the
specified price. The order, however, can only be filled at the stop limit price or better.
Stop Logic Functionality: A provision applicable to futures traded on the CME’s Globex electronic trading
system designed to prevent excessive price movements caused by cascading stop orders. Stop Logic
Functionality introduces a momentary pause in matching (Reserved State) when triggered stops would
cause the market to trade outside predefined values. The momentary pause provides an opportunity for
additional bids or offers to be posted
Stop Loss Order: See Stop Order.
A PRIL 2011 83

Stop Order: This is an order that becomes a market order when a particular price level is reached. A sell
stop is placed below the market, a buy stop is placed above the market. Sometimes referred to as stop
loss order. Compare to market‐if‐touched order.
Straddle: (1) See Spread; (2) an option position consisting of the purchase of put and call options having
the same expiration date and strike price.
Strangle: An option position consisting of the purchase of put and call options having the same
expiration date, but different strike prices.
Strategy‐Based Margining: A method for setting margin requirements whereby the potential for gains on
one position in a portfolio to offset losses on another position is taken into account only if the portfolio
implements one of a designated set of recognized trading strategies as set out in the rules of an
exchange or clearing organization. Also see Portfolio Margining.
Street Book: A daily record kept by futures commission merchants and clearing members showing
details of each futures and option transaction, including date, price, quantity, market, commodity,
future, strike price, option type, and the person for whom the trade was made.
Strike Price (Exercise Price): The price, specified in the option contract, at which the underlying futures
contract, security, or commodity will move from seller to buyer.
Strip: A sequence of futures contract months (e.g., the June, July, and August natural gas futures
contracts) that can be executed as a single transaction.
STRIPS (Separate Trading of Registered Interest and Principal Securities): A book‐entry system operated
by the Federal Reserve permitting separate trading and ownership of the principal and coupon portions
of selected Treasury securities. It allows the creation of zero coupon Treasury securities from designated
whole bonds.
Strong Hands: When used in connection with delivery of commodities on futures contracts, the term
usually means that the party receiving the delivery notice probably will take delivery and retain
ownership of the commodity; when used in connection with futures positions, the term usually means
positions held by trade interests or well‐financed speculators.
Support: In technical analysis, a price area where new buying is likely to come in and stem any decline.
See Resistance.
Swap: In general, the exchange of one asset or liability for a similar asset or liability for the purpose of
lengthening or shortening maturities, or otherwise shifting risks. This may entail selling one securities
issue and buying another in foreign currency; it may entail buying a currency on the spot market and
simultaneously selling it forward. Swaps also may involve exchanging income flows; for example,
exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa,
84 A PRIL 2011

while not swapping the principal component of the bond. Swaps are generally traded over‐the‐counter.
See Commodity Swap.
Swap Dealer (AS): An entity such as a bank or investment bank that markets swaps to end users. Swap
dealers often hedge their swap positions in futures markets. Alternatively, an entity that declares itself a
“Swap/Derivatives Dealer” on CFTC Form 40.
Swaption: An option to enter into a swap—i.e., the right, but not the obligation, to enter into a specified
type of swap at a specified future date.
Switch: Offsetting a position in one delivery month of a commodity and simultaneous initiation of a
similar position in another delivery month of the same commodity, a tactic referred to as
“rolling forward.”
Synthetic Futures: A position created by combining call and put options. A synthetic long futures position
is created by combining a long call option and a short put option for the same expiration date and the
same strike price. A synthetic short futures contract is created by combining a long put and a short call
with the same expiration date and the same strike price.
Systematic Risk: Market risk due to factors that cannot be eliminated by diversification.
Systemic Risk: The risk that a default by one market participant will have repercussions on other
participants due to the interlocking nature of financial markets. For example, Customer A’s default in X
market may affect Intermediary B’s ability to fulfill its obligations in Markets X, Y, and Z.
T
Taker: The buyer of an option contract.
TAS: See Trading at Settlement.
T‐Bond: See Treasury Bond.
Technical Analysis: An approach to forecasting commodity prices that examines patterns of price
change, rates of change, and changes in volume of trading and open interest, without regard to
underlying fundamental market factors. Technical analysis can work consistently only if the theory that
price movements are a random walk is incorrect. See Fundamental Analysis.
TED Spread: (1) The difference between the interest rate on three‐month U.S. Treasury bills and three‐
month LIBOR; (2) the difference between the price of the three‐month U.S. Treasury bill futures contract
and the price of the three‐month Eurodollar time deposit futures contract with the same expiration
month (Treasury Over Eurodollar).
Tender: To give notice to the clearing organization of the intention to initiate delivery of the physical
commodity in satisfaction of a short futures contract. Also see Retender.
Tenderable Grades: See Contract Grades.
A PRIL 2011 85

Terminal Elevator: An elevator located at a point of greatest accumulation in the movement of
agricultural products that stores the commodity or moves it to processors.
Terminal Market: Usually synonymous with commodity exchange or futures market, specifically in the
United Kingdom.
TIBOR (Tokyo Interbank Offered Rate): A daily reference rate based on the interest rates at which banks
offer to lend unsecured funds to other banks in the Japan wholesale money market (or interbank
market). TIBOR is published daily by the Japanese Bankers Association (JBA). See EURIBOR, LIBOR.
Tick: Refers to a minimum change in price up or down. An up‐tick means that the last trade was at a
higher price than the one preceding it. A down‐tick means that the last price was lower than the one
preceding it. See Minimum Price Fluctuation.
Time Decay: The tendency of an option to decline in value as the expiration date approaches, especially
if the price of the underlying instrument is exhibiting low volatility. See Time Value.
Time‐of‐Day Order: This is an order that is to be executed at a given minute in the session. For example,
“Sell 10 March corn at 12:30 p.m.”
Time Spread: The selling of a nearby option and buying of a more deferred option with the same strike
price. Also called Horizontal Spread.
Time Value: That portion of an option's premium that exceeds the intrinsic value. The time value of an
option reflects the probability that the option will move into‐the‐money. Therefore, the longer the time
remaining until expiration of the option, the greater its time value. Also called Extrinsic Value.
Total Return Swap: A type of credit derivative in which one counterparty receives the total return
(interest payments and any capital gains or losses) from a specified reference asset and the other
counterparty receives a specified fixed or floating cash flow that is not related to the creditworthiness of
the reference asset. Also called total rate of return swap, or TR swap.
To‐Arrive Contract: A transaction providing for subsequent delivery within a stipulated time limit of a
specific grade of a commodity.
Trade Option: A commodity option transaction in which the purchaser is reasonably believed by the
writer to be engaged in business involving use of that commodity or a related commodity.
Trader: (1) A merchant involved in cash commodities; (2) a professional speculator who trades for his
own account and who typically holds exchange trading privileges.
Trading Ahead: See Front Running.
Trading Arcade: A facility, often operated by a clearing member that clears trades for locals, where e‐
locals who trade for their own account can gather to trade on an electronic trading facility (especially if
the exchange is all‐electronic and there is no pit or ring).
86 A PRIL 2011

Trading at Settlement (TAS): An exchange rule which permits the parties to a futures trade during a
trading day to agree that the price of the trade will be that day’s settlement price (or the settlement
price plus or minus a specified differential).
Trading Facility: A person or group of persons that provides a physical or electronic facility or system in
which multiple participants have the ability to execute or trade agreements, contracts, or transactions by
accepting bids and offers made by other participants in the facility or system. See Many‐to‐Many.
Trading Floor: A physical trading facility where traders make bids and offers via open outcry or the
specialist system.
Transaction: The entry or liquidation of a trade.
Transfer Trades: Entries made upon the books of futures commission merchants for the purpose of:
(1) transferring existing trades from one account to another within the same firm where no change in
ownership is involved; (2) transferring existing trades from the books of one FCM to the books of another
FCM where no change in ownership is involved. Also called Ex‐Pit transactions.
Transferable Option (or Contract): A contract that permits a position in the option market to be offset by
a transaction on the opposite side of the market in the same contract.
Transfer Notice: A term used on some exchanges to describe a notice of delivery. See Retender.
Treasury Bills (or T‐Bills): Short‐term zero coupon U.S. government obligations, generally issued with
various maturities of up to one year.
Treasury Bonds (or T‐Bonds): Long‐term (more than ten years) obligations of the U.S. government that
pay interest semiannually until they mature, at which time the principal and the final interest payment is
paid to the investor.
Treasury Notes: Same as Treasury bonds except that Treasury notes are medium‐term (more than one
year but not more than ten years).
Trend: The general direction, either upward or downward, in which prices have been moving.
Trendline: In charting, a line drawn across the bottom or top of a price chart indicating the direction or
trend of price movement. If up, the trendline is called bullish; if down, it is called bearish.
UV
Unable: All orders not filled by the end of a trading day are deemed “unable” and void, unless they are
designated GTC (Good Until Canceled) or open.
Uncovered Option: See Naked Option.
Underlying Commodity: The cash commodity underlying a futures contract. Also, the commodity or
futures contract on which a commodity option is based, and which must be accepted or delivered if the
option is exercised.
A PRIL 2011 87

Variable Price Limit: A price limit schedule, determined by an exchange, that permits variations above or
below the normally allowable price movement for any one trading day.
Variation Margin: Payment made on a daily or intraday basis by a clearing member to the clearing
organization based on adverse price movement in positions carried by the clearing member, calculated
separately for customer and proprietary positions.
Vault Receipt: A document indicating ownership of a commodity stored in a bank or other depository
and frequently used as a delivery instrument in precious metal futures contracts.
Vega: Coefficient measuring the sensitivity of an option value to a change in volatility.
Vertical Spread: Any of several types of option spread involving the simultaneous purchase and sale of
options of the same class and expiration date but different strike prices, including bull vertical spreads,
bear vertical spreads, back spreads, and front spreads. See Horizontal Spread and Diagonal Spread.
Visible Supply: Usually refers to supplies of a commodity in licensed warehouses. Often includes floats
and all other supplies “in sight” in producing areas. See Invisible Supply.
Volatility: A statistical measurement (the annualized standard deviation of returns) of the rate of price
change of a futures contract, security, or other instrument underlying an option. See Historical Volatility,
Implied Volatility.
Volatility Quote Trading: Refers to the quoting of bids and offers on option contracts in terms of their
implied volatility rather than as prices.
Volatility Spread: A delta‐neutral option spread designed to speculate on changes in the volatility of the
market rather than the direction of the market.
Volatility Trading: Strategies designed to speculate on changes in the volatility of the market rather than
the direction of the market.
Volume: The number of contracts traded during a specified period of time. It is most commonly quoted
as the number of contracts traded, but for some physical commodities may be quoted as the total of
physical units, such as bales, bushels, or barrels.
Volume Weighted Average Price (VWAP): A method of determining the settlement price in certain
futures contracts. It is the average futures transaction price, weighted by volume, during a specified
period of time.
WXYZ
Warehouse Receipt: A document certifying possession of a commodity in a licensed warehouse that is
recognized for delivery purposes by an exchange.
Warrant: An issuer‐based product that gives the buyer the right, but not the obligation, to buy (in the
case of a call) or to sell (in the case of a put) a stock or a commodity at a set price during a specified
period.
88 A PRIL 2011

Warrant or Warehouse Receipt for Metals: Certificate of physical deposit, which gives title to physical
metal in an exchange‐approved warehouse.
Wash Sale: See Wash Trading.
Wash Trading: Entering into, or purporting to enter into, transactions to give the appearance that
purchases and sales have been made, without incurring market risk or changing the trader's market
position. The Commodity Exchange Act prohibits wash trading. Also called Round Trip Trading, Wash Sales.
Weak Hands: When used in connection with delivery of commodities on futures contracts, the term
usually means that the party probably does not intend to retain ownership of the commodity; when used
in connection with futures positions, the term usually means positions held by small speculators.
Weather Derivative: A derivative whose payoff is based on a specified weather event, for example, the
average temperature in Chicago in January. Such a derivative can be used to hedge risks related to the
demand for heating fuel or electricity.
Wild Card Option: Refers to a provision of any physical delivery Treasury bond or Treasury note futures
contract that permits shorts to wait until as late as 8:00 p.m. Chicago time on any notice day to
announce their intention to deliver at invoice prices that are fixed at 2:00 p.m., the close of futures
trading, on that day.
Winter Wheat: Wheat that is planted in the fall, lies dormant during the winter, and is harvested
beginning about May of the next year.
Writer: The issuer, grantor, or seller of an option contract.
Yield Curve: A graphic representation of market yield for a fixed income security plotted against the
maturity of the security. The yield curve is positive when long‐term rates are higher than short‐term rates.
Yield to Maturity: The rate of return an investor receives if a fixed income security is held to maturity.
Zero Coupon: Refers to a debt instrument that does not make coupon payments, but, rather, is issued at
a discount to par and redeemed at par at maturity.

A PRIL 2011 89

© OECD/IEA 2011. All Rights Reserved
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User’s Guide and Glossary to the IEA Oil Market Report

For information on the data sources, definitions, technical terms and general approach used in preparing
the Oil Market Report (OMR), Medium-Term Oil and Gas Markets (MTOGM) and Annual Statistical Supplement
(current issue of the Statistical Supplement dated 11 August 2010), readers are referred to the Users’
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price assessments are based on daily Platts prices, converted when appropriate to US$ per barrel
according to the Platts specification of products (© 2011 Platts - a division of McGraw-Hill Inc.).
The Oil Market Report is published under the responsibility of the Executive Director and
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companies, neither governments nor companies necessarily share the Secretariat’s views
or conclusions as expressed therein. © OECD/IEA 2011
OTC Commodity Derivatives
Trade Processing Lifecycle Events
An ISDA Whitepaper
April 2012
This whitepaper provides a summary of key trade processing lifecycle events in the over-the-
counter (OTC) commodity derivatives markets, with an overview of the current state of
processing, related issues and opportunities for further improvement. Additionally, the paper
analyzes existing and potential opportunities for further standardization in these markets.
For further information, contact:

Nichole Framularo
nframularo@isda.org
www.isda.org
©2012 International Swaps and Derivatives Association, Inc.

2
TABLE OF CONTENTS
SECTION I: OTC COMMODITY DERIVATIVES MARKET OVERVIEW ......................................4

1. INTRODUCTION............................................................................................................. 4
2. CURRENT LEVEL OF STANDARDIZATION IN THE COMMODITY DERIVATIVES MARKETS . 4
3. EXECUTION .................................................................................................................. 7
4. CONFIRMATION ............................................................................................................ 7
5. SETTLEMENT ................................................................................................................ 7
6. CLEARING – CCPS ....................................................................................................... 8
7. TRANSPARENCY ........................................................................................................... 8
8. FUTURE STANDARDIZATION INITIATIVES ................................................................... 10
SECTION II: SUMMARY OF COMMODITY MARKETS' TRADE PROCESSING LIFECYCLE
EVENTS................................................................................................................................................11
1. TRADE CAPTURE AND REVISIONS ............................................................................... 11
(a) Initial Trade Capture ................................................................................. 11
(b) Trade Capture Revisions ........................................................................... 11
2. CONTROLS PROCESSING ............................................................................................. 11
(a) Broker Recap ............................................................................................ 11
(b) Counterparty Affirmation ......................................................................... 12
(c) Confirmation ............................................................................................. 12
3. SETTLEMENTS ............................................................................................................ 13
(a) Pre-Settlement Activity............................................................................. 13
(b) Post-Settlement Activity ........................................................................... 13
(c) Nuances to Settlements Activity in Commodities .................................... 13
4. OPTION EXERCISE ...................................................................................................... 19
(a) Financially Settled Options ....................................................................... 19
(b) Physically Settled Options ........................................................................ 19
5. COLLATERAL MARGINING .......................................................................................... 19
6. CLOSE-OUTS .............................................................................................................. 20
(a) Terminations ............................................................................................. 20
(b) Trade Compressions.................................................................................. 20
(c) Assignments and Novations ...................................................................... 20
7. NATURAL MATURITY ................................................................................................. 20
SECTION III: CURRENT STATE OF LIFECYCLE EVENT PROCESSING ...................................21
1. TRADE CAPTURE AND REVISIONS ............................................................................... 21
(a) Initial Trade Capture ................................................................................. 21
(b) Trade Capture Revisions ........................................................................... 21
2. CONTROLS PROCESSING ............................................................................................. 21
(a) Broker Recap ............................................................................................ 21
(b) Counterparty Affirmation ......................................................................... 21
(c) Confirmation ............................................................................................. 21
3. SETTLEMENTS ............................................................................................................ 22
4. OPTION EXERCISE ...................................................................................................... 22
OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

3
(a)Financially Settled Options ....................................................................... 22

(b)Physically Settled Options ........................................................................ 22
5. COLLATERAL MARGINING .......................................................................................... 22
6. CLOSE-OUTS ............................................................................................................... 23
(a) Terminations ............................................................................................. 23
(b) Trade Compressions.................................................................................. 23
(c) Assignments and Novations ...................................................................... 23
7. NATURAL MATURITY ................................................................................................. 23
SECTION IV: ISSUES WITH CURRENT PROCESS ........................................................................24
SECTION V: POTENTIAL END STATE............................................................................................28
SECTION VI: CONCLUDING REMARKS ........................................................................................28
ANNEX A: BEST PRACTICE GUIDELINES FOR ELECTRONIC CONFIRMATION
MATCHING .........................................................................................................................................30
ANNEX B: KEY INDUSTRY FORUMS ............................................................................................37
ANNEX C: ISSUES WITH CURRENT PROCESS (REF. SECTION IV(A)) BY LIFECYCLE
EVENT TYPE .......................................................................................................................................38

4
SECTION I: OTC COMMODITY DERIVATIVES MARKET OVERVIEW
1. Introduction
In March 2011, the International Swaps and Derivatives Association (ISDA) Commodities
Steering Committee (COSC) and Commodities Major Dealers Implementation Group (CMD)
made a commitment to global supervisors1 to continue to drive a high level of product, processing
and legal standardization, with a goal of securing further operational efficiency, mitigating
operational risk and increasing the netting and clearing potential for appropriate products.2 This
whitepaper (the Paper) analyzes existing and, where appropriate, potential opportunities for
further standardization in the over-the-counter (OTC) commodity derivatives market.
Additionally, the Paper includes a summary of key commodities’ trade processing lifecycle
events, aligned, where appropriate, with established industry programs concerning metrics,
documentation and electronic processing3.
Listed trades and cleared OTC trades have been specifically excluded from the scope of this
Paper due to the high degree of automation inherent in the processing of such trade types.
2. Current level of standardization in the commodity derivatives markets
OTC commodity derivatives have been in existence for centuries, far longer than some of the
other OTC derivatives asset classes. The vast majority of commodity derivatives products have
become standardized over time and, since the 1990s, additional standardization has occurred with
a specific focus on electronic confirmation, lifecycle event processing and clearing.
OTC commodity derivatives are a highly standardized asset class with the majority of its turnover
occurring on regulated exchanges globally. The ISDA Commodities Steering Committee
conducted a 2010 survey of members to ascertain the volume of financial oil business that is
conducted on exchange or cleared OTC. The essential conclusion from this survey was that the
significant majority of business is conducted through exchange or is cleared,4 meaning that the
data is readily accessible in support of post-trade transparency. There is a proportion of business
that is more structured in nature which will be client driven, with the payouts, contract terms and
collateral arrangements designed to meet the risk management needs and requirements of the
particular target end-user client base.
Within the OTC commodity derivatives market there is already a high degree of standardization.
The OTC commodity derivatives market features:
 Well-understood product mechanics

 Robust, proven legal framework
1
See the March 2011 Supervisory Commitment Letter available via
http://www2.isda.org/attachment/MjkwMw==/Supervisory_Commitment_Letter-31_March_2011_FINAL.pdf.
2
Recognizing that standardization is only one of a number of criteria for clearing eligibility.
3
Please note that there are various proposed and final regulations implementing the Dodd-Frank Act in regard to trade
reporting, processing, execution and confirmations. These best practices are meant as guidelines prior to the formal implementation
of regulatory requirements.
4
According to the survey, approximately 55% of OTC financial oil for all counterparties is conducted via exchange, 19% is cleared
and the remaining 26% is OTC.

5
 Standardized documentation5
 Electronic trade affirmation / legal confirmation
 Extensive electronic execution capabilities
 Active clearing across a variety of central clearing counterparties (CCPs)
 High and improving rates of straight-through-processing (STP)
 Robust bilateral settlement
The OTC commodity derivatives market benefits from a diversity of market participants ranging
from commercial producers to local energy distribution companies to banks.6 Many individual
asset classes are covered within the broader commodities umbrella. The OTC commodity
derivatives market is comprised of several different market segments including the trading of
agriculture, base metals, coal, commodity index products, crude oil, emissions, freight, gas, oil
products, plastics products, power, precious metals and weather.7 Therefore, the concentration of
market risk is diversified and not in any one particular product. A large amount of commercial
information in relation to OTC commodity derivatives transactions is already publicly available
from commercial service providers.8
2.1 Definitions
Almost all OTC commodity derivative trades are executed under standard legal terms. Typically,
they are contained in the ISDA Master Agreement between the parties, although in a limited
number of cases they are contained in the national equivalent such as Rahmenvertrag in
Germany, AFB in France (or in another master agreement between the parties). At the trade level,
the standard trade incorporates the ISDA definitions, supplements, protocols and other
documentation as set forth for that particular product in the ISDA Commodities Documentation
Matrix, all of which have been developed over the past decade. This development has included
incremental modification and standardization over time in order to make trades on the same
underlying, to the same maturity date fungible in order to facilitate compression and clearing,
where appropriate. For trades confirmed electronically, these standard provisions are typically
incorporated via the rules and procedures governing use of the platform. For trades confirmed on
paper, these standard provisions are usually incorporated via the relevant standard documentation
forms. It is important to note that standardized agreements still require bilateral agreement for
novations.
2.2 Contracts
Across the OTC commodity derivatives market, the vast majority of all contracts are confirmed
electronically via confirmation matching platforms. To date, more than 85% of eligible inter-
CMD metals trades and 90% of energy trades are confirmed electronically. There is no material
backlog of unexecuted confirmations.9 The small subset of transactions that are not confirmed
electronically are confirmed via paper. The monthly metrics provided by the CMD also include
data on G15 to non-G15 electronic matching. The metrics indicate that the average percentage of
5
The ISDA Commodities Documentation Matrix summarizes various types of OTC commodity derivatives documentation and their
current state. The Documentation Matrix is also available on the ISDA website via the following link:
http://www2.isda.org/functional-areas/market-infrastructure/commodity-derivatives.
6
The G15 comprise approximately 24% of the OTC commodity derivatives market, according to the Q4 2011 metrics reporting.
7
See ISDA Commodities Documentation Matrix: http://www2.isda.org/functional-areas/market-infrastructure/commodity-
derivatives.
8
See service providers list on page 17.
9
The level of outstanding confirmations continues to fall, with the business days outstanding Q4 2011 average at 0.059, down from
0.106 for Q3 2010. Source: Markit Metrics.

6
total volume that is electronically eligible has increased for G15 to non-G15 transactions from
70% in March 2009, trending at around 90% across all quarters in 2010 and into 2011, and has
shown a steady 95% average for the G15-to-G15 transactions.10
The confirmation matching process is accomplished by the bilateral electronic submission or

affirmation of confirmable transaction details by each party to the trade. Any unmatched trades
(or unmatched fields of linked trades) are investigated and resolved by the parties to the
trade. The electronic confirmation platforms provide both detail and summary analysis of the
current status of all transactions within their respective platforms for efficient risk management of
the confirmation process. Market participants have well-established processes for escalation and
resolution of trade breaks.
2.3 Market Practices
Standardized Terms:
OTC commodity derivatives transactions are effectively standardized through product templates
and market practice standards for the majority of non-economic fields. The industry framework
enables end users to customize transactions to meet their specific requirements without having to
forego the benefits that a standardized infrastructure delivers.
2.4 Lifecycle Events
Confirmable Events:
 New trades
 Amendments
 Partial unwinds
 Notional increases/decreases (relative to commodity index transactions)
 Novations/partial novations
As outlined above, electronically eligible activity on trades is typically confirmed via electronic
confirmation mechanisms or bi-lateral agreement to modify master agreements and supporting
annexes. This item will be further discussed later in this Paper.
2.5 Other Standardization Features
STP: The OTC commodity derivatives market has developed a very high level of straight-
through-processing (STP). From the use of electronic trade booking to central clearing
counterparty (CCP) processing, the industry continues to leverage the established infrastructure to
drive further efficiency in trade processing and a reduction in operational risk.11
CCPs: central clearing has been in place for a number of years across a variety of products. See
below for further information.
Collateral: For non-cleared transactions, there is widespread use of bilateral collateral

arrangements (via the ISDA Credit Support Annex (CSA), and approximately 60% of all
10
Source: Markit Metrics
11
See ISDA 2011 Operations Benchmarking Survey; available via http://www2.isda.org/functional-areas/research/surveys/operations-
benchmarking-surveys.

7
commodity derivatives trades are subject to such arrangements.12 Additionally, the dealers in the
CMD are meeting the daily reconciliation requirements for portfolios greater than 500 trades,13 in
line with the ISDA Collateral Steering Committee commitments. There has been significant
progress with regard to agreement for standardization of fields needed to improve portfolio
reconciliation matching rates, as well as setting the groundwork for the commodities trade
repository.
3. Execution
OTC commodity products are traded across both exchange and OTC venues, providing adequate
pre-trade transparency to market participants. A significant percentage of the commodity futures,
options and forwards are executed on exchanges and settled via central counterparties. In terms of
pre-trade execution venues, there are voice execution venues, electronic trading venues and
exchanges available. Hence, exchanges, brokers, MTFs and clearing houses14 provide data that is
already sufficient to their participants on the most pricing-relevant transactions.
4. Confirmation
As highlighted above, the combination of the established documentation and electronic

affirmation/confirmation rates means that there is a highly standardized and efficient legal
framework in place. Market participants and supervisors continue to work with the confirmation
platform providers to expand the population of transactions covered by electronic confirmation.
Continued industry efforts, in conjunction with continued documentation take-up,15 will move
more types of products onto electronic confirmation platforms and will further mitigate risks and
increase automation in this process. For cleared transactions, the prime record of the transaction is
automatically processed and maintained within the respective CCP.
5. Settlement
Current levels of nostros breaks outstanding on bilateral trades are extremely low, evidencing the
effectiveness of existing settlement mechanisms.16 These are typically managed via in-house
automated derivatives processing systems and via standardized messaging to correspondent
banks, with any settlement netting pre-agreed on a bilateral basis.
Additionally, all cleared transactions have settlement automatically executed via the respective
clearing process.
12
According to the ISDA 2011 Margin Survey; available via http://www2.isda.org/functional-areas/research/surveys/margin-surveys.
13
Achieving matching rates greater than 97%.
14
See 'Execution and Clearing' appendix for further information in relation to a sample list of various service providers that offer these
types of services.
15
See ISDA Documentation Matrix via http://www.isda.org/publications/isdacommderivdefsup.aspx.
16
See ISDA 2011 Operations Benchmarking Survey; available via http://www2.isda.org/functional-areas/research/surveys/operations-
benchmarking-surveys .

8
6. Clearing – CCPs
The OTC commodity derivatives market has a significant number of central counterparty and
clearing infrastructures in place today. Examples include:
 Agriculture CME Clearing / ICEClear US

 Base Metals LCH / CME ClearPort
 Coal CME ClearPort
 Crude Oil ICEClear / CME ClearPort/ NGX
 Emissions ICEClear / NOS Clearing / ECC / CME GreenEx
 Freight NOS Clearing / LCH
 Gas European Commodities Clearing (ECC) / ICEClear /
CME ClearPort / APX / NGX
 Oil Products ICEClear / CME ClearPort
 Plastics Products LCH
 Power European Commodities Clearing (ECC) / APX /
ICEClear / CME ClearPort / NGX
 Precious Metals LCH / CME ClearPort
 Weather CME ClearPort
 A significant percentage of the commodity futures, options and forwards are executed on
exchanges and settled via central counterparties.
 Several of the institutions named above provide for central counterparties for non-exchange-
traded transactions.
 Based on Q4 2011metrics provided by the CMD, ~30% of the CMD OTC commodity
derivatives are settled via central counterparties (~50% for Energy) ); YTD 2011 metrics17
evidence an uptick in energy cleared OTC in line with increased overall reported volumes.
7. Transparency
The OTC commodity derivatives market is relatively transparent (pre and post-trade), with a
significant proportion of transactions centrally cleared, electronically confirmed and bilaterally
collateralized.18 The market is a heterogeneous market, although there are some market niches
with great standardization. Market participants are varied and financial investors coexist with
non-financial investors, whose main purpose is to hedge risk. Additionally, there are several
different market segments that allow for diversification of product risk.
The OTC commodity derivatives market already provides central clearing for swaps that are
suitable to be centrally cleared. Based on monthly metrics provided by the CMD, over 35% of
17
Note: Volume reported to the supervisory community includes OTC financial, physical and cleared OTC products transactions with
G15 and non-G15 counterparties and clients. Listed derivatives volume is reported separately (at present) to the CFTC and other
supervisors.
18
See http://www.meti.go.jp/english/press/data/20101109_02.html, which includes output from the ISDA COSC process and
partnership with FRB-NY and the co-chairs of the IOSCO Commodities Futures Task Force (UK FSA and CFTC). Also see
http://isda.org/c_and_a/pdf/CMD-CommoditiesSupervisoryLetter.pdf.

9
their OTC commodity derivatives are settled via central counterparties (over 45% for Energy).
Other market-led initiatives include monthly reporting on a number of key performance
indicators, a 61% decrease in the gross number of outstanding confirmations since September
2008 and an increase in the average percentage of total volume that is electronically eligible from
52% (Dec 07) to a high of 70% (March 09).19
7.1 Pre-Trade Transparency
There is excellent pre-trade transparency, via a variety of platforms, to a wide array of end-users.
The sources of pre-trade information that the OTC commodity derivatives markets utilize include
brokers, price reporting agencies, electronic trading platforms and bilateral price discovery
methodologies. The sources of post-trade information utilized within the OTC commodity
derivatives markets include electronic trading platforms, electronic confirmation services, and
clearing venues.
Pre-trade transparency is available via a variety of mechanisms including exchanges, brokerages,

electronic trading platforms and bilateral arrangements. Pre-trade information in relation to
exchange prices can be accessed on reasonable commercial terms. The information is
consolidated via exchanges, electronic trading platforms and major dealer pricing information.
There is already a highly developed exchange-traded market with high levels of consolidated pre-
trade transparency. At present, there does not seem to be demand for additional pre-trade
transparency for non-standardized OTC deals.
The vast majority of OTC transactions in commodity derivatives markets are priced with
reference to readily observable market prices (either a benchmark futures contract or physical
underlying).. Potential drawbacks include exposing firms’ proprietary positions that could impact
trade size and frequency. Also, there are potential risks to liquidity and the willingness of market
participants to commit liquidity. There are no clear benefits on what would accrue as a result of
increased pre-trade transparency, particularly in respect of non-standardized bilateral OTC
contracts, as the pricing of each deal is different and takes into account a wide range of factors
specific to that deal (i.e, creditworthiness of counterparty, physical market conditions, etc.). In a
market where market participants are hedging against specific risks, pre-trade transparency would
do little good and significant harm (exposing commercially sensitive risk positions to other
market participants). Ill-conceived pre- and post-trade transparency requirements for commodity
derivatives risk negatively impacting liquidity and exacerbating volatility in the market.20
7.2 Post-Trade Transparency
Post-trade transparency is available to global supervisors, who receive reports on a regular basis.
Commodity derivative volume reported to the supervisory community includes OTC financial,
physical and cleared OTC products transactions with CMD and non-CMD counterparties and
clients. Listed derivatives volume is reported separately (at present) to the CFTC and other
supervisors. Post-trade transparency is available to the broader marketplace via commercial
venues and processes that provide various types of information, examples below.
19
20
Additionally, CESR and ERGEG, in their advice to the European Commission “came to the conclusion that there is no need to take
action in relation to purely bilateral trading which often is so bespoke that transparency information would not add materially to the
price discovery process”.

10
 CCPs: Clearinghouses provide end of day prices for contracts that are eligible to be
cleared. The clearinghouse end-of-day process typically requires executable pricing from
all participating members.
 Valuation Reports: Another important source of post-trade transparency to clients can

be found in the valuation reports that are provided to clients by dealers, which typically
include a position level mark-to-market valuation on the positions that the client has
facing the dealer.
 Industry Metrics: There are extensive metrics across a variety of indicators provided to
primary regulators on a monthly basis providing strong transparency regarding the
performance of the industry in the areas identified as important by regulators.
8. Future Standardization Initiatives
8.1 Electronic Affirmation/Confirmation/STP
The markets continue to strive for further operational standardization. There is a strong industry
focus on the industry utilities keeping up with developing volumes in the marketplace. This is
tracked and managed via an established and mature reporting process that confirms the level of
penetration of electronic versus paper confirmation.
8.2 Trade Repository
In June 2011, the COSC selected DTCC/EFETnet to partner with them in building the
commodities trade repository. The industry has met its commitment to establish a central trade
reporting repository to deliver a first phase by Q1 2012.21 There are concerns in relation to the
likely proliferation of global, regional and local/country-specific trade repositories. The industry
view is that a single global trade repository per asset class would provide Supervisors and market
participants with valuable efficiencies.22 In particular, there would be no redundancy of platforms,
no need for additional levels of data aggregation and reduced risk of errors and greater
transparency. A single trade repository per asset class would avoid the risk of errors associated
with transmitting, aggregating and analyzing multiple sources of potentially incompatible and
duplicative trade data. A single global trade repository would also reduce the risk of reporting to
multiple repositories in different jurisdictions.
21
See 2011 March Supervisory Commitment Letter and ISDA Commodities Trade Repository RFP, available via www.isda.org.
22
See http://www2.isda.org/attachment/MzIwMg==/SwapData_Recordkeeping_and_ReportingRequirements_Pre-
Enactment_and_TransitionSwaps.pdf.

11
SECTION II: SUMMARY OF COMMODITY MARKETS' TRADE PROCESSING

LIFECYCLE EVENTS
The following bilateral OTC trade processing lifecycle events are considered in this Paper:
1. Trade Capture and Revisions initial trade capture, trade capture revisions
2. Controls Processing broker recap, counterparty affirmation, confirmation
3. Settlement pre-settlement activity, post-settlement activity
4. Option Exercise financially-settled options, physically-settled options
5. Collateral Margining
6. Close-Out terminations, trade compressions, assignments/novations
7. Natural Maturity
1. Trade Capture and Revisions
(a) Initial Trade Capture
Once a transaction has been executed, both of the parties to the trade must enter the full terms
of the transaction into their respective trade capture systems. The Trade Capture System,
either independently or through a technological interface, should provide robust, accurate,
reliable, real-time information related to credit risk, market risk and position exposure
management, as well as provide trade support functionality to enable processes such as
position verification, broker recaps, counterparty affirmations, confirmations, settlements,
collateral margining, and financial control.
(b) Trade Capture Revisions
Trade capture revisions can be categorized as either economic or non-economic.
Economic trade capture revisions can arise from any post-trade capture control processes,
including during the risk management and position verification processes, or the broker
recaps, counterparty affirmation and confirmation or settlements processes. The need for
these revisions may occur on or after trade date (T) according to the timeframe of the process
that highlights such need. Regardless of the source of identification of the need for the
revision, modifications to any existing transaction details recorded should always be done at
the trade capture level, and not within the downstream processing environment. economic
trade capture revisions will typically have an impact on downstream processing, such as the
need for a revised confirmation or a revised invoice being raised.
Non-economic trade capture revisions can also arise from post-trade capture. Examples
include an incorrectly identified broker, or a re-modeling of a transaction for internal
purposes, where such re-modeling maintains the original economic intent of the transaction
without altering the terms of the trade as agreed between the two parties. With the exception
of electronic broker matching, Non-economic trade capture revisions will typically have
minimal impact on downstream processing.
2. Controls Processing
(a) Broker Recap

12
For trades executed via a broker, the broker recap process typically occurs on T or T+1 for
standardized vanilla trade types (but may take place on a longer time frame for the more
structured trade types). Traditionally, the broker will send a written recap of the economic
details of the trade to both parties involved in the transaction by either facsimile or email.
However, there is now some take-up of both the ability of parties to download their own
broker recaps from a web portal, and also, increasingly, the available use of electronic broker
matching. This independent third-party verification of trade details is used by each of the two
contracting parties to validate the accuracy of their trade capture in order to gain confidence
that the economic details of the trade are correctly understood and reflected in the official
records of the parties concerned. This process often serves as the earliest point of risk
mitigation in correctly securing the economic details of the trade.
(b) Counterparty Affirmation
Counterparty affirmation also typically occurs on T or T+1. According to a party’s internal

organization and processes, the counterparty affirmation process may be done (i) only for
transactions that are traded direct (i.e, non brokered transactions) and which are not
confirmed with the counterparty by means of electronic matching, or (ii) for non-brokered
transactions irrespective of the method used for the counterparty confirmation, or (iii)
brokered and non-brokered trades which are not confirmed with the Counterparty by means
of electronic matching, or (iv) all trades. The process is performed between the two parties to
the transaction via telephone or through the delivery of a trade summary by email. It should
be noted that some parties choose not to participate in the verbal affirmation process because
their internal structural organization of resources’ responsibilities does not support this
lifecycle event.
(c) Confirmation
Confirmation is the process by which, either through electronic messaging or through the use
of paper confirmations, the parties legally memorialize the terms of the trade. Confirmation is
typically performed on T, or as soon as practical thereafter. Confirmation execution is the
process by which the two parties confirm their agreement to the full terms of the trade as set
out in the confirmation.
The parties may confirm a transaction by matching electronically on a bilateral basis, or on a

third-party vendor matching platform.
Paper confirmations may be created manually, systemically with some user interaction, or
systemically with full STP. According to the terms of any prevailing Master Agreement
and/or the governing law, confirmations may be legally binding by (i) one party signing and
returning the other party’s confirmation, (ii) an exchange of confirmations between the
parties, (iii) one party affirming their agreement to the terms of the confirmation by some
means but without actually signing the confirmation, or (iv) one party implying their
acceptance of the other party’s confirmation by virtue of not having disputed it within a given
specified timeframe.
Paper confirmations that are not executed/agreed by both parties may be an indication of
disagreement on the terms of the trade, and in such case a verbal counterparty affirmation of
the core economic trade details should occur between the parties pending the resolution of the
any legal, credit, or other provision(s) that remain in discussion.

13
For a more detailed discussion of the controls processing lifecycle events, CMD members
should refer, and adhere, to the Best Practice Guidelines as issued by the CMD, where
applicable. Parties not included in the CMD are referred to the Best Practice Guidelines on
Electronic Confirmation Matching for Commodities Products (which is based on the CMD
Guidelines) as issued by the ISDA Commodity Operations Working Group, and published on
the ISDA website (a copy of the current version is appended hereto as Annex A).
3. Settlements
(a) Pre-Settlement Activity
Settlement prices for transactions can be obtained either electronically or manually, but in
any event should be done on a timely basis, at the latest the opening of business on the day
following the day, or last day, of pricing in question.
When obtained electronically, the relevant prices are taken from the price source through a
technological interface, most commonly by way of a Logical Information Machine (LIM)
feed or a data scrape of a particular website.
When obtained manually, operations personnel will consult the appropriate price source
based on the relevant pricing convention for the particular trade type and commodity product
to be settled and manually input the relevant price(s). Best practices dictate that settlement
prices that are input by one person (Maker) should be verified by a separate person
(Checker).
Irrespective of whether the prices are taken by automated or manual means, they must be
input into a system or format that will ultimately be used for the purposes of trade valuation,
collateral margining and invoicing.
Once prices are updated and available for invoicing purposes, invoices are issued,
reconciliation occurs between the parties, and any discrepancies between the payment
amounts calculated by each of the parties are investigated and resolved. Payment affirmation
is then exchanged between the parties either in the form of affirmation of settlement amounts
or an exchange of invoices, and cash movements are effected for the correct value date.
(b) Post-Settlement Activity
Once cash movements are effected, operations personnel will conduct a nostro reconciliation
of ledger entries against cash movement. Discrepancies between cash and ledger entries are
typically the result of failure to pay, underpayment or overpayment of agreed amounts,
inadvertent payment to a different legal entity, or withholding of wire transfer fees.
Operations personnel will investigate the discrepancies and resolve the matter via their
individual organization’s escalation controls, procedures and processes, but always with the
goal of obtaining complete and accurate recording of cash movements (or exceptions) to the
general ledger.
(c) Nuances to Settlements Activity in Commodities
Bilateral Settlements consist of the settlement of (i) financial transactions and (ii) physical
transactions for which delivery either occurs or is “booked out” by another physical
transaction with similar characteristics.

14
Settlement frequency varies according to trade type and commodity product. For example:
 Financial transactions are typically settled a specific number of days after the final
pricing date of the relevant pricing period, depending on the market convention for the
underlying commodity product. For transactions involving calendar monthly pricing
periods, this often results in a high volume of settlements on a few specific days during
the early part of the following month. For financial transactions with pricing periods that
comprise a single day, settlements will occur throughout the month, on the specified day
after the pricing period. Option premiums are typically settled a specific number of days
after the trade date, although they can also be netted with the final settlement.
 Precious metals and base metals settlement takes place on the day of delivery of the
commodity.
 Transactions where physical delivery of electricity or gas occurs possess product-specific

settlement conventions, where the delayed settlement provides for reconciliation of
physical deliveries and book-out of transactions between counterparties at delivery points
on natural gas pipelines and within electricity ISOs and RTOs, or at other regional
scheduling locations on the grid. For example:
 North American Physical Power and European and UK Physical Natural Gas
transactions settle on a monthly cycle 20 days after the end of the delivery
month;
 UK Physical Power transactions settle on a monthly cycle 10 days after the end
of the delivery month; and
 North American Physical Gas transactions settle 25 days after the end of the
delivery month.
 Bilateral physical power settlements consists of the purchase and sale of electricity as it
moves across one or a series of power grids from point A to point B. Often times there
are “cuts” along the way as power that has been contracted is not actually delivered.
Investigating these curtailments in the power flow of buyers and sellers comprises a
significant portion of the settlement effort. However, each movement along the grid(s) is
tracked via a “tag” that aids in the investigation of the discrepancy. Power transacted with
an Independent System Operator (ISO) must be settled according to the ISO’s invoice
and timeline. Disputes may only be raised via the ISO’s dispute resolution service. ISOs
also remain risk neutral; for each settlement cycle they require that all receivable
payments are made before their payables are made, and if a participant fails to make a
scheduled payment, the ISO remits payment, resulting in a pro-rata shortfall to the paying
participants.
 Physical natural gas settlement is the settlement of the purchase, sales, storage, or
transportation of natural gas either between parties or via a natural gas pipeline. Since
physical natural gas being delivered from point A to point B may involve various parties
and/or pipelines, imbalances may occur as the result of imbalances along the path.
Volume actualization between the parties in the “daisy chain” comprises a significant
portion of the settlement effort. The resolution process is manual and paper intensive, and
takes place using data obtained from each individual pipeline’s Electronic Bulletin Board
(EBB). CMD members should adhere to any Best Practice Guidelines as issued by the
CMD, where applicable.

15
 As a result of the physical power curtailments and physical natural gas imbalances
mentioned above, it is not atypical for portions of these invoices to have incomplete
reconciliation for several months (or longer) after the initial settlement cycle.
 Physical oil settlements vary in frequency and process by the type of product and
transportation mode on the transaction and are governed by the individual purchase/sale
contract. For waterborne transactions (barges and vessels of varying sizes), payment
terms generally range from prepayment based on an estimated volume or estimated price,
to monthly settlements in the month following delivery. For pipeline transactions, a
similar range can be seen, but with the majority of the US refined product pipeline
business transacted under two-day payment terms after movement and receipt of the
invoice and backing documentation from the pipeline company. Although some of the
liquidly traded physical oil transactions are booked out against a chain of other
counterparty trades or bilaterally with a single opposing trade with the same counterparty,
most oil trades go to physical delivery and settlement. These transactions, like the power
and gas transactions described above, have to be “actualized” with actual volumes, dates,
and product quality measurements based on what actually occurred. Thus two settlements
are often required: a Provisional settlement for the estimated quantity and quality, and a
Final settlement to true up to the actual amount due.
In addition, some parties participate in payment netting in those instances where different
commodity products settle on the same payment date and in the same currency.
(d) Current Settlement Process
(i) Over-the-Counter (OTC) Trades
The OTC commodity derivatives settlement process is a date-driven process. Certain key
dates each month correspond to the settlement of different products. In many cases, specific
products are settled only once a month. For example:
 Many financial commodities (such as gas, crude and refined products) settle five business
days after completion of pricing; and
 US financial power settles on the 10th business day of the month.
 Physical commodities also have different settlement conventions based on the product
and region. For example:
o North America physical power settles on the 20th calendar day of the month
following flow month;
o North America physical gas settles on the 25th calendar day of the month
following flow month;
o European physical natural gas settles on the 20th calendar day of the month
following flow month; and
o Spot precious metals trade for spot value, which is two business days after the
trade date.
The longer settlement times on physical energy products is reflective of the greater amount of
reconciliation required in the event of a discrepancy due to the dependence upon
transportation statements. Power prices are published on an hourly basis or, in some cases,
every 15 minutes, which results in a large number of resets which need to be reconciled when

16
a discrepancy arises. In the event that agreement is not reached by parties by the settlement
date, the undisputed amount is often paid.
The settlement calculation for physical transactions is volume multiplied by price. Prices are
either agreed upon at the time of the transaction (“fixed”) or settled against a published index
(“floating”; ex. Platts Gas Daily).Some products require a provisional invoice since the
quantity, the price or even both may not be known at the time at which a provisional payment
is required. Final settlement is then performed to true-up to actuals. It is not uncommon when
physical commodities are settled to see an “actualization”, where the contractual quantity is
updated to reflect the actual quantity delivered. In addition, physical power and gas add a
level of complexity as volumetric “cuts” need to be reconciled. Cut resolution can take
months as all upstream and downstream parties need to agree.
Settlement calculations for financial transactions are similar, volume multiplied by price, but
more than one price is involved. One price may be fixed and compared against an index price
(Fixed Swap) or there may be two index prices (Float-Float Swap or Basis Swap) multiplied
by the volume and settled against one another (e.g, 310,000 mmbtu * 3.50 versus 310,000
mmbtu * Gas Daily-Texok.) Swaps are always settled net; individual legs are never settled
gross. There also can be multiple prices with different weightings, which comprise a basket.
Typically, invoices are settled net, meaning multiple transactions settling on the same day
with the same counterparty in the same currency and same legal entity are netted together,
with only one party moving the cash. In some jurisdictions, such as the European markets, tax
requirements require sellers of physical commodities to invoice the counterparty for delivered
goods, and only sell trades are on the invoice.
Invoices include such relevant information as trade date, volume, fixed price and/or floating
price, and settlement amount per trade. As soon as practicable after all prices are known,
counterparties issue invoices to one another—and, in the case of physical gas, either on
nominated volumes or after volumes are actualized. Settlement affirmation is standard in the
industry, where parties confirm cash amounts prior to the settlement date. This practice
reduces settlement breaks and ensures that reconciliations are performed prior to cash
moving. This is a major contributing factor to the low rate of settlement fails across
commodities. According to the 2011 ISDA Operations Benchmarking Survey, the percent of
monthly settlement volume resulting in nostro breaks is only 8% across the industry.
There are a number of explanations for the low rate of outstanding settlement fails in
commodities, partly explained by the well-controlled confirmation processes below, which
allow for trade discrepancies to be remedied well in advance of settlement:
 The OTC commodity derivatives markets have a record of striving for electronic
confirmation Matching. Vendor solutions such as ICE eConfirm, EFETnet and SWIFT
have facilitated this approach. The industry continues to add both products and trade
types to these electronic platforms in order to decrease the number of trades requiring
paper confirmations. Additional vendors are also beginning to enter this market (e.g,
Markitwire and Misys).
 Many transactions are brokered by a third party. A broker recap is sent out (in addition to
the Confirmation) and is diligently checked to ensure that trade economics are accurately
booked.
 A number of market participants perform verbal confirmation of trade economics should
there be no type of affirmation by Trade Date + 1.

17
 Pre-settlement affirmation of cash flows identifies discrepancies early and allows for
reconciliations prior to settlement date.
 At times, the movement of the physical commodity serves as a pre-settlement affirmation
of economics, with the exception of price.
Discrepancies on physical transactions relate primarily to cuts in physical power and gas,
where the actual quantity of the delivered commodity is different from the contractual
quantity due to operational factors, e.g., congestion on the power grid. Each organization has
its own, essentially similar, process for reconciling volumes (i.e., the use of pipeline
statements and OATI tags) and, in the event of a volume discrepancy, the invoicing groups
work together and share support to resolve any differences. Scheduling groups, and in the
case of power, real-time trading desks, may get involved as well, to resolve volumetric
differences. Should a difference remain at settlement time, counterparties will advise one
another as to what the payment amount will be, and agree to continue working on the
disputed portion of the invoice. Counterparties typically have a shared interest in resolving
these outstanding items, so cooperation between counterparties is generally good. The UK
power and gas markets are structured differently from North America markets and
contractual obligations are usually met in full, with the financial impact of any changes in
delivered volumes often managed centrally.
(ii) Listed and OTC Cleared Trades
Although this Paper does not focus on the specifics of the markets for Listed Trades and
cleared OTC trades, OTC settlement risk in the OTC commodity derivatives markets has to
be considered in the context of the overall commodity settlement volume. A significant
percentage of commodities transaction volume is traded as futures and options on regulated
exchanges run by entities such as the following:
 the CME Group, which controls the New York Mercantile Exchange (NYMEX), Chicago
Board of Trade (CBOT) and Chicago Mercantile Exchange (CME);
 the Intercontinental Exchange, Inc. (ICE), which controls ICE Futures US and ICE
Futures Europe;
 Commodity Exchange (COMEX);
 London Metal Exchange (LME);
 NYSE Euronext LIFFE (LIFFE);
 Singapore Exchange (SGX);
 Dubai Mercantile Exchange (DME);
 European Energy Exchange (EEX); and
 Tokyo Commodity Exchange (TOCOM) offering commodity products globally.
The OTC commodity derivatives markets pioneered the development of central clearing of
OTC transactions. In the late 1990s, NYMEX was one of the first exchanges to offer the
ability to clear OTC contracts. Counterparty demand for alternate solutions to complement
bilateral collateral arrangements led to the development of a platform to clear OTC as futures
through NYMEX’s Clearport mechanism. The subsequent growth and success of OTC
clearing coincided with Enron's bankruptcy and subsequent credit instability in the energy
markets. In 2001, NYMEX Clearport provided the industry with the ability to clear centrally.
The continued credit instability experienced during the late 2001-2002 period re-enforced the
benefit of OTC clearing and its ability to provide capital efficiencies and access to a wide
range of products. Other commodity exchanges and clearing houses followed the NYMEX

18
example with ICE Clear, CME Clearport, LCH.Clearnet, European Commodities Clearing
(ECC), NOS Clearing, AsiaClear and many others offering central clearing of OTC products.
Examples of commodity central counterparty and clearing organizations today include:
 Gas Trading: ECC / ICEClear / CME Clearport / APX Group

 Base Metals Trading: LCH.Clearnet / CME Clearport
 Precious Metals Trading: LCH.Clearnet / CME Clearport
 Power Trading: ECC, APX Group
 Plastics Products Trading: LCH.Clearnet
 Oil Products Trading: ICEClear / CME Clearport (formerly NYMEX Clear)
 Crude Oil Trading: ICEClear / CME Clearport
 Coal Trading: CME ClearPort, ICEClear
 Freight Trading: NOS Clearing / LCH.Clearnet
 Agriculture Trading: CME Clearport / ICEClear US
 Emissions Trading: ICEClear / NOS Clearing / ECC
 Iron Ore Trading: AsiaClear, LCH Clearnet
To date, NYMEX has launched more than 650 OTC-cleared contracts,23 and ICE Clear24
more than 600. Market participants commonly use central clearing, and there is strong
competition between exchanges and clearing houses to launch new products providing capital
efficiencies and credit risk management. Some of the most recent examples include:
 ECC clearing contracts traded on the European Energy Exchange, European Energy
Derivatives Exchange and Powernext;
 NASDAQ and Nordpool working together to deliver central clearing services for UK
power;
 launch of Iron Ore OTC clearing by SGX/AsiaClear as well as LCH.Clearnet;
 launch of Coal Futures by EEX; and
 planned launch of gold forwards cleared by the CME Group, with LCH.Clearnet and
NYSE Euronext also offering gold clearing solutions.
Settlement risk is being reduced by the shift towards central clearing. The benefit of facing
the exchange on cleared trades rather than having bilateral OTC trades on with multiple
counterparts is (1) the reduction in counterparty credit risk and (2) the ability to net long and
short positions across a range of different product types, which may reduce the amount of
collateral that is required for posting. In December 2011, the CMD processed 443,492
commodity OTC derivatives transactions of which 68,894 (16%) were OTC-cleared.25
Central clearing combined with the ongoing efforts to increase electronic confirmation
matching has led to a significant continued decline in OTC settlement risk and a low number
of aging fails amongst the CMD group.
23
See www.cmegroup.com.
24
See www.theice.com.
25

19
4. Option Exercise
(a) Financially Settled Options
Financially settled options are options that can be exercised automatically if, by comparing
the reference price to the option strike price, the option is determined to be in-the-money. The
option buyer is not required to give notice of exercise to the option seller. The automatic
exercise will result in a payment by the option seller to the option buyer of the cash
settlement amount, which may be netted with other transactions of the same commodity type
and/or on the same settlement date. Financial settlement follows the same processes described
in the Settlements section above.
(b) Physically Settled Options
Physically settled options that are in-the-money at expiry will result in the creation of a new
transaction between the parties. The decision to exercise is based upon the value the option
buyer places on the underlying product. Most physically settled options require the option
buyer to notify the option seller (usually by telephone) by an agreed cutoff time on expiration
date.
Failure of the buyer to notify the seller by the cutoff time will result in the option expiring
worthless. The new trade may be a swap (settles financially) or a forward (settles physically)
depending on the nature of the option traded. Depending on the market convention for the
product, a written notice of exercise delivered to the option seller by the option buyer may be
required, and a confirmation may be generated for the new trade.
Margining is the process by which collateral calls are made and collateral is exchanged
between counterparties based on mark-to-market position valuation and the terms of the
credit agreement between them. For any trade included within the scope of the relevant
collateral provisions, collateral margining will commence the inclusion of that trade on T+1.
Credit terms may be documented in a CSA or similar document, and are incorporated into the
relevant Master Agreement. Credit terms may also be included in individual confirmations,
particularly the independent amount, which is a cushion of additional collateral pledged by
one party to the other that is held for the duration of the trade irrespective of the movement of
variation margin. The credit terms specify terms such as the frequency of valuation, timing of
margin calls, types of eligible collateral, minimum amounts of collateral that can be
transferred, and interest on collateral.
The ISDA Collateral Steering Committee has drafted both a Best Practices Whitepaper and a
Dispute Resolution Procedure, available on the ISDA website.26 Those documents are
incorporated by reference herein.
26
See www.isda.org

20
6. Close-Outs
(a) Terminations
At any time during the term of a transaction, the parties may agree to terminate the
transaction (i.e, end the trade early before its natural maturity date). The parties must agree on
the terms, timing, and any payment relating to such termination. A termination agreement
will be drafted and executed between the parties to memorialize this agreement.
(b) Trade Compressions
While the benefits of trade compression either by moving bilateral OTC trades to be cleared
OTC trades, or by participating in ‘tear-ups’, are recognized, a number of obstacles exist that
prevent wide-spread participation is such exercises. There is a separate Portfolio
Compression Working Group operating under remit from the COIG currently addressing
these issues through its membership.
(c) Assignments and Novations
At any time during the term of a transaction, the parties may agree that one or both parties
may transfer (by means of an assignment or a novation, as appropriate) their position to
another party, which may be either an affiliate or an external party. All parties to the transfer
must agree to the terms and timing of the transfer by executing either an assignment
agreement or novation agreement, as applicable.
Depending on the nature of the transfer, the parties to the new transactions created through
the transfer may draft the transfer agreement so that the New Transactions are either (i) re-
confirmed between the remaining parties by separate Confirmations, or (ii) considered to
have been re-confirmed between the remaining parties by way of the transfer agreement.
7. Natural Maturity
A transaction matures naturally when it has completed its term and all obligations under the
contract have been met. In this event, there is no impact on downstream processing.

21
SECTION III: CURRENT STATE OF LIFECYCLE EVENT PROCESSING
1. Trade Capture and Revisions
(a) Initial Trade Capture
Trade capture is automated for most electronic trading platforms. The trade details are
automatically fed to the risk system from external sources, greatly reducing the occurrence of
errors. Bilateral OTC trades are entered manually into the trading application by the trader,
marketer or trading assistant. Proper segregation of duties requires that trade capture is not
performed by anyone who has access to confirmation or settlement systems.
(b) Trade Capture Revisions
Revisions are automated for most electronic trading platforms. For the remaining trades,
revisions are performed manually by the trader, marketer or trading assistant. Again, proper
segregation of duties requires that revisions are not performed by anyone who has access to
confirmation or settlement systems.
2. Controls Processing
(a) Broker Recap
Affirmation is not required for trades that are counterparty-matched via an electronic
platform, because the match takes place on T+0 or T+1, in the same timeframe that
affirmation would normally take place. Electronically matched trades are binding, so the
affirmation becomes unnecessary. For non-electronically bilaterally matched trades, some
broker matching takes place electronically. However, the majority of broker affirmation is via
faxed broker recaps that are manually reconciled against the trade entry. For direct deals,
affirmation is manually performed via telephone or email.
(b) Counterparty Affirmation
Affirmation is not required for trades that are counterparty-matched via an electronic
platform, because the match takes place on T+0 or T+1, in the same timeframe that
affirmation would normally take place.
(c) Confirmation
Many OTC commodity derivatives transactions are electronically matched via an electronic
platform. The remaining transactions are executed via the use of paper confirmations. Metrics
regarding the use of electronic confirmation matching systems versus Paper Confirmations,
as between the members of the CMD, can be found in the Commodities Metrics Reports that
are published each calendar month.
By convention, in some physical markets, the seller’s terms govern the transaction. For these
trades only, the seller sends a confirmation (although in some cases the buyer may opt to also
send their confirmation), and in the absence of a rejection of any terms by the buyer, the
terms are deemed accepted.

22
3. Settlements
Settlement takes place after the receipt of a valid invoice agreed by the counterparty. Invoices
are sent by facsimile or email. In financial markets, the CMD and most high-volume
counterparties will also send Invoices, enabling a reconciliation of settlement amounts.
Alternatively, an exchange of settlement details only occurs if the paying party disputes the
invoice.
In physical markets, payment takes place after the receipt of a valid invoice, and if applicable
also only after receipt of the relevant shipping documents. Invoices are sent by email and
facsimile.
4. Option Exercise
(a) Financially Settled Options
Because the exercise process for most financially settled options is automatic, trading and
settlement systems are typically designed to calculate the settlement amount (or zero
settlement amount for options which expire out of the money) without manual intervention.
These cash settlement amounts can be grouped with other derivatives payments and settled as
set out in Section III.3 Settlements.
(b) Physically Settled Options
As explained in Section II.4.(b), the decision to exercise a physically settled option is

typically a commercial decision made by the option buyer. If exercised, two processes must
take place. The buyer must notify the seller of their decision to exercise the option, and both
the buyer and the seller must cause the resulting underlying transaction to be entered into
their systems. Typically, the notification will be in the form of a phone call, instant message
or email from the buyer’s trader to the seller’s trader. The traders will then mark the options
as exercised in the trading application, which will result in the automatic creation of the
resulting underlying trade. These trades can then be settled in the normal manner.
However, there can be variations to this process. For instance, the risk system might not have
the functionality to automatically create the underlying trade. In this case, the trader will have
to manually enter the resulting trade. Additionally, for some markets the option exercise
notification may not be performed by the trader. If so, the trader will have to notify the
middle office or operations department of their intention to exercise, who will in turn notify
the counterparty of the option exercise. This process is typically performed by facsimile.
For cleared transactions, the margining process is automated via the clearing house’s initial
margin requirements and subsequent variation margin calculations.
For bilateral (i.e, non-cleared) transactions, the parties send margin calls via email or fax, and
acknowledgement is typically performed via email or telephone.

23
6. Close-outs
(a) Terminations
Termination of transactions prior to natural maturity occurs for only a small percentage of
commodity trades. The termination agreements are manually drafted, and the degree of
automation of the closeout process depends on each firm’s processing capabilities.
(b) Trade Compressions
Since the summer of 2009, the commodities industry has seen a shift in transaction volume
from OTC transactions to the clearing of transactions through an exchange. There is also an
on-going effort to work with vendors to establish routine ‘tear-up’ exercises amongst both the
inter-dealer and non-inter-dealer groups.
(c) Assignments and Novations
Assignment and novations of transactions prior to natural maturity occurs for only a small
percentage of commodity trades. Assignments and novations are manually drafted, and the
degree of automation of the transfer process depends on each firm’s processing capabilities.
7. Natural Maturity
This implies settlement or option expiry, and so the processes are as described in the previous
sections.

24
SECTION IV: ISSUES WITH CURRENT PROCESS
(a) Lifecycle Processes
A limited number of lifecycle processing issues have been identified and are attached hereto
as Annex C.
(b) OTC Settlements Processes
A number of issues related to the current settlement process for OTC trades have been
identified where further thought and analysis are required before a potential end-state solution
can be discussed.
 Different levels of automation among market participants – The OTC commodity

derivatives market is made up of a diverse range of participants of varying scale,
including financial institutions, utilities, energy trading companies, hedge funds, end
users, manufacturers and industrials. Levels of automation vary greatly among
participants, where some have extremely high levels of automation, while others may
have very manual processes. More automated groups have systems (either built in-house
or by third-party vendors) which calculate settlement amounts and generate invoices to be
sent to counterparties. Less automated participants may utilize spreadsheets to calculate
amounts owed as well as prepare invoices.
 Invoice Distribution – (a) The sender of the invoice can spend a lot of time trying to
obtain and verify new counterparty contact information. (b) Invoices are sent by fax or
email, depending on counterparty preference. A potential electronic solution could create
a uniform method to transfer invoices and a new method for distribution that has contact
information for all participating counterparts in a single repository. Each company should
maintain their own contact information to ensure the highest level of accuracy.
 Discrepancy Identification – During the process of cash flow affirmation prior to

settlement date, a discrepancy may be found. Currently, to resolve the discrepancy, a
manual line -by-line reconciliation is performed which can be time consuming,
particularly on an invoice that can contain over a thousand line items. A potential
electronic matching solution would be able to quickly compare invoice amounts and filter
out the few that do not match. This could allow users to focus on the identified
discrepancies rather than line -by-line reconciliations.
 Rounding – Even though there are industry standards addressing the number of decimal
places a price should have for each product, because of the complexity of commodity
calculations, often involving unit conversions, different counterparty systems calculate in
different ways, resulting in small differences in settlement amounts, i.e, rounding in the
middle of a conversion calculation from one unit to another versus truncating. The
solution is usually agreed upon between the parties, often splitting the difference.
 Holiday Calendars – The maintenance of holiday calendars can become quite tedious. Not
only must attention be paid to bank holidays in the various currencies traded, but holidays
relating to price source publications must be kept accurate and up-to-date as well. Often
the price sources publish the holidays only one to two years in advance. Since commodity
trades have tenors well exceeding two years, there is continual updating that needs to

25
occur in order to manage the life of the transaction. Additionally, unscheduled holidays
e.g, President Reagan’s or President Ford’s funeral, must be updated in holiday calendars
together with the correct pricing treatment.
 Different Trade Representation – Counterparties may represent trades differently in their

respective systems, often due to system constraints. For example, instead of having a
single trade, e.g., a crack swaps where the differential between the two products is traded,
the counterparty will enter the trade as two trades in their system. This structural
difference should not affect the total value of the settlement, but it is difficult to match the
two deals to the single differential deal. A potential solution would be to somehow
identify that the two trades are indeed one with a “link ID”. This would assist not only in
settlement matching, but also in the confirmation process and portfolio reconciliation.
 Affirmation of cash flow amount prior to settlement – similar to invoice distribution, it is

essential to have a good list of counterparty contacts for this stage of the process.
Otherwise, inefficiencies can occur.
 Counterparties that refuse to net – There are a number of exceptional counterparties that
settle gross instead of net, usually driven by a limitation of their settlement systems. Since
this poses an increased settlement risk to both parties, analysis should be done to eliminate
this practice.
 Non-standard settlement terms – Due to technical constraints, some participants are

unable to customize settlement dates, resulting in the need to manually reconcile and
process.
 Re-publishing of Settlement Prices – There are times when published settlement prices are
re-issued, i.e, a power ISO or Platts restating a settlement price. Depending on the timing
of this “re-settlement”, this could require an invoice to be amended and resent or cash to
be moved to compensate for the difference.
 Physical volume changes before settlement – Examples could be differences in what was
contracted to be delivered versus what was actually delivered or a force majeure event.
This could require additional reconciliations, invoice amendments and reaffirmation with
the counterparty.
 Market design changes in electricity markets – Particularly in the US, there have been a
number of market changes that impact scheduling and settlements processes. For example,
on April 1st 2009, the CAISO (California) implemented MRTU, which modified delivery
locations and revised market price calculations that resulted in changes to the settlement
process. Additionally, an ERCOT (Texas) to redesign was implemented on Dec 1, 2010.
These types of changes often require extensive system development and testing and have
led to re-settlements of prior periods after go-live as the market adapts to the new market
design.
(c) Settlement Matching Processes
Despite the issues raised in Section IV(b), the established OTC commodity derivatives
settlement process has been successful overall, as evidenced by the low rate of outstanding
settlement fails for this sector. Since levels of automation for the process differ among the

26
diverse base of market participants, it is believed that automated settlement matching would
be instrumental in reducing the inefficiencies in the process. It was therefore agreed that this
functionality could be the logical first step towards a more complete end state.
The ISDA and LEAP Settlement Working Groups have been discussing automated settlement
matching. The two groups have worked closely together, representing organizations such as
banks, oil companies, trading houses, brokers and other service providers for the physical and
financial energy trading industry. LEAP have published a whitepaper focused on settlement
matching which we have leveraged in this document. The working group began to research
settlement matching to help improve efficiency, provide scalability and to a lesser extent
increase controls.
As discussed in Section II A, there are manual components to the current settlements process.
According to market conventions, parties either exchange invoices or the seller sends their
invoice, the invoice amounts are then agreed upon, with any discrepancies identified and
reconciled prior to settlement date. Each of these steps is communicated by telephone,
facsimile, email or web portal. For certain products it is common to share settlement data to
aid the reconciliation. This data is usually in a spreadsheet format with each participant’s
information formatted differently and in varying levels of detail.
Automated settlement matching would allow counterparties to upload their settlement

(invoice) information to an industry platform. The platform would electronically match
settlement details at both the summary level, e.g., total cash flow and at the detailed level, e.g.
individual trade line items. The platform would highlight any exceptions (unmatched items),
saving hours of manual reconciliation. The exception process should be managed on the
platform and users should have the ability to remove disputed trades from an invoice to allow
for payment of undisputed amounts. Once the settlement is agreed upon on the platform, the
payments would be processed bilaterally outside of the platform (at least initially).
The group also captured the following requirements:

 The platform should hold counterparty contact information.
 The platform should be able to capture settlement instructions.
 The platform should be accessible to all industry participants and should have very low
barriers to entry.
 Parties should be able to agree via the platform to tolerances. Differences within the
tolerance range would match without further reconciliation.
 Disputes/unmatched items should be highlighted and both parties information should be
available to view side by side.
 Netting preferences can be updated on the platform.
 The platform should allow parties to communicate and resolve disputes.
 The platform should distinguish settlement items for current flow month from
adjustments to prior periods (e.g, cash settlement relating to a dispute) which could
appear on one invoice.
 The platform should allow real time updates (volumetric updates can be made right up to
settlement due to the volume actualization process).
 The platform should provide different options depending on users’ preferences, for
example;
o Both parties submit their invoice information to the platform for electronic
matching. This will be an automated process in which a user’s internal system

27
sends the information to the platform. Once matched, the platform could notify a
user’s internal system that payment can be processed.
o One party uploads their invoice information to the platform. The other party
would be able to review this information and approve the invoice, which would
mean the payment has been agreed and could be processed.
o A party could submit their invoice information to the platform and upload their
counterparty’s invoice to the platform if it were in Microsoft excel and formatted
appropriately. This would mean the matching functionality could be utilized.
The ability to customize is important as it allows all types of market participants to choose
what suits them best based on their individual circumstances and preferences. Considerations
would be volume, technology budgets and products traded, among others.
To date, there have been a number of presentations and demonstrations from three different
vendors focused on the development of a settlement matching platform, though none are
available for use at this point. The industry will continue working with the various vendors to
provide additional requirements and address other open items such as matching logic and
service cost.
To summarize, a list is provided of the perceived advantages and challenges of a settlement

matching service:
Advantages :
 Efficiency benefits
 Processing would be more scalable
 Increased control
 Offsetting errors would be identified
 Users can select different levels of service
Challenges:
 Difficulty/Cost of providing granular settlement data to the platform (e.g, hourly
quantities and prices as seen in the power markets).
 Cost for creating an electronic settlement system would not be too beneficial given the
fact that most financially settled activity is straight-through-processed (STP) for most
organizations and most physical settlements will continue to need manual processing.
 Matching logic has not yet been completely defined.
 Parties structure trades differently (e.g, crack spreads may be booked as one trade by
Party A and two trades by Party B). There is no clear solution for how this match would
occur.
 Unlikely to improve the physical cut reconciliation and agreement process for physical
power and physical gas.
 Re-publishing of settlement prices after invoice is sent or after settlement date requiring
reprocessing.
 There would likely be significant implementation costs – the ongoing cost as well as
internal development costs to integrate with the service. These would have to be
compared to proposed efficiency gains.
 Difficulty of on-boarding counterparties due to the diverse range of market participants.
Any benefit will be reduced unless the majority utilizes the service.

28
SECTION V: POTENTIAL END STATE
There are number of broad challenges the OTC commodity derivatives industry faces, setting it
apart from the other OTC asset classes, including:
 the diverse nature of the client base, which includes traditional financial houses, but also
producers, consumers, wholesalers, municipalities and utilities, many of which have limited
appetite for electronic processing;
 the diverse nature of the products presents challenges in that the client base has different
needs depending on the type of commodity on which they transact. For example, Bullion,
electricity, emissions and freight are all commodity products with quite different market
conventions; and
 the lack of a single central body of governance, such as ISDA, which limits the ability
forbroad industry participation. The ISDA Governance Structure, to the extent that it applies
to the OTC commodity derivatives, contemplates a basis of joint collaborative efforts
between the various industry organizations active for each commodity.
SECTION VI: CONCLUDING REMARKS
Whilst certain industry challenges do exist for OTC commodity derivatives which are not
experienced by the other asset classes, lifecycle events in the commodities markets are not that
unlike lifecycle events in the other asset classes.
The OTC commodity derivatives markets are well-controlled, as evidenced by the monthly
metrics submissions to the regulators. As amongst participating firms, the asset class has the
lowest number of outstanding confirmations, though not the lowest volumes.27 Similarly, the rate
of settlement fails is extremely low. This Paper has identified areas where further efficiencies can
be introduced in continuance of bringing these numbers down.
As an asset class, the CMD laid out an aggressive plan in the July and October 2008 commitment
letters to supervisors. Subsequent letters, including the March 2011 Supervisory Commitment
letter, set forth a detailed industry which as of publication remains on target28. Across the asset
class, participants are committed to moving standardized products to cleared platforms and have
made significant progress in this area. In fact, cleared OTC products were first developed in the
commodities space. The CMD metrics now show increased transparency, categorizing the data in
a more meaningful way and increasing the frequency of reporting. Industry working groups are
driving the standardization of Annexes to the ISDA Master Agreement documentation structure
to lay the groundwork for standard confirmation language and are adding both products and trade
types to electronic confirmation matching systems. Participants are aggressively building out their
infrastructure to add additional products like base metals, agricultural products, coal and freight
onto electronic platforms. As a result, the number of electronically eligible trades will continue to
increase through these efforts, while the number of outstanding confirmations should decrease.
The OTC commodity derivatives markets’ participants have been extremely effective in making
trading more standardized and are working towards the broader goals set up by the regulators.
27
28
See: http://www2.isda.org/functional-areas/market-infrastructure/G20-objectives/

29
This Paper discusses a number of ways in which the OTC commodity derivatives marketsare
unique. These differences pose challenges to recent proposals that all “standardized” OTC
derivatives be cleared through regulated central counterparties. Some such challenges are as
follows:
 Physical products are made more complex by the need to reconcile physical deliveries in
certain markets (e.g, North American power and gas). These actualizations result in actual
quantities deviating from the contracted quantity. For example, in the US power markets, it
can take months to retrieve meter data and supply documentation to both upstream and
downstream participants in order to agree on amounts to settle. The use of an exchange to
resolve volumetric cuts would be extremely burdensome.
 Financial products are often tied to the underlying physical commodity, this would make
certain transactions difficult to standardize. For example, a unit contingent financial swap in
power has notional quantities which can change on an hourly basis to mimic the energy
output of a power plant.
 Many market participants are producers and consumers of a commodity and regularly hedge
their production/consumption with OTC derivatives. Many are not market makers, but use the
OTC markets as a vital risk management tool.
 Central clearing does not provide such participants with the customization that they get from
OTC structures. While standardized products are one tool in a hedging portfolio, customized
OTC transactions allow producers and consumers to tailor transactions to their risk profile by
eliminating mismatches with standardized products.
The recommendation is to allow the OTC commodity derivatives markets to continue on the path
upon which they have conscientiously started. The number of cleared commodities products
offered by exchanges is continually increasing. Most recently, there is new interest in offering a
mechanism for clearing of OTC precious metals (bullion) trades. The OTC commodity
derivatives markets’ participants and the regulators are aligned on the direction of focus.
Settlement matching appears to be the logical first step to a potentially full-scale central
settlement solution. A central repository for settlement prices, SSIs and contact information could
address many of the outstanding efficiency issues. Work and further analysis is key to
understanding the possibilities for formal central settlement of OTC not on an exchange, similar
to CLS and FX markets. The settlement working group will continue to focus on the areas we
have discussed and will update this Paper periodically to address changes as well as update on
progress.

30
ANNEX A:
Best Practice Guidelines for Electronic Confirmation Matching
Background
This Annex offers a collection of best practice guidelines associated with the electronic
confirmation matching of the standardized over- the- counter (OTC) financial and physical
products in the OTC commodity derivatives markets (the Best Practices).
The adoption of these Best Practices can mitigate operational risks that are specific to the
confirmation matching process, and also help to reduce the level of risk in the OTC commodity
derivatives markets more generally. In addition, these Best Practices can help reduce processing
costs, encourage systems’ interoperability and increase operational scalability.
These Best Practices are already used, to varying degrees, by the OTC commodity derivatives
major market participants responsible for this paper and other market participants. Collectively,
the OTC commodity derivatives major market participants feel that these are best practices
towards which all market participants should actively strive. Therefore, these best practices serve
both to provide recommendations and a checklist for organizations new to the OTC commodity
derivatives markets as well as act as a benchmarking tool for all market participants as they
periodically review the efficacy of their operations.
These Best Practices are recommendations that all parties engaging in the OTC commodity
derivatives markets, regardless of the organization’s size or role in the marketplace, should
consider adopting. In addition, it is clear that the greater the number of transactions executed by
the organization, the more important it is to implement these Best Practices.
Confirmation Matching Overview

A confirmation evidences the economic terms of, and defines/references the legal framework
applicable to, a bilateral OTC transaction entered into between two parties. The confirmation
matching process is therefore an important control in reducing market and operational risk
between the parties involved.
It should be noted that certain short dated physical gas and power trades are not subject to the
confirmation matching process because the scheduling of the physical flow, due to its nature and
timeliness, provides a compensating control.
These Best Practices do not assume the exclusive use of one electronic confirmation matching
system, since the ideal industry scenario would be that any number of Electronic confirmation
matching systems could be completely interoperable in order to provide maximum coverage of
products and trade types within the OTC commodity derivatives markets (and even across
some/all other OTC markets), and achieve the greatest risk mitigation and economies of scale.
Best Practice no. 1: Single point of trade capture
Potential Risk: Inconsistent representation of trade details within the organization’s processing
systems rendering the confirmation matching process ineffectual.

31
Within an organization’s technology infrastructure, there should be one single point for
capturing the details of a transaction, and for capturing any subsequent Trade Event
relating to that transaction.
To eliminate the potential errors that can occur if trade details are entered independently into
multiple systems across an organization, a single point of trade capture should be employed in the
organization’s technology infrastructure. Consequently, whenever there is a trade event, this
should be updated once within the trade capture system (either manually or automatically via a
data feed from the trade execution system), and that in turn should automatically update all
downstream infrastructure systems.
Where an organization is unable to support a single point of trade capture then, as a risk mitigant,
comprehensive inter-system reconciliations should be employed to ensure trades are captured in a
consistent and timely manner across the various systems.
Best Practice no. 2: Employ electronic confirmation matching
Potential Risk: Delays or errors in the confirmation matching process caused by manual
intervention.
Electronic confirmation matching, whether via an in-house or third-party system, should be

employed by the organization.
The confirmation matching process should involve the two parties to the transaction submitting
electronic confirmations to either an in-house proprietary electronic confirmation matching
system or a third-party vendor electronic confirmation matching system. This bilateral submission
of electronic confirmations for automated matching is the most reliable and process-efficient
method of confirming trades, and provides for the earliest possible means of risk mitigation
within the Confirmation Matching Process.
If only one of the parties is able to send electronic confirmations to the electronic confirmation
matching system then, in order to support bilateral confirmation matching, the electronic
confirmation matching system should provide a facility which allows one party to submit their
electronic confirmation and the other party to view and then accept or reject the submitted
confirmation via a secure on-line facility. Thus a positive confirmation match is still achieved.
All parties should endeavor to utilize electronic confirmation matching system(s) to match as
many standardized products and trade types as are generally available for such in the
marketplace. Where a standardized product or trade type is not yet available via electronic
confirmation matching system(s), parties should actively support industry initiatives to on-board
such products so as to increase the range of products and trade types which are eligible via
electronic confirmation matching system(s). Where a product or trade type is not yet standardized
in its approach to confirmation terms, parties should actively support Industry Initiatives to reach
general market agreement on standardized Confirmation terms and thereby support the
evolutionary cycle of standardization facilitating automation (please reference Appendix A for a
list of some of the key industry bodies that can be engaged in this respect).
Best Practice no. 3: Electronic matching of broker recaps
Potential Risk: Delays identifying inaccurate trader risk positions.

32
Broker recaps should be processed via an electronic confirmation matching system.
Some trades between organizations are executed via brokers as an intermediary, rather than
directly between the two parties concerned. Trades brokered in this manner allow for trade details
to be checked against the broker recap, which is typically sent by the broker on trade date.
Economic trade mismatches can be identified in advance of the confirmation matching process. It
is important to note that broker recaps are not confirmations between the two parties of the
transaction and therefore Broker recaps do not supersede or negate the need for the confirmation
matching process. Whilst some brokers do engage in electronic messaging as a means of sending
their broker recaps, this is separate to the confirmation matching process between the two parties
to the trade.
All parties should endeavor to utilize an electronic confirmation matching system for matching
broker recaps. Two-way matching, with a broker, should be accomplished on trade date. Use of
this process dramatically reduces the time involved in checking broker recaps and identifies
errors in a timely fashion. Optimally, parties should utilize an electronic three-way match (broker
and two counterparties, each matching with one another) via an electronic confirmation matching
system. Where broker recaps are not yet available via electronic confirmation matching
system(s), parties should actively support industry initiatives to on-board them (please reference
Appendix A for a list of some of the key industry bodies that can be engaged in this respect).
Best Practice no. 4: Electronic confirmation issuance
Potential Risk: Delay in executing the confirmation matching process.
Electronic Confirmations should be issued on a timely basis.
An organization should support electronic confirmation matching on trade date. Therefore, an

organization should issue (i.e, generate and make available for matching) electronic
confirmations throughout the trading day (i.e, intra-day issuance).
If an organization is unable to issue electronic confirmations intra-day then, as a minimum,

electronic confirmations should be issued to the electronic confirmation matching system prior to
the start of the next business day following the trade date.
In the situation that a counterparty has been unable to issue a confirmation then, as part of this
escalation process, it is recommended that an attempt is made between parties to verbally agree
upon the trade economics.
Best Practice no. 5: Confirmation matching status tracking
Potential Risk: Ineffective escalation of confirmation matching delays or disputes.
An organization should be able to track the real-time status of every confirmation processed
by the electronic confirmation matching system.
Reporting capability should exist within an electronic confirmation matching system which
enables an organization to track the real-time status (e.g, unmatched, matched, partial-match,
queried, etc.) of every Confirmation submitted to that electronic confirmation matching system.
This reporting capability enables the operations staff to implement timely and proactive

33
escalation of every unmatched trade. It is recommended that intra-day escalation should be

established, but if this is not possible then, as a minimum, end-of-day escalation should occur.
Best Practice no. 6: Avoid updating trade-related information directly into the electronic
confirmation matching system
Potential risk: confirmation matching process is rendered ineffective as a result of data

corruption.
It is essential that the electronic confirmation matching system, operations processing

system and trade capture system (if this is different from the operations processing system)
remain synchronized.
When an update to Trade information is required in the electronic confirmation matching system,
this should be initiated by updating the information in the trade capture system (as the single
point of record). This update should then automatically feed through to the electronic
confirmation matching system as part of the normal deal life cycle trade event processing.
Updating trade information into the electronic confirmation matching system independently of
the trade capture system and/or the operations processing system should be prevented by
technical system restrictions. If this is not possible then prevention should occur via the
implementation of appropriate operational controls and checks, each performed by separate
individuals.
An exception to this best practice exists in the situation in which parties refer to the same trade
data in different ways. For example, within the gold market, counterparties confirm the delivery
location (e.g, London) and can refer to this in different ways (e.g, “Ldn” versus “Lon”). In such
situations, without the availability of corrective mapping rules within the in-house systems or
electronic confirmation matching system, a confirmation can only be matched if either: a) the
trade data is updated, and thus synchronized, directly in the electronic confirmation matching
system or b) the trades are “forced matched” – matched with the acknowledgement that
differences exist – within the electronic confirmation matching system. As a control, any updates
of this type should be independently checked (i.e, one person performs the update and another
validates that this update has been made correctly). Long-term solutions should be pursued in
these situations via either establishing industry standards or creating systematic mapping tables.
Best Practice no. 7: Ensure system integrity
Potential Risk: Inconsistent representation of trade details within the organization’s processing
systems rendering the confirmation matching process ineffectual.
To ensure the integrity of the confirmation matching process, the data contained in the
electronic confirmation matching system must be consistent with that held in the other
systems within the organization.
There is a risk, as a result of a system issue, user error or malicious intent, that system data
becomes corrupted or out of date. Therefore, data integrity reconciliation checks should be
implemented between each of the trade capture system, the operations processing system and the
electronic confirmation matching system. These integrity reconciliation checks should occur at
least once per day. There should be an effective resolution process in place so that breaks
highlighted on any particular business day (B) are addressed by close of business the following
business day (B+1).

34
Best Practice no. 8: Timely resolution of interface errors
Potential Risk: Delay in executing the confirmation matching process.
When submitting trades to an electronic confirmation matching system, Operations should

regularly monitor available system interface error logs in order to identify and correct feed
failures in a timely fashion.
Trades submitted to an electronic confirmation matching system could potentially be rejected

(i.e, they “fail” upon submission) due to system feed errors. Operation staff should regularly
monitor available error logs in real-time throughout the day so that any such failed trades are
identified intra-day. Whenever a failure is highlighted, the organization should endeavor to
perform corrective action, and resubmit the trade to electronic confirmation matching system, on
the same day that failure occurred.
Best Practice no. 9: Timely electronic confirmation matching
Potential Risk: Ineffective escalation of confirmation matching delays or disputes.
By Trade date plus one business day, a trade should be electronically matched or, if this is
not possible, an exception formally raised.
Trades processed by the electronic confirmation matching system should be matched on trade
date (T).
If the electronic confirmation matching system is unable to establish a match by trade date plus
one business day (T+1) then an exception, detailing an Unmatched Trade should be recorded and
formally escalated by this time. In the situation that a Counterparty has been unable to upload
their version of the trade, then, as part of this escalation process, an attempt should be made to
verbally affirm the trade economics. Verbal affirmations do not supersede or negate the need for
the confirmation matching process. Therefore a successful confirmation match is still required
after a trade has been verbally agreed upon.
The Counterparties of a trade should look to resolve any exceptions relating to the economics of a
trade on the same day that the exception was raised. An organization should establish benchmark
resolution times for the other types of trade mismatches based upon their materiality.
Best Practice no. 10: Segregation of duties
Potential Risk: Compromising the independence and effectiveness of the confirmation matching
process.
Management should ensure that appropriate segregation of duties exists between

operational staff and their management, and those individuals involved in trade execution.
All individuals involved in trade execution (such as traders, marketers and sales staff) should
have no responsibility for the execution, supervision or management of the electronic
confirmation matching process.
Commodities Trade Processing Lifecycle Events – ISDA Whitepaper April 2012

35
Operations staff should be responsible for the execution and management of the electronic
confirmation matching process. Resources permitting, there should be a distinct operational group
whose sole responsibility is for matching confirmations and addressing associated exceptions.
Best Practice no. 11: Control systems’ access
Potential Risk: Malicious or accidental corruption of data and/or controls by a user.
Users of any technology system should not be able to alter the functionality of that system
directly within the production environment. Developers should have limited access to
production systems, and only then within a strictly controlled environment.
Each system should have robust and reliable access controls which allow only authorized
individuals to alter the system and/or grant user access. To support this, the creation of a set of
job function-specific user access profiles is recommended.
Rigorous systems controls need to be implemented and monitored to ensure that data integrity
and security are not sacrificed. External user access controls should be as robust as internal user
access controls.
Access to production systems should only be allowed for those individuals who require access in
order to perform their job function. When creating user access profiles, system administrators
should tailor the profile to match the user's specific job requirements, which may include "view
only" access. System access and entitlements should be periodically reviewed, and users who no
longer require access to a system should have their access revoked. Under no circumstance
should operations staff have the ability to modify a production system for which they are not
authorized.
Best Practice no. 12: Reference data management
Potential Risk: Effectiveness of the confirmation matching process is impacted as a result of

incomplete or inaccurate data.
The reference data associated with the electronic confirmation matching process should be
managed in a robust and reliable manner.
The integrity of the confirmation matching process is reliant on maintaining reference data that is
correct and comprehensive. To ensure that this is the case, an organization should look to:
 maintain data via automated feeds from external sources, where possible;
 validate data that is manually received against independent sources;
 task qualified operations personnel with maintaining the reference data mapping tables;
 store and maintain reference data in one central source only;
 have rigorous controls to ensure the timely and accurate update of data into systems; and
 monitor all system interface feed failure logs to ensure that missing/incorrect mappings are
corrected in a timely fashion .

36
Best Practice no. 13: Contingency plans
Potential Risk: Suspension of the confirmation matching process through a loss of key personnel
or infrastructure.
Operations groups should develop and test contingency plans for operating in the event of
the incapacitation of any/all of their system(s), operational site(s) and/or staff.
Contingency plans should be reviewed, updated, and tested at least annually. These contingency
plans should cover both short-term (up to one month) and long-term (over one month)
incapacitation associated with one or more of the following scenarios:
 failure or inaccessibility of operational site(s): resultant fall-back of function and primary

staff (those who usually perform the function) to contingency site(s);
 system hardware failure: resultant fallback of system(s) to contingency hardware and backup
data; and
 primary staff unavailability: resultant fallback of job functions to secondary staff (those who
do not normally perform the function but are capable of doing so in a contingency) in a
different location to the primary staff.

37
ANNEX B:
Key Industry Forums
1) LEAP: Specifically oil-focused (www.energyleap.org).
2) EFET: European gas and power trading. Coverage of regulatory and documentation issues
(www.efet.org).
3) IETA: International Emissions Trading Association: Global trade association for primary
emissions markets under the UN Kyoto Protocol. Standard documentation for primary markets
(so-called ERPAs) and secondary trading (www.ieta.org).
4) LBMA: London Bullion Market Association: Representatives of London wholesale bullion

markets. Standard documentation being ISDA based (www.ibma.org.uk).
5) EEI: Edison Electric Institute. US association of power utilities (www.eei.org) .
6) FOA: Futures & Options Association: Industry association for futures and options trading
(mainly on UK exchanges). Regulatory affairs and standard docs (as administrators for UK power
trading agreements -GTMA) (www.foa.co.uk) .
7) WRMA: Weather Risk Management Association: Service provider to the weather risk
management industry (includes all kinds of weather protection products, insurance, exchange and
off-exchange trading); global coverage. Standard documentation produced in cooperation with
ISDA (www.wrma.org)
8) FFABA: Forward Freight Agreement Brokers Association: Promotion of freight trading and
standard documentation (ISDA based) (www.balticexchange.com/ffaba).
9) CTA: Coal Trading Association: (www.coaltrade.org). North America-focused.
10) IECA: International Energy Credit Association (www.ieca.net/). Producers of some

supplementary documentation to standardize contracts (e.g, ISDA CSA and EFET/SIFMA
CPMA).
11) AIPN: Association of International Petroleum Negotiators (www.aipn.org/). Mission is to

enhance cross-border trading in petroleum products.
12) Energy Institute (www.energyinst.org.uk/): Promotion of the safe, environmentally

responsible and efficient supply and use of energy in all its forms and applications. Most recently
the EI have started working on standard contracts for physical transactions in crude oil (in
cooperation with LEAP and ISDA).
13) ISDA: International Swaps and Derivatives Association, Inc. (www.isda.org): represents
participants in the privately negotiated derivatives industry and focuses its efforts on the
identification and reduction of the sources of risk in the derivatives and risk management
business.

38
ANNEX C:
ISSUES WITH CURRENT PROCESS (REF. SECTION IV(A))
BY LIFECYCLE EVENT TYPE
Early Settlements
Rationale for Ready for Industry Impact: Impact:
Impact: Metrics
Inclusion Action? documentation Settlements
1. No standard 1. Relatively low 1. No standard 1. Manual Minimal:
industry practice volume of early early termination calculation and 1. Potential
for documentation. settlements in document. booking of reduction in
2. No standard commodities (*validate 2. Early settlement discount amount unexecuted, if
industry utility for with supporting process may trigger required. early settlement
processing. metrics). the generation of precedes
2. Majority of early standard invoices, execution
settlement requests which may need to 2. Possible noise
come from the buy side be suppressed and from CnC and
(investors, consumers replaced with a trade bookings
and utilities) and so notification of early related to partial
successful technology termination. closeouts.
solutions would require 3. Partial early
take-up by a large settlement (for
number of relatively example, early
lower volume market settlement of trades
participants (*validate that do not fully
with supporting offset) can require
metrics.) editing of existing
trades and booking
of new trades,
potentially triggering
new confirms or
requiring manual
intervention to
prevent STP of
confirms.
Novations
Impact: Metrics
1. No standard 1. Relatively low 1. Standard ISDA 1. Careful 1. Novated
industry utility for volume of novations in novation templates monitoring to trades can lose
processing. commodities (*validate are in use. ensure pricing their affirmation
with supporting 2. Depending on periods that are status, causing
metrics). how market not novated are noise on
2. Majority of novation participant's systems settled with the confirm/affirm
requests come from the work, offsetting remaining party. metrics until
buy side (investors, close out trades may Often short manually
consumers and utilities) be required to timelines between overridden.
and so successful process novations. novation date and
technology solutions This can trigger new first settlement
would require take up confirms, or require date.

39
by a large number of manual intervention 2. Manual

relatively lower volume to prevent STP of processing of
market participants new confirms. payments for
(*validate with MTM
supporting metrics). gains/losses
However, although rare, novated.
novations between CMD
members can involve a
high volume of trades.
Electricity 'Cuts'
Impact: Metrics
1. Cuts are a 1. Need to distinguish 1. Cut trades need 1. Failure to 1. Cuts are a
major cause of between two issues: (i) to be excluded from book cuts, or significant cause
settlement incorrect entry of cuts the confirm /affirm disputes of trial balances
discrepancies and a due to human oversight, process. regarding the in the physical
main driver of which can cause amount or electricity
settlement discrepancies at liability for markets.
reconciliation effort settlement but are liquidated
for physical quickly resolved; and damages, are a
electricity. Master (ii) settlement disputes major source of
agreements due to disagreements settlement
typically allow for between the parties disputes in the
disputes to remain regarding liability for, or physical
unresolved for up the amount of, electricity
to two years. liquidated damages. The markets.
former might be reduced
by better interaction
between scheduling and
settlement systems. The
latter are disputes in
interpreting the
liabilities and
obligations resulting
from physical supply
events that will not be
resolved through
changes to trade
processing.
2. Industry dominated
by utilities with
established processes
and systems. Buy in
from these participants
would be necessary for a
solution to have material
impact.

40
Physical Natural Gas

Impact: Metrics
1. Volume 1. Need to distinguish 1. Cut trades need 1. Failure to 1. Cuts are a
actualization between two issues: (i) to be excluded from book cuts, or significant cause
comprises a incorrect entry of cuts the confirm /affirm disputes of trial balances
significant portion due to human oversight, process. regarding the in the physical
of settlements which can cause amount or natural gas
effort for physical discrepancies at liability for market.
natural gas. Unlike settlement but are liquidated
electricity, there are quickly resolved; and damages, are a
no scheduling Tags (ii) settlement disputes major source of
to assist with the due to disagreements settlement
reconciliation. between the parties disputes in the
Pipeline Tariffs regarding liability for, or physical natural
typically allow for the amount of, gas markets.
imbalances to liquidated damages. The
remain unresolved former might be reduced
for up to two years, by better interaction
which over the between scheduling and
years has settlement systems. The
developed into an latter are disputes in
accepted industry interpreting the
standard. liabilities and
obligations resulting
from physical supply
events that will not be
resolved through
changes to trade
processing.
2. Industry dominated
by utilities with
established processes
and systems. Buy in
from these participants
would be necessary for a
solution to have material
impact.

41
COMMODITIES TRADE PROCESSING LIFECYCLE EVENTS

OTC DERIVATIVES:
A COMPARATIVE ANALYSIS OF
REGULATION IN THE UNITED STATES,
EUROPEAN UNION, AND SINGAPORE
Rajarshi Aroskar*
This study compares the regulation of OTC derivatives in the United States,
European Union, and Singapore. All jurisdictions require central clearing
and reporting of OTC derivatives. The onus of reporting falls primarily on
financial counterparties to an OTC contract. The main difference in regulation
is that only the United States and the European Union require mandatory
trading of cleared derivatives. Additionally, implementation is proceeding in
different stages across jurisdictions. These two differences have the potential
to result in regulatory arbitrage across jurisdictions.
T
he over-the-counter (OTC) derivatives market is the largest financial market
worldwide. It represents various financial and nonfinancial participants in
the United States, Europe, Hong Kong, Singapore, and other financial centers.
Nonfinancial participants usually use these markets to hedge business risks, while
financial participants use them for both speculation and hedging.
According to the Bank of International Settlements’ semiannual survey, the
OTC derivatives market has grown from $603.9 trillion in December 2009 to $647.8
trillion in December 2011. As seen in Figure 1, interest rate contracts represent
85% of the total OTC derivatives, while credit default swaps represent 5% of the
total OTC derivatives and commodity contracts, equity linked contracts, and foreign
exchange contracts each represent 1% of the total OTC derivatives contracts (BIS
2012).
OTC contracts were blamed for the credit crisis of 2008 (Dømler 2012). This
led to the Pittsburgh Declaration by G20 members to regulate the OTC derivatives
market:
All standardized OTC derivative contracts should be traded on exchanges
or electronic trading platforms, where appropriate, and cleared through
central counterparties by end-2012 at the latest. OTC derivative contracts
should be reported to trade repositories. Non-centrally cleared contracts
should be subject to higher capital requirements. We ask the FSB and its
*Rajarshi Aroskar is an associate professor of finance in the Department of Accounting and Finance
at the University of Wisconsin-Eau Claire. E-mail: aroskar@uwec.edu.
Acknowledgements: The author acknowledges a grant received from the Institute for Financial Markets.
Keywords: OTC derivatives, regulation, Dodd-Frank Act, EMIR

JEL Classification: G18, G28, K22
32 Review of Futures Markets
Figure 1. Outstanding OTC Derivatives by Categories.
1% 1% 1%
5%
Commod ity co ntrac ts
7%
Equity-linked co ntrac ts
Fo reign exchange
contracts
Cred it default swap s
Unallocated
In terest rate c ontracts

85%
relevant members to assess regularly implementation and whether it is

sufficient to improve transparency in the derivatives markets, mitigate
systemic risk, and protect against market abuse (Financial Times 2009).
Ever since the declaration there has been sweeping regulation on both sides of
the Atlantic with the Dodd-Frank Act in the United States and European Market
Infrastructure Regulation (EMIR) in the European Union (EU). Other nations around
the world have also formulated their own regulations to monitor and regulate the
OTC markets.
This study compares and contrasts regulation of the OTC derivatives markets
in three different jurisdictions, the United States, the European Union, and Singapore.
As depicted in Figure 2, 32% and 37% of the single currency interest rate OTC
derivatives contracts were in US dollars and euros, respectively. These two
regulatory regimes were the first to propose regulation of OTC derivatives. The
advent of these regulations has led some to fear a loss of OTC markets in countries
where there is less or no regulation. Additionally, it is possible for counterparties in
countries that have less stringent regulation to avoid business with the US
counterparties (e.g., Armstrong 2012).
Singapore has been chosen in this study since regulation of its OTC market
has only recently been proposed in February 2012. Also, Singapore does not form a
part of the G20. Hence, it serves as an excellent case where there may be a
perception that Singapore has less stringent regulations than the G20 countries.1
1. The author would like to thank the anonymous reviewer who pointed out that this perception
may not be correct, especially in light of the stricter requirements that go beyond Basel III. (See
Armstrong and Lim 2011, UPDATE 1-Singapore banks to face tougher capital rules than Basel III.
Reuters, http://www.reuters.com/article/2011/06/28/singapore-basel-idUSL3E7HS1TM20110628.)
OTC Derivatives Regulation: A Comparison 33
Figure 2. Percentage of Outstanding OTC Single-Currency Interest Rate Derivatives.
1% 1% 1%
6%
9% Euro
US dollar
37%
Japanese yen
Poun d sterling
1 3%
Other
Canadian d ollar
Swedish kron a
Swiss franc
32%
I. LITERATURE REVIEW
A. Central Clearing
An OTC derivative transaction between two parties has inherent risk of default
by a counterparty. Before 2007, market participants preferred searching for the
best value to close out an OTC position rather than looking for a reduction in
counterparty credit risk. This meant that the close out of the OTC position may not
have been with the original counterparty (Vause 2010). This resulted in offsetting
contracts with a best value provider. Consequently, the number of outstanding OTC
contracts increased.
After the credit crisis, management of counterparty credit risk became important.
There are various techniques used to reduce counterparty risk, including trade
compression and central clearing through a central counterparty (CCP).
Standardization of contracts is essential for using trade compression and CCPs
(Vause 2010). Trade compression reduces counterparty risk by reducing the number
of outstanding contracts among market participants. However, market participants
are still subject to bilateral credit risk for the remaining contracts (Weistroffer 2009).
This risk could be eliminated using a central counterparty.
A central counterparty (CCP) provides risk mitigation by imposing itself
between the buyer and the seller. Thus, it is a buyer to the seller and seller to the
buyer. In case of a default by any one of its members, the CCP is the only party that
will be affected. All other members of the CCP system remain unaffected. The
CCP can reduce or eliminate the impact of default by a member through collateral
management.
A CCP could give an open offer to act as a counterparty to members or become
a counterparty after an OTC contract has been signed between two parties. In the
latter case, the original contract is void when the CCP becomes the counterparty.
Using CCPs doubles the total number of contracts; however, there are also possibilities
of netting across contracts (Vause 2010).
Another advantage of a CCP is multilateral netting where, instead of there
being one buyer to a seller, CCPs can take off-setting positions with multiple members
and, thus, diversify away the risk. The CCP could provide anonymity to transactions
and thereby reduce the impact of the trader’s position. Additionally, the CCP could
provide post-trade management and provide financial management of members’
collateral deposits.2 Thus, a CCP is in a much better position to ensure fulfillment of
obligations to its trading members than a bilateral OTC contract.
Cecchetti, Gyntelberg, and Hollanders (2009) indicate that using CCPs improves
counterparty risk management and multilateral netting and increases transparency
of prices and volume to regulators and the public. Using a CCP can also reduce
operational risks and efficiently manage collateral. A CCP is in a better position to
mark to market and to manage and evaluate exposure.
Acharya and Bisin (2010) indicate that OTC markets are opaque and
participants possess private information that provides them incentive to leverage
their position. This increases their likelihood of default. Centralized clearing by a
CCP would reduce this opacity by either setting competitive prices or providing
transparency of trade positions. Culp (2010) indicates that the CCP structure is
time-tested and has sustained various market disruptions and individual institutional
defaults. Benefits of using a CCP include a reduction in credit risk and evaluation
of exposure, transparency of pricing, evaluation of correlation of exposures, default
resolution, and default loss reduction.
Novation of a contract using a CCP concentrates risk with the CCP and, to
that extent, will contribute to the systemic risk (BIS 2004; Koeppl and Monnet
2008). The CCP has offsetting long and short positions. Hence, they do not have
any directional risk. However, they do face counterparty risk (Duffie, Li, and Lubke
2010). With a CCP, bilateral risk is replaced with that of the failure of a market
participant in the CCP. This risk is separate from the operational failure of a CCP
(Weistroffer 2009).
Biais, Heider, and Hoerova (2012), Milne (2012), and Pirrong (2010) indicate
that central clearing mutualizes risk but does not eliminate risk. Such mutualization
can be detrimental to the market as players possess private information, leading to
underpricing of risk. Liu (2010) indicates that central clearing reduces counterparty
risk but not default risk. Thus, governance and choice of financially robust market
participants are more important than central clearing to the elimination of risk.
Pirrong (2009) indicates information asymmetry could lead to a preference for
bilateral arrangements over that of a CCP. In bilateral arrangements, parties to a
contract can better monitor, and hence price, counterparty credit risk. Thus, the
benefit of a CCP does not outweigh its cost. Lewandowska and Mack (2010) show
2. http://www.cmegroup.com/clearing/cme-clearing-overview/about-central-counterparties.html.
that multilateral arrangements provide comparable netting efficiency to that of CCP

clearing.
Culp (2010) suggests that members could resist clearing through a CCP if they
see that the credit risk mitigation is marginal, the margin requirements are not for
risk management, or the pricing is not acceptable. Further, the study states that the
imposition of the margin is costly due to opportunity cost. Additionally, marking-to-
market will impose liquidity constraints on dealers. CCP-required standardization
may preclude market participants from being able to effectively hedge their risks
as the standardized products lead to basis risk and do not exactly offset their risk
exposure. Finally, CCP risk managers who perceive themselves at an information
disadvantage with respect to its members may impose higher requirements of
collateral (Weistroffer 2009).
Studies have suggested various methods of organizing a CCP, the optimal
number of CCPs, and ways CCPs may cope with losses. Koeppl and Monnet
(2008) indicate that CCPs can be structured as mutual ownership or for-profit
organizations. To secure itself from default by any of its members, a CCP will
require margin and a default fund. A profit-maximizing CCP will require a larger
default fund, whereas a mutualized CCP will enforce a higher margin requirement.
In stressed market conditions, a profit-maximizing CCP will provide efficient trading,
while a user CCP will shut down.
The Committee on the Global Financial System (2011) indicates that indirect
access of clearing through dealers leads to a concentration of risk at these dealers.
Also, it makes the system uncompetitive compared to one in which market participants
have direct access to clearing. Indirect clearing can be efficient if end users have
portability of their accounts across dealers. A domestic CCP may be helpful in
maintaining regulatory oversight; however, multiple CCPs will lead to fragmentation
and an increased need for collateral. The Committee further advocates coordination
of regulation among global regulators to avoid regulatory arbitrage. Links between
multiple CCPs will be advantageous due to multilateral netting possibilities through
an expanded number of counterparties. However, these links could provide
propagation of shocks and systemic risk.
Duffie and Zhu (2011) advocate having a lower number of CCPs as it will
reduce counterparty credit risk. Having a separate CCP for each asset will reduce
netting benefits across assets. It will also increase collateral needs and counterparty
credit risk. Hence, having interoperability agreements will be beneficial. Multiple
CCPs will have initial margin and equity requirements for each CCP. There is also
a potential for regulatory arbitrage. Finally, trade and positions across multiple CCPs
need to be consolidated.
A CCP could create a fund by contributions from its members. This fund could
be utilized in case of default by a member to settle claims with the surviving
counterparties (BIS 2004). The net obligations could be limited to the size of this
fund. To mitigate this risk, CCPs could impose initial and variation margins, depending
on the size and liquidity of positions. Additionally, they could impose capital
requirements to create a fund for mutualizing losses (Duffie et al. 2010).
Cecchetti et al. (2009) indicate that a CCP may need access to liquidity from
the central bank in times of market stress or in the case of reduced liquidity due to
a member’s default.
B. Trade Repositories
In addition to central clearing, regulators across jurisdictions have proposed
trade repositories. It has been contended by studies such as Wilkins and Woodman
(2010) that there was not enough information about the OTC trades before the
crisis. Regulators lacked information about the size of trades and the volume of
trades linked to a counterparty. Hence, they were not in a position to identify
concentration of risk in a contract or an institution. There was no central database
where regulators could gather and analyze OTC information. Studies have suggested
that a trade repository (TR) would help reduce this opacity.
Trade repositories can disseminate trade data to the public and help increase
market transparency. They can help OTC market participants ascertain the deal on
their trades. A trade repository is an institution that maintains a centralized database
that records details about OTC derivatives contracts. The purpose of a trade
repository is to increase pre-trade (quotes) and post-trade (information on executed
trades) transparency. It is a single place where regulators can access data about
the entire OTC market, a single trade, or any institution. The objective of a TR is to
provide a centralized location where regulators can access data to monitor the
OTC market. Regulators can identify concentrations of risk in a trade or with an
institution before such concentration becomes destabilizing for the market. They
can perform post-mortems on trades and identify guilty parties or aspects that are
suspicious or illegal. Trade repositories can help manage trade life cycle events
(Hollanders 2012).
Russo (2010) thinks that reporting of OTC trades should be mandatory.
Additionally, TRs should give free access to regulators to the information stored in
the registry (Wilkins and Woodman 2010). By disseminating trade information to
market participants, TRs can improve market transparency and confidence in market
participants. This dissemination of information will strengthen OTC markets.
Wilkins and Woodman (2010) advocate exchange trading of standardized and
liquid OTC derivatives to improve transparency. Market participants can access
firm quotes and see trade prices. This information will help level the playing field
for both sophisticated and unsophisticated market participants. Electronic trading
platforms, by providing indicative quotes, can offer limited pre-trade transparency.
Avellaneda and Cont (2010) distinguish between pre-trade and post-trade
transparency of OTC derivatives data and between regulatory and public
dissemination of data where participants in the interest rate swap market use these
instruments to hedge the underlying interest rate risk. Standard interest rate
derivatives market trades are usually large, OTC, and institutional. Pre-trade
information can be disseminated among dealers using dealer networks such as
ICAP, Tradition, BGC, and Tullet Prebon. Quotes from dealer networks could be
used to provide aggregate indicators of market variables to the whole market.
Post-trade information includes detailed information about trades. Avellaneda

and Cont (2010) suggest that electronic trading platforms and clearing facilitites
can facilitate processing and transmission of post-trade data to regulators and trade
repositories. However, there are impediments to post-trade reporting. Electronic
networks have not yet gained traction in OTC markets. Clearing facilities keep
trade information confidential and, hence, do not disseminate this information to the
market.
Exchange trading of derivative contracts can help pre-trade and post-trade
transparency. However, corporations using customized variations of tenors and
maturity may not be able to use exchanges, unless the exchanges offer a wide
range or variety of products. Additionally, Avellaneda and Cont (2010) and Wilkins
and Woodman (2010) indicate that when the trade size is large and volume low,
market makers may have to hold a position for a longer period of time. In fragmented
markets, full transparency is feasible as a single position does not affect the price.
However, when the size of the position is greater than average trading volume, full
transparency will lead to front running and will dissuade market makers as they
may not be able to offload risk (Avellaneda and Cont 2010). Hence, full post-trade
disclosure may adversely affect market makers. They may be reluctant to enter a
trade and provide a market (Wilkins and Woodman 2010). Additionally, dealers
could stop or reduce OTC market participation in favor of standardized exchange
contracts. Both these measures will reduce liquidity in the OTC market and may
be, in general, detrimental.
Tuckman (2010) argues that the objective of ascertaining counterparty credit
risk may not be met if the data are anonymized or if there is no reporting of intra-
company trade. As such, market stability may be impacted.
Knowledge of price and volume data can help market participants decide on
the appropriate capital to cushion potential losses and other risk management
procedures. Price information can reduce collateral disputes. Public information
can help identify counterparty credit risk and help calm markets as the market
participants ascertain exposure level to derivatives (Duffie et al. 2010).
Avellaneda and Cont (2010) suggest that if post-trade transparency is mandated,
then such dissemination should be delayed and capped at a certain threshold. Duffie
et al. (2010) indicate that position data should be reported with a delay. This delay
will help market participants trade on fundamental information rather than on market
information. Additionally, this delay will reduce the price impact of the knowledge
of real time position information and help market makers exit or change positions at
close to the available market price.
This study finds that while mandatory clearing is required in all jurisdictions,
there are differences in cleared assets, timing, and exemption of parties. Only
Singapore exempts foreign exchange swaps and forwards from clearing. Both the
EU and Singapore require immediate clearing for all asset classes. The United
States phases in clearing based on asset and counterparties to a transaction. All
financial institutions face stricter regulations in the EU, with the United States and
Singapore exempting smaller financial institutions. Though in theory all jurisdictions
are less stringent on nonfinancial institutions, there could be differences in the levels
used to decide the size of an institution. There are also differences in organizational
requirements for a CCP in these jurisdictions. These differences in requirements
for assets, timing, and counterparties could lead to regulatory arbitrage across
jurisdictions. Singapore, alone, does not mandate trading of cleared derivatives.
This exemption increases the choices available to market participants who trade
OTC products.
Regulations in all three jurisdictions focus on the collection of data and reporting
to the TR to increase post-trade transparency. All jurisdictions require reporting of
both cleared and uncleared OTC derivatives in all asset classes. However, there is
no consistency in priority given to asset classes in various jurisdictions.
In all jurisdictions, the onus of reporting is mostly on large financial institutions.
While the United States focuses on complete reporting by both financial and
nonfinancial institutions, the EU and Singapore are less stringent on nonfinancial
institutions. Also, only the United States has a phased-in approach to reporting
depending on the institution’s category. This difference in reporting requirements
based on asset classes and institutions creates differing costs for reporting entities.
As such, there is the potential that these reporting entities will choose more favorable
jurisdictions for OTC derivatives, leading to regulatory arbitrage.
The rest of the paper is organized as follows. First, I discuss the scope of the
regulations governing central clearing, margin requirements on noncentrally cleared
derivatives, backloading of existing transactions, trading, and trade repositories in
each of the jurisdictions. This discussion is followed by a comparison of those same
regulations and, finally, concluding remarks.
II. REGULATORY AUTHORITY

The US Commodity Futures Trading Commission (CFTC) is charged with the
regulation of all OTC derivatives except the OTC derivatives based on exchange-
traded securities. The US Securities and Exchange Commission (SEC) is charged
with the regulation of OTC derivatives representing exchanged-traded securities
The European Securities Market Authority (ESMA) is the EU-wide regulator
charged with drafting regulations on OTC derivatives. It is the sole authority that
approves OTC products for mandatory central clearing.
The Monetary Authority of Singapore (MAS) is the sole authority responsible
for regulating OTC derivatives market in Singapore.
The United States is the only jurisdiction in this study that has multiple authorities
regulating OTC derivatives market. This may lead to delay in legislation on
differences in the timing and compliance mandated by the two authorities.
III. REGULATORY REQUIREMENTS

In the United States, OTC derivative contracts called swaps are regulated and
include all asset classes, interest rate, commodity, equity, foreign exchange, and
credit default swaps. Two authorities in the United States regulate swaps. Swaps
regulated by the SEC are focused on securities and include single security total
returns or narrowly based indexed total returns. All other swaps including optionality
in a total return swap are regulated by the CFTC.
A bilateral mixed swap with a counterparty that is a registered dealer or a
major participant with the CFTC and the SEC will be subject to key provisions of
the Commodity Exchange Act (CEA) and related CFTC rules and requirements of
the federal securities law. For all other mixed swaps, joint permission could be
sought to comply with the parallel provisions of either the CEA or the Securities
Exchange Act.
The European Market Infrastructure Regulation (EMIR) incorporates all
derivatives contracts that are traded OTC and not on a regulated market. There
are no exclusions for any particular type of derivatives.
The Monetary Authority of Singapore incorporates all derivatives contracts.
The definition of a derivative contract is very broad and includes forwards, options,
and swaps.
Of the authorities in these three jurisdictions, all have very comprehensive
definitions of derivatives contracts. The US definition, though, is very prescriptive
(detailed) and has specific exemptions for insurance, consumer and commercial
transactions, and commodity forwards. The EU and Singapore are very broad in
their definition and do not have any exceptions. Additionally, complications in the
registration with either the SEC or the CFTC are confusing and could be costly.
A. Central Clearing
1. United States
All swaps, regardless of their asset class, need to be centrally cleared. There
is a possibility that the Treasury Secretary may exempt foreign exchange swaps
and forwards from central clearing. However, the latest clarification from the CFTC
(2012) indicated that even if such an exemption from the swap regulation were to
be granted by the Treasury Secretary, the swaps would still be subject to reporting
requirements under the CEA.
Certain insurance products and commodity forward contracts are not required
to be centrally cleared. Additionally, the Federal Energy Regulatory Commission
regulates instruments or electricity transactions that the CFTC finds to be in the
public interest are exempt from central clearing.
End users of derivatives are exempt from central clearing. Additionally, the
definition of end user is expanded to include small financial institutions (with assets
of $10 billion or less) (CFTC and SEC 2012) to be exempt from the regulation.
Cooperatives such as farm credit unions and credit unions are also exempt from
clearing requirements.
2. European Union
All standardized OTC derivatives that have met predetermined criteria need
to be centrally cleared. All firms, financial and nonfinancial, that have substantial
OTC derivatives contracts need to use central counterparty clearing houses.
Nonfinancial firms below a certain “clearing threshold” are exempt from
clearing through a CCP. Any OTC contract that is considered to be a hedge is
exempt from clearing and as such does not even count toward the total clearing
threshold. The threshold has yet to be set by the ESMA and the European Systemic
Risk Board.
The “European System of Central Banks, public bodies charged with or
intervening in the public debt, and the Bank for International Settlements” (EUR-
Lex 2010) are not subject to clearing. There is a temporary exemption from clearing
through the CCP for pension funds. There is also an exemption for intragroup
transactions subject to higher bilateral collateralization by the EMIR.
3. Singapore
All standardized OTC derivatives need to be centrally cleared. Singapore dollars
interest rate swaps and US dollar interest rate swaps, and nondeliverable forwards
(NDFs) denominated in certain Asian currencies have been prioritized for mandatory
clearing followed by other asset classes in the future. The MAS exempts foreign
exchange forwards and swaps from the clearing obligation. However, currency
options, NDFs, and currency swaps are not exempt. They identify the Dodd-Frank
Act in the United States for such exemptions or nonexemptions. Clearing is required
when at least one leg of the OTC contract is booked in Singapore and if either one
of the parties is a resident or has a presence in Singapore and has a clearing mandate.
B. Requirements of CCPs
The CFTC may exempt a foreign CCP from registration if it determines that
the CCP is regulated and supervised by an appropriate authority in its home country
with regulations comparable to those of the United States.
A CCP is required to maintain adequate capital to cover at a minimum a loss
by a defaulting member and one year’s operations. It is required to have sufficient
liquidity arrangements to settle claims in a timely manner. Organizationally, the
board needs to have market participants as its members. The CCP should have
fitness standards for its board, members of a disciplinary committee should reduce
(mitigate) any conflicts of interest, and it should maintain segregation of client funds.
The CCP should be able to measure and manage risks.
The European Union recognizes a third country CCP if the ESMA is satisfied
that the regulations in that third country are equivalent to that of the EU. Further,
the CCP should be regulated in that third country and that third country regulator
must have cooperation arrangements with the ESMA.
The ESMA is responsible for the identification of contracts that need to be
centrally cleared (Europa.eu 2012). A competent authority in a member state can
authorize a CCP; as such, it will then be recognized and can operate in the entire
EU.
There are permanent capital requirements for CCPs of €5 million. A CCP is
required to maintain sufficient funds to cover losses by a defaulting clearing member
in excess of the margin posted and default funds. These funds include insurance
arrangements, additional funds by other nondefaulting clearing members, and loss
sharing arrangements. Additionally, a CCP should have appropriate liquidity
arrangements (EUR-Lex 2010).
There are specific organizational and governance requirements for CCPs. These
include separation of risk management and operations, remuneration policies to
encourage risk management, and frequent and independent audits. Additionally,
CCPs must have independent board members and a risk committee chaired by an
independent board member. Finally, there are specific guidelines to avoid a conflict
of interest and maintain segregation of client funds (EUR-Lex 2010).
Singapore has no requirement of clearing through only domestic CCPs.
Singapore-based corporations can act as clearing houses if they are approved.
Foreign clearing houses can operate in Singapore if they are recognized.
There are no specific requirements of the central counterparties in relation to
the amount of capital required. The only presumption is that the clearing house
needs to have sufficient financial, human, and system resources (MAS 2012). The
MAS requires segregation of client funds.
C. Margin Requirement for Noncleared OTC Derivatives

In the United States, the CFTC (2011) proposes rulemaking for initial margin
and variation margin for swap dealers (SD) and major swap participants (MSP) for
which there is no “prudential regulator” on swaps that are not centrally cleared
through a derivative clearing organization. The proposal allows for netting of legally
enforceable positive and negative marking to market swaps and reduction in margin
requirements with off-setting risk characteristics. Only swaps entered after the
effective date of the regulation are covered. The forthcoming capital rules will
encompass existing swaps. There are no margin requirements on nonfinancial end
users. Initial and variation margin requirements would not be required if payments
are below the “minimum transfer amount” of $100,000.
SD, MSP, or financial entities can post initial margins in the form of cash; US
government or agency securities; senior debt obligations of the Federal National
Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal
Home Loan Bank, or the Federal Agricultural Mortgage Corporation; or any “insured
obligation of a farm” credit system bank. A variation margin has to be posted in
cash or US Treasury securities. For nonfinancial entities, there is flexibility about
assets that could be used as long as their value can be easily assessed on a periodic
basis.
Those SD and MSP that have a “prudential regulator” are required to meet the
margin requirements of that regulator. A prudential regulator is the Federal Reserve
Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, the Farm Credit Administration, or the Federal Housing Finance Agency.
These commissions will propose capital requirements and financial condition reporting
for SD and MSP at a later date.
In the EU, financial and nonfinancial firms that enter into OTC contracts that
are not centrally cleared through a CCP have to adopt procedures to measure,
monitor, and mitigate both operational and credit risk including timely electronic
confirmation of contract terms and early dispute resolution. Additionally, the contracts
have to be marked to market on a daily basis. Finally, there should be appropriate
exchange of segregated collateral or appropriate and proportionate holding of capital.
These rules are applicable only to market participants subject to central clearing
obligations (Herbert Smith LLP 2012).
Singapore recommends financial buffers of capital and margins to mitigate the
risk of OTC derivatives that are not centrally cleared. The amount of capital and
margin should reflect and be proportionate to the risk of noncentrally cleared OTC
contracts.
The MAS will be implementing the Basel III requirements of capital for banks
and will seek to align capital requirements of other regulated financial institutions
with Basel III. The MAS will seek to align margin requirements on noncentrally
cleared derivatives in accordance with the recommendations of the working group
made up of representatives from the Basel Committee on Banking Supervision
(BCBS), the Committee on the Global Financial System, the Committee on Payment
and Settlement Systems, and the International Organization of Securities
Commissions.
D. Trading
All centrally cleared swaps in the United States are required to trade on a
swap execution facility unless the swap execution facility or exchange does not
accept the swaps. In the EU, all cleared OTC derivatives have trading requirements
mandated by the Markets in Financial Instruments Directive. The MAS does not
require trading of centrally cleared OTC derivatives in Singapore.
E. Backloading of Existing OTC Contracts

In the United States, the Dodd-Frank Act applies to swaps entered only after
the mandatory clearing requirement. However, this exemption is not applicable for
reporting. The EU has proposed to require backloading of outstanding contracts
with remaining maturities over a certain threshold (MAS 2012). In Singapore, a
contract for a product subject to mandatory central clearing and having more than
a year left before maturity is backloaded. Table 1 summarizes the regulatory
requirements for these three jurisdictions.
F. Reporting Requirements
1. United States
In the United States, swaps trade repositories are regulated by the CFTC or
the SEC. TRs authorized by the CFTC (SEC) deal in swaps regulated by the CFTC
(SEC). All traded or bilaterally negotiated swaps have to be reported. These swaps
Table 1. Summary of Regulatory Requirements by Jurisdiction.
United States European Union Singapore
Mandatory clearin g Yes Yes Yes
All financials and non - All financial counterparties
All financials,all end users, financials above a threshold. above a threshold , at least
Who will clear all above $10 billion Temporary exemption for one leg in Singapore or one
pension funds of the parties in Singapore
All except foreign
Assets All assets All assets exchange swaps and
forwards
Yes (exception if fo reign
Yes (exception if foreign CCP is in comparable
Domestic CCP only CCP is in comparable No
jurisdiction and contract with
jurisd iction)
foreign regulator)
Backloading Yes Yes, above a threshold Yes, above a year
Interoperability None Yes None
Mandatory trading Yes Yes No
Margin requirement for
non-centrally cleared Yes Yes Yes
derivatives
Base capital for CCP Yes Yes Yes
Organizational
Yes Yes Yes
requirements
Capital for loss and one year Capital liquidity
Loss Mitigation operation liq uidity arrangements, default funds, N/A
arrangements and insurance guarantees
OTC Derivatives Regulation: A Comparison
43
have to be between two unrelated parties and any changes to the swap agreement
have to be reported.
If a swap is executed by a swap execution facility (SEF) or designated contract
market (DCM), the SEF or the CCP is required to report swap data to the TR as
soon as technologically possible. For an off-facility swap, the hierarchy lies with
the SD followed by MSP, followed by a non-SD or non-MSP. When the
counterparties are within the same category, they have to choose which one of
them will report. Both parties can choose to report and there is no condition of
nonduplication. The party required to report is ultimately liable for the reported data
even if that party contracts reporting to a third party (Young et al. 2012).
Any swap (mandatory cleared or nonmandatory) that is cleared before the
reporting deadlines for primary data can be reported by the clearing facility.
Confirmation data on a cleared swap need to be reported by the clearing facility.
For a noncleared swap, confirmation data need to be reported by the counterparty
as soon as technologically possible. Any changes to the swap over its lifetime need
to be reported by the respective parties listed above. Additionally, the state of the
swap needs to be reported daily to the TR (Young et al. 2012).
There is a real time public reporting obligation by a TR. Such reporting will not
identify the counterparty and should be done when technologically possible. These
records must be retained for the life of the swap and for five years after the
termination of the swap.
A TR needs to be appropriately organized and be able to perform its duties in
a fair, equitable, and consistent manner. The TR should have emergency procedures
and system safeguards and provide data to regulators.
2. European Union
The ESMA has the regulatory power to register a trade repository in Europe.
Regulators in individual countries cannot do so. Foreign authorities can deal with
the ESMA for exchange of information and bilateral negotiations.
Foreign TRs are recognized if regulations in the foreign country are comparable
to those of the EU and there is appropriate surveillance in that third country.
Additionally, there should be agreement between that country and the EU for
exchange of information.
Financial counterparties are required to report to a TR and to report to
regulatory authorities if a TR is unable to record a contract. A counterparty required
to report may delegate such reporting to another counterparty. Reporting should
include the parties to the contract, the underlying type of contract, maturity, and the
notional value. A nonfinancial counterparty, above the information threshold, is
required to report on OTC contracts. Such reporting must be done in one business
day from the execution, modification, or clearing of the contract. There should be
no duplication.
The regulation has proposed robust governance arrangements including
organizational structure to ensure continuity, orderly functioning of the TR, quality
of management, and adequate policies and procedures. Operational requirements

include a secure TR with policies for business continuity and disaster recovery.
Data reported to a TR should be confidential even from affiliates or the parent of
the TR.
A TR will share information with (a) the ESMA; (b) the competent authorities
supervising undertaking subject to the reporting obligation under Article 6; (c) the
competent authority supervising CCPs accessing the trade repository; and (d) the
relevant central banks of the European System of Central Banks. A TR will maintain
confidentiality of information and maintain records for at least 10 years after the
termination of a contract. A TR will aggregate data based on both class of derivatives
and reporting entity.
3. Singapore
The MAS does not require reporting to a domestic TR. The MAS has proposed
two types of trade repositories — approved and recognized overseas trade
repositories (ATR and ROTR). Approved TRs are domestic, whereas ROTRs are
foreign incorporated TRs. The MAS has not required foreign regulators to indemnify
ATRs or ROTRs before obtaining data from them.
The MAS has proposed reporting for all asset classes of derivatives. However,
it recommends a phased implementation of the reporting requirement with a priority
given to asset derivatives from a significant share of the Singapore OTC market
interest rate, foreign exchange, and oil derivatives. Oil forms a significant part of
the physical market during the Asian time zone, but it does not form a significant
part of the Singapore derivatives market.
All contracts that are booked or traded in Singapore or denominated in Singapore
dollars are required to be reported. All contracts where the underlying entity or
market participant is resident or has a presence in Singapore also need to be reported.
Any foreign finance entities are not required to report in Singapore. However, if
MAS has an interest in an entity, it will seek information from a foreign authority.
All financial entities and any nonfinancial entity above a threshold (that takes
into account the asset size of the entity) have to report. Additionally, group-wide
reporting is required for Singapore incorporated banks.
Singapore allows single-sided reporting and third-party reporting. While single-
sided reporting is mandatory for financial entities, only one of the nonfinancial entities
(among a group) needs to report. Foreign entities are not required to report, and
public bodies are excluded from reporting.
Transaction-level data, including transaction economics, counterparty, underlying
entity information, and operational and event data, need to be reported. The content
of the data needs to be reported in both functional and data field approaches. Any
changes to the terms of the contract over its life need to be reported. The MAS has
proposed a legal entity identifier and standard product classification system, but has
not required it. The data need to be reported within one business day of the
transaction. The MAS requires backloading of pre-existing contracts.
Both TRs are required to have safe and efficient operations with appropriate
risk management and security. They are required to avoid conflict of interest and
maintain confidentiality of user information. They are required to maintain transparent
reporting with authorities. The MAS is considering minimum base capital
requirements on TRs. A ROTR may comply with comparable regulations in home
jurisdictions. Table 2 summarizes the reporting requirements for the three
jurisdictions.
IV. COMPARISON OF REGULATORY REQUIREMENTS
A. Clearing Requirements
Clearing exemptions for a certain asset class may not necessarily mean that
these assets will not move to central clearing. As mentioned before, noncentrally
cleared assets are required to maintain higher collateral. This increased requirement
in collateral may lead to prohibitive costs.
The EU regulation is stricter for all financial entities as it gives no exemption
on the size of the financial entity. Financial entities in Singapore below a certain
threshold (below $10 billion in the United States) have an exemption from central
clearing. As such, they and those exempted entities in the United States may have
reduced costs and a competitive advantage over larger domestic rivals and all EU
rivals.
The regulations for nonfinancial entities below a certain threshold are
comparable in their exemption. While the United States has specified a $10 billion
threshold, such has not yet been specified by the EU and Singapore. Any differences
among these jurisdictions in the clearing threshold will be beneficial to the entities in
respective jurisdictions.
The EU is the only jurisdiction that exempts pensions from clearing requirements.
The idea is that pensions are mostly fully invested. To subject them to the clearing
requirement will be detrimental to the pension funds.
However, pensions do deal in derivatives to hedge their interest rate and inflation
risk. Leahy and Hurrell (2012) indicate that in many cases pension funds hedge
those risks with financial counterparties. A requirement on financial counterparties
to hold higher collateral on noncentrally cleared derivatives will require them to
hold higher collateral for derivative hedges they enter with pension funds. This
increases the cost to financial institutions which, in turn, pass them on to pension
funds.
An exemption given to any nonfinancial entity below a certain threshold may
still be costly for these institutions because, in most cases, the counterparty to these
transactions may be a larger financial institution. To the extent that these larger
financial institutions have to hold higher collateral, nonfinancial entities will bear a
higher cost. This defeats the very purpose of the exemption. The alternative will be
that even the exempt nonfinancial institutions will have to centrally clear their
products.
Only Singapore gives an exemption from central clearing to domestic and foreign
central banks and supranational institutions. The EU regulation exempts member

state banks from central clearing but is not clear on exemptions for foreign central
banks.
B. Requirements for CCPs

The United States and EU require clearing through a domestic CCP. Clearing
through a foreign CCP is acceptable in these jurisdictions if a foreign CCP is under
a jurisdiction that has regulations comparable to that of either the United States or
the EU. There are concerns that such requirement of equivalence in regulation will
result in comparing identical points of regulations rather than the intent of regulations
in foreign jurisdictions. The requirement for equivalency in foreign jurisdictions results
in central clearing through a domestic CCP rather than foreign CCP. Having multiple
CCPs will result in fragmentation of clearing.
Singapore is the only jurisdiction that allows central clearing using a foreign
CCP without requiring investigation of regulations and agreements with foreign
regulators. As such, Singapore has much more flexible regulations with respect to
the choice of the CCP.
The EU has the most prescriptive regulation on the organization of a CCP and
a choice of model for the CCP. The regulation indicates a mutualized CCP where
the losses of a clearing member’s default are mutualized through a default fund and
loss sharing. As mentioned by Koeppl and Monnet (2008), this mutualization may
ensure that the impact of default is minimized and may not pose systemic risk.
However, liquidity may be affected in the case of default as the CCP focuses on
default resolution rather than efficient trading, which is taken care of by the regulation
through liquidity arrangements and insurance guarantees.
Only Europe allows interoperability of a CCP and, to that extent, reduces risk.
Thus, it allows netting across asset classes. As such, there is a reduced need for
collateral. Further, multilateral netting across asset classes also reduces risk.
C. Backloading of Existing Contracts

Backloading of contracts written prior to the regulation requires market
participants to clear through CCPs. When these contracts were written, there was
no regulation requiring OTC contracts to novate through a CCP. The choice of the
counterparty was based on the best value provided rather than the counterparty
credit risk and any mandated collateral requirements. Additionally, requiring these
contracts to clear through a CCP subjects them to the model of a CCP. Backloading
is of particular importance in the case of jurisdiction, such as the EU, that prescribes
a CCP model. Each CCP model has specific costs. These costs may not have been
considered while writing the original contracts. As such, the original contracts may
be uneconomical for market participants subject to new regulations.
The US regulation is strict as it requires backloading with no exemption for the
size or the duration of the contract. Therefore, market participants will face additional
costs in the United States.
Table 2. Summary of Reporting Requirements.
48

Reporting by TR
Real time public reporting Yes No No
Minutes, “as soon as
Time delay to report to SDR ++1 day ++1 day
technologically possible”
Disclosure of identity of counterparty to public No No No
Notional amount reporting to public Capped N/A N/A
5 years until swap terminated, 2
Recordkeeping 10 years N/A
years after termination
Regulation of TR
Domestic only No No No
Cooperation among regulators required Yes Yes Yes
Indemnity required Yes No No
Governance of TRs Yes Yes Yes
Capital requirement No No No
Foreign TR reporting Yes Yes Yes
3rd party reporting Yes Yes Yes
Single-party reporting Yes Yes Yes
Double reporting Yes No No
Review of Futures Markets
Table 2, continued. Summary of Reporting Requirements.
Regulated by CFTC or SEC ESMA MAS
Reporting for Products
Required for cleared derivatives Yes Yes Yes
Required for un-cleared derivatives Yes Yes Yes
Interest rate, foreign
Phased-in reporting by product Interest rate first followed by None exchange, & oil first,
foreign exchange & co mmodity
followed by o thers
Phased reporting by entity SD and MSP first, followed by None None
non-SD & non-MSP
Threshold None Yes Yes
Backloading None Yes Yes, over 1 year
Intragroup trades Not reported Not reported Not reported
What swaps need to be reported All All All
Upon execution and Upon execution and
When reported Upon execution and changes
changes changes
Confirmed Yes N/A N/A
Subsequent changes to the swap Reported Reported Reported
Daily value of the swap Yes* N/A N/A
OTC Derivatives Regulation: A Comparison
49
The EU regulation is most beneficial for transactions below the threshold and
does not benefit any specific asset class. The Singapore regulation has the potential
to benefit foreign exchange contracts (Global Financial Markets Association 2012)
as they are typically short term in nature. As indicated, 99% of these contracts are
for less than one year and hence do not need to be renegotiated.
D. Margin Requirements for Noncleared OTC Derivatives

All jurisdictions require an initial and variation margin. The US regulation has
details about netting among legally enforceable offsetting contracts and “minimum
transfer” amount. The United States exempts all nonfinancial end users, while the
EU exempts any user not subject to central clearing. Singapore is not clear on this
requirement. As all jurisdictions subject financial companies to these regulations,
their costs may increase to hold collateral and margins. To the extent that these
financial companies are on the other side of the contract with exempt companies,
financial companies are still subject to these regulations. It is likely that these
additional costs will be passed on to the nonfinancial companies exempt from the
regulation.
E. Reporting Requirements
Reporting requirements are consistent across all three regulatory environments
in that they require reporting on all asset classes. However, there is a difference in
the timeline for reporting. In Europe, there is no phasing in. Singapore requires
interest rate, foreign exchanges, and oil derivatives to be reported, followed by
others. Finally, the United States has the most tiered reporting requirement. Interest
rate derivatives are to be reported first, followed by the foreign exchange and
commodity derivatives. Both cleared and uncleared trades need to be reported in
all three jurisdictions.
The Singaporean requirement of reporting affects any party or transactions
related to Singapore. Singapore is a relatively smaller market; hence, its immediate
reporting requirement of foreign exchange and oil derivatives, which are additional
to that of the United States of interest rate derivatives, may not affect a significant
number of market participants or transactions.
The European requirement of immediate reporting of all assets will be a
dominating requirement. Phasing-in allowed by the United States will give little
flexibility if most of the transactions are cross-border.
All countries require financial institutions to report. However, there are
significant differences. While Singapore requires only financial institutions above a
threshold to report, both the EU and the United States require all financial institutions
to report.
Nonfinancial entities only above a certain threshold are required to report in
both the EU and Singapore. In the United States, while nonfinancial institutions are
the last to report, there is no exemption for smaller institutions. The Singapore
regulation is more accommodating for smaller (financial and nonfinancial) institutions

and will help such institutions keep costs down.
Only the US regulation has phased-in reporting, with financial institutions
reporting first, followed by nonfinancial institutions. This gives nonfinancial institutions
additional time to comply.
All three jurisdictions allow third-party reporting and single-sided reporting.
However, only the United States allows for double reporting. Double reporting might
be beneficial to the trade repository to confirm the accuracy of the data being
reported. It would be costly for the trade repository to verify the accuracy of the
data if double reporting is not allowed. However, double reporting involves costs
associated with consolidation of data and the reporting costs incurred by each
counterparty.
Time to report information to the trade repository is almost immediate in the
United States. Both the EU and Singapore allow one day to report information to
the trade repository. All three countries require not only initial reporting but also any
subsequent changes to the contract. The Depository Trust and Clearing Corporation
(DTCC 2012) believes that for day+1 care should be taken to avoid intraday cutoff.
Only the United States requires real time public reporting by the TR. While all
countries require that the identity of the counterparties be kept confidential, only
the United States requires the notional amount of the swap to be capped while
public reporting. Capping of notional amounts will provide an added measure of
security in keeping the identity of the counterparty confidential.
All three countries have similar governance of TRs. TRs are required to keep
data confidential. The MAS proposal indicates that data collected by a TR serve a
regulatory purpose. However, it does not specifically prohibit use of that data by
affiliates of the TR or the TR itself for commercial use. Such absence of a specific
prohibition may allow these private entities to benefit from privileged information
(Argus 2012).
Only the EU prohibits the TR from sharing data with its parent or a subsidiary.
Only Singapore is considering base capital requirement from the TR.
Singapore has no requirement for the time to keep records. The United States
requires the data to be kept for 5 years and the EU for 10 years after the expiration
of the contract.
The objective of the OTC regulation is to improve collection and monitoring of
the OTC market. As such, the regulators in the three jurisdictions have focused on
post-trade transparency. A major portion of this post-trade transparency deals with
reporting information to the TR in a timely manner. Market participants in the United
States face the most stringent deadline regarding reporting of information to the TR
upon execution. All three jurisdictions have comparable information that needs to
be reported.
In all jurisdictions, the onus of reporting falls primarily on financial institutions.
Singapore is more favorable to smaller financial institutions. In the United States,
nonfinancial institutions have to report only when there is no financial counterparty.
Both Singapore and the EU require only nonfinancial institutions above a certain
threshold to report. Thus, regulations in Singapore and the EU are more favorable
to smaller, nonfinancial institutions. Additionally, a potential for regulatory arbitrage
is possible depending on the threshold level used.
The bulk of the above regulations focus on reducing reporting and regulatory
costs for nonfinancial participants and smaller institutions. The idea is that as these
participants do not regularly deal with derivatives, it will be costly for them to report.
Even if these participants deal with derivatives, the financial counterparties have
the requisite manpower and systems to meet the reporting obligations. Thus, it will
be more cost effective to use their existing system for reporting.
Single-sided reporting is based on the same concept as stated above. However,
only mandating a single counterparty to report while reducing reporting and
reconciliation costs may increase inaccuracies in reported data. Improper data will
definitely not help the regulators to properly maintain the markets. Though single-
sided reporting may reduce costs, there may be situations in which double-sided
reporting is preferred. This might be in the case of firms that want to be consistent
with reporting and report all their trades. Also, if a party is ultimately responsible for
the accuracy of a trade, it may want to report it. Finally, double reporting may be
essential for trade repositories as it will be easier to compare and note and/or
correct differences (DTCC 2012).
To avoid fractioning of data across jurisdictions and TRs, regulators in all three
countries approve of reporting to TRs in foreign jurisdictions. They condition this
approval on agreements between regulators in foreign countries with domestic
regulators and compatibility of regulation. Bilateral negotiations between jurisdictions
could take a considerable amount of time. The two regulators in the United States,
the CFTC and SEC, had to go through various negotiations and time to propose
rules on OTC derivatives. Hence, it is possible that market participants may have
to report in various TRs leading to duplication and increased costs. There is also a
chance that this will lead to fragmentation of data. Any fragmentation of data will
not give regulators a complete picture of a market participant’s exposure or about
an asset class. Hence, regulators will not be in a position to maintain global
concentration of positions by asset on a counterparty.
Regulators in all three jurisdictions have erred on maintaining confidentiality.
The US regulation is more stringent, not just requiring counterparty confidentiality
but also requiring capping of the notional amount in public reporting. This requirement
will not help post-trade transparency. However, where markets are more
concentrated by few participants, it is wise to maintain trade confidentiality. This
will help market makers provide liquidity in the market.
V. CONCLUSION
This study compares clearing and reporting regulation of OTC derivatives in
Singapore, the United States, and the EU on assets, institutions, and the timing of
regulation. The United States and the EU require central clearing and trading of all
asset classes. Singapore requires only central clearing but not trading of all assets
except foreign exchange swaps and forwards. Further, only the United States has
phased implementation for reporting; Singapore prioritizes foreign exchange
derivatives, interest rate contracts, and oil contracts. As the United States is in the
most advanced stages of implementation of OTC regulation, the phasing in will be
only a marginal reprieve. Singapore’s clearing regulation is less stringent on foreign
exchange derivatives but not on reporting.
Small nonfinancial companies in Singapore and the EU face no regulation of
mandatory clearing and reporting. While smaller financial companies have no
clearing requirements in Singapore and the United States, they do face reporting
requirements (last to report). Hence, the bulk of the regulation is to minimize costs
for nonfinancial companies, in particular, the smaller nonfinancial institutions.
Regulatory arbitrage is thus possible only based on the threshold used for clearing
and reporting in each of the jurisdictions.
The United States is in the most advanced stages of the derivatives regulation.
It has both adopted and implemented regulations on clearing and reporting. The EU
has agreement among members on the OTC regulation but has not yet implemented
the regulation. Finally, Singapore has not yet adopted nor implemented OTC regulation
(Financial Stability Board 2012). Thus, it is the time to implement regulation that
may lead to a regulatory arbitrage towards the EU and Singapore.
The main difference in the three regulatory jurisdictions is the nonrequirement
of trading of cleared derivatives in Singapore. This difference has the potential to
provide substantial choices in trading venues for market participants.
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Alert Memo
APRIL 9, 2013
Navigating Key Dodd-Frank Rules Related to the

Use of Swaps by End Users
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-
Frank”) enacted a new regime of substantive regulation of over-the-counter (“OTC”)
derivatives under U.S. securities and commodities laws. Over the course of 2013, many key
provisions of Dodd-Frank are being implemented by the Commodity Futures Trading
Commission (the “CFTC”) with respect to “swaps.” While many of the regime’s
requirements focus on “swap dealers” (“SDs”) and “major swap participants” (“MSPs”),
commercial entities that enter into OTC derivatives transactions to hedge or mitigate risk,
referred to as “end users,” will also become subject to a wide range of substantive
requirements.
In particular, end users will need to:
• determine whether the derivatives they use are required to be cleared or to be traded on a
regulated execution facility and, if so, whether they are eligible for, and have completed
the steps necessary for, reliance on the exception available for commercial end users;
• determine whether they must post collateral to their derivatives counterparties;
• obtain legal entity identifiers for the purpose of public and regulatory reporting
requirements;
• maintain full, complete and systematic records with respect to their swap transactions;
• enter into the latest International Swaps and Derivatives Association (“ISDA”) Dodd-
Frank Protocols or otherwise amend existing swap agreements;
• comply with new position limit requirements; and
• comply with new antifraud and antimanipulation regulations.
Under proposed guidance and a final exemptive order, non-U.S. end users will generally
not be subject to such requirements with respect to swaps entered into with other non-U.S.
counterparties. Appendix A to this memorandum is a table summarizing the requirements
applicable to end users as well as relevant compliance time frames. Appendix B is a list of
key CFTC rulemakings.
© Cleary Gottlieb Steen & Hamilton LLP, 2013. All rights reserved.
This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments
that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal
advice. Throughout this memorandum, "Cleary Gottlieb" and the "firm" refer to Cleary Gottlieb Steen & Hamilton LLP and its
affiliated entities in certain jurisdictions, and the term "offices" includes offices of those affiliated entities.
Table of Contents
Which Derivatives Are Subject to Dodd-Frank?...................................................... 3

Who Is an End User?................................................................................................. 5
What Requirements May Apply to End Users?.......................................................... 8
Clearing……………………………………………………………………. 8
Trade Execution……………………………………………………………. 17
Margin……………………………………………………...……………… 20
Reporting………………………………………………………………….... 22
Business Conduct and Swap
Documentation……………………………………………………………... 26
Recordkeeping…………………………………………………………….... 32
Position Limit………………………………………………………………. 33
Antifraud and Antimanipulation………………………………………….... 34
Will Dodd-Frank Impose Requirements on Swaps Between Non-U.S. Persons?..... 35
2
Which Derivatives Are Subject to Dodd-Frank?
• In General. Dodd-Frank regulates a variety of previously unregulated
derivatives, including interest rate swaps (“IRS”); non-spot foreign exchange
transactions (unless exempted as described below); currency swaps; physical
commodity swaps; total return swaps; and credit default swaps (“CDS”). 1 Dodd-
Frank divides this group of previously unregulated derivatives into two
categories: “swaps” (which come under the jurisdiction of the CFTC) and
“security-based swaps” (which come under the jurisdiction of the Securities and
Exchange Commission (“SEC”)). The SEC has not yet finalized most of its
substantive rules. Accordingly, this memorandum does not address the
regulation of security-based swaps.
• What Is a “Swap”? The term “swap” is broadly defined and, unless an
exclusion applies, includes a wide range of agreements, contracts or transactions
linked to an array of underliers such as physical commodities, rates, foreign
currencies, broad-based security indices or U.S. government or other exempt
securities (other than municipal securities). 2 OTC derivatives based on a single
non-exempt security or narrow-based security index are generally security-based
swaps.
• Exemption for Physically-Settled Foreign Exchange Swaps and Forwards.
The U.S. Secretary of the Treasury has exempted certain physically-settled
foreign exchange swaps and foreign exchange forwards from some Dodd-Frank
requirements. The exemption does not apply to products such as non-deliverable
foreign exchange forwards, foreign exchange options or currency swaps. 3
Exempt foreign exchange swaps and foreign exchange forwards do remain
subject to the regulatory reporting requirements and external business conduct
standards discussed later in this memorandum.
• Excluded Instruments. Some common financial products are excluded from the
new framework. These include listed futures, options on listed futures, listed and
unlisted options on securities and on broad- and narrow-based security indices,
1
See 77 Fed. Reg. 48,208 (August 13, 2012) (“Product Definitions Final Rule”).
2
For these purposes the term “exempt securities” means certain securities exempted under Section
3(a)(12) of the Securities Exchange Act of 1934 (the “Exchange Act”) but does not include,
among other securities, municipal securities. Examples of exempted securities include U.S.
Treasuries and securities issued by the Federal National Mortgage Association (Fannie Mae) and
Federal Home Loan Mortgage Corporation (Freddie Mac).
3
See 77 Fed. Reg. 69,694 (Nov. 20, 2012) (“Final Treasury Determination”).
3
commodity trade options, 4 securities repurchase agreements, depository
instruments, security forwards and non-financial commodity forwards intended
to be physically settled. The CFTC retains anti-evasion authority with respect to
the structuring of certain transactions to evade regulation.
4
The CFTC has exempted from many Dodd-Frank rules trade option transactions that are between
either two users of the commodity or between a user of the commodity and an ECP In this
context, a user of the commodity is a person that is a producer, processor or commercial user of,
or a merchant handling the commodity that is the subject of the trade option transaction, or the
products or byproducts thereof, and that is offered or entering into the trade option transaction
solely for purposes related to its business. The trade option must also be intended to be
physically settled. Such transactions are exempt from many Dodd-Frank requirements, including
public reporting and clearing (both discussed below), but only exempt from regulatory reporting
(also discussed below) if the end user does not enter into any non-trade option transactions that
must otherwise be reported.
4
Who Is an End User?
• In General. Title VII of Dodd-Frank created two new categories of registration
for SDs and MSPs. SDs and MSPs are subject to comprehensive, substantive
regulation, including capital, margin, documentation, reporting, recordkeeping,
and internal and external business conduct requirements.
o SDs. An entity is regarded as a swap dealer if it: (i) holds itself out as a
dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into
swaps as an ordinary course of business for its own account; or (iv)
engages in any activity causing the person to be commonly known in the
trade as a dealer or market maker in swaps. 5 Dodd-Frank provides a de
minimis exception from designation as a swap dealer for a person that
enters into less than $8 billion of gross notional value in swaps over the
preceding twelve months. 6 Under the CFTC’s current cross-border
proposed guidance and exemptive order (discussed further below), the
calculation of the de minimis threshold excludes swaps with non-U.S.
persons and foreign branches of U.S. persons that are registered as swap
dealers.
o MSPs. Even if an entity is not an SD, it may still become subject to
registration with the CFTC if: (i) it maintains a “substantial position” in
any major category of swaps, excluding (I) positions held for hedging or
mitigating commercial risk and (II) positions maintained by an employee
benefit or governmental plan, as defined under the Employee Retirement
Income Security Act of 1974 (“ERISA”), for the primary purpose of
hedging or mitigating risks directly associated with the operation of the
plan; (ii) its swaps create “substantial counterparty exposure”; or (iii) it is
a private fund or other ”financial entity” that is highly leveraged, is not
subject to capital requirements established by an appropriate Federal
5
The CFTC has indicated that it interprets this definition in a manner similar (although not
bounded by) the SEC’s dealer/broker distinction. See 77 Fed. Reg. 30,596 at 30,607 (May 23,
2012) (the “Registered Swap Entity Final Rule”).
6
See Registered Swap Entity Final Rule. A smaller, $25 million notional cap applies in the case of
swaps with certain so-called “Special Entities.” Special entities include any (i) Federal agency;
(ii) State, State agency, city, county, municipality, or other political subdivision of a State; (iii)
employee benefit plan subject to Title I of ERISA; (iv) governmental plan, as defined in Section 3
of ERISA; (v) endowment, including an endowment that is an organization described in Section
501(c)(3) of the Internal Revenue Code of 1986; or (vi) employee benefit plan defined in Section
3 of ERISA, not otherwise defined as a Special Entity, that elects to be a Special Entity by
notifying an SD or MSP of its election prior to entering into a swap with such SD or MSP. After
the expiration of phase-in period in 2016, the $8 billion cap will decrease to $3 billion unless the
CFTC decides to set it at a different level.
5
banking agency and maintains a “substantial position” in a major
category of swaps. 7
 A “substantial position” is defined (i) in the case of rate or
currency swaps, as $3 billion in negative mark-to-market exposure
or $6 billion in negative mark-to-market plus potential future
exposure or (ii) in the case of credit, equity or commodity swaps,
as $1 billion in negative mark-to-market exposure or $2 billion in
negative mark-to-market plus potential future exposure.
 “Substantial counterparty exposure” is defined as $5 billion in
negative mark-to-market exposure across all swaps or $8 billion in
negative mark-to-market plus potential future exposure across all
swaps.
 Under the CFTC’s current cross-border exemptive order, the
calculation of these thresholds by a non-U.S. person excludes
swaps with non-U.S. persons and foreign branches of U.S. persons
that are registered as swap dealers.
• End Users. Title VII of Dodd-Frank also applies to end users that do not qualify
as SDs or MSPs. Dodd-Frank divides end users into two broad categories—
financial and non-financial end users.
• Financial End Users. An end user is a financial end user if it is a commodity
pool, 8 private fund, 9 employee benefit plan, 10 or person that is predominantly
engaged in activities that are in the business of banking, or in activities that are
financial in nature, as defined in section 4(k) of the Bank Holding Company Act
of 1956.
o “Predominantly Engaged in Activities that Are Financial In Nature.”
According to final rules under Title I of Dodd-Frank, an entity is
7
Id.
8
In general, a “commodity pool” is any investment trust, syndicate or similar form of enterprise
operated for the purpose of trading in derivatives regulated by the CFTC. See CEA § 1a(10).
9
A “private fund” is an issuer that would be an investment company, as defined in the Investment
Company Act of 1940, but for sections 3(c)(1) and 3(c)(7) of that Act. See Investment Advisers
Act of 1940 § 202(a)(29).
10
For purposes of this memorandum, an “employee benefit plan” means an employee benefit plan
or governmental plan as defined in paragraphs (3) and (32) of section 3 of ERISA, respectively.
See CEA § 2(h)(7)(C)(i)(VII).
6
“predominantly engaged in activities that are financial in nature” 11 if in
either of its last two fiscal years:
 the annual gross revenues derived by the company and all of its
subsidiaries from activities that are financial in nature represents
85 percent or more of the consolidated annual gross revenues of
the company; or
 the consolidated assets of the company and all of its subsidiaries
related to activities that are financial in nature represents 85
percent or more of the consolidated assets of the company. 12
o Accounting for Subsidiaries. Under this standard, an end user may take
into account its own gross revenues and/or assets as well as the gross
revenues and/or assets of all of its consolidated subsidiaries in
determining whether it qualifies as a financial end user. This is true even
if the end user is an intermediate holding company.
11
Activities that are financial in nature include (1) lending, exchanging, transferring, investing for
others or safeguarding money and securities; (2) certain insurance activities; (3) providing
financial, investment or economic advisory services, including advising an investment company;
(4) securitizing; (5) underwriting, dealing in or making a market in securities; (6) extending credit
and servicing loans; (7) activities related to extending credit (e.g., real estate and personal
property appraising, arranging commercial real estate financing, collection agency services, credit
bureau services); (8) certain of leasing personal or real property; (9) operating nonbank
depository institutions; (10) trust company functions; (11) financial and investment advisory
activities (including providing information, statistical forecasting and advice with respect to any
transaction in swaps); (12) securities and derivatives brokerage, riskless principal and private
placement services; (13) investment transactions as principal; (14) management consulting and
counseling activities; (15) support services in connection with financial activities; (16)
community development activities; (17) issuance and sale of money orders, savings bonds and
traveler’s checks; (18) processing of financial, banking or economic data; (19) providing
administrative and other services to mutual funds; (20) owning shares of a securities exchange;
(21) acting as a certification authority for digital signatures and authenticating the identity of a
person; (22) providing employment histories to third parties for use in making credit decisions;
(23) check cashing and wire transmission services; (24) postage, vehicle registration or public
transportation services; (25) real estate title abstracting; (26) operating a travel agency in
connection with financial services; (27) organizing, sponsoring and managing a mutual fund; (28)
merchant banking; (29) lending, exchanging, transferring, investing for others or safeguarding
financial assets other than money or securities; (30) providing any device or other instrumentality
for transferring money or other financial assets; and (31) arranging, effecting or facilitating
financial transactions for the account of third parties. See 12 C.F.R. Part 242 (Apr. 5, 2013)
(Board of Governors of the Federal Reserve System (“Federal Reserve”) rule defining
“Predominantly Engaged in Financial Activities”).
12
See id. See also Dodd-Frank Act Section 102(a)(6). The CFTC has not formally interpreted the
“predominantly engaged in financial activities” standard, but the preamble to the CFTC’s final
rule regarding the clearing exception for inter-affiliate swaps (discussed below) suggests that the
CFTC will defer to the Federal Reserve on this interpretation.
7
What Does It Mean to Clear a Swap?
• Overview of Clearing. To clear a swap, the counterparties to the swap that is

subject to mandatory clearing will, as soon as practicable after execution, submit
their respective sides of the swap to a derivatives clearing organization (“DCO”)
either through a clearing broker (called a futures commission merchant or
“FCM”) or directly (if the party is itself a member of the DCO), rather than
establishing a bilateral contract with each other. Since most end users are not
self-clearing members, to accomplish this, an end user will need to establish a
clearing relationship with an FCM and enter into cleared derivatives execution
agreements (sometimes referred to as “give up” agreements) with its
counterparties. The two counterparties to a cleared swap are not required to, but
may, use the same clearing broker to clear the swap.
• Margin Requirements. Cleared swaps are subject to margin requirements

established by the DCO, including daily exchanges of cash variation (or mark-to-
market) margin and an upfront posting of cash or securities initial margin to
cover the DCO’s (and FCM’s) potential future exposure to the end user in the
event of its default.
• End Users May Choose the DCO. Dodd-Frank provides that the counterparty
to a swap transaction that is not an SD or MSP has the sole right to select the
DCO for a transaction that is required to be cleared. Swap pricing may be
affected by the DCO selected to clear the swap.
• End Users May Choose to Clear Swap Transactions Not Subject to

Mandatory Clearing. An end user is entitled to elect to clear swap transactions
that are not subject to mandatory clearing, at a DCO of such end user’s choice.
Which Swaps Are Subject to Mandatory Clearing?
• In General. The Commodity Exchange Act (“CEA”) authorizes the CFTC,

either upon application by a DCO or upon its own initiative, to require a
designated swap or category of swaps to be cleared by a DCO. 13 On November
28, 2012, the CFTC issued its first mandatory clearing determination for certain
IRS and CDS.
• IRS. Very generally, the following IRS are subject to mandatory clearing:
o Fixed-to-floating swaps;
o Floating-to-floating swaps (also known as basis swaps);
13
See CEA § 2(h)(2).
8
o Forward rate agreements; and
o Overnight indexed swaps.
The mandatory clearing determination only applies to the IRS listed above in
the following currencies: United States dollar, Euro, Sterling or Yen.
• CDS. Very generally, the following CDS are subject to mandatory clearing:
o Untranched indices covering the CDX.NA.IG and CDX.NA.HY; and
o Untranched indices covering the iTraxx Europe, iTraxx Europe Crossover
and iTraxx Europe High Volatility. 14
• The CFTC plans to make additional clearing determinations in the future. End
users should consider establishing policies and procedures to monitor which
swaps become subject to mandatory clearing.
What Are the Exceptions or Exemptions to Mandatory Clearing?

• In General. The CFTC has issued final rules detailing (i) a limited exception to
the mandatory clearing requirement for a defined category of non-financial end
users and (ii) an exemption to the mandatory clearing requirement for
transactions between certain affiliated entities.
• Swap Terminations. In a recent no-action letter, the CFTC staff has clarified
that swaps that partially or fully terminate existing uncleared swaps are not
required to be cleared. 15
What Are the Criteria for the Non-Financial End-User Exception?
• Eligibility. The CFTC has issued final rules outlining a limited exception to the
mandatory clearing requirement for a defined category of non-financial end
users. 16 Both third-party and inter-affiliate trades may qualify for the exception.
In order to qualify for the exception for a particular swap transaction:
o The Entity Entering into the Swap Must Not Be a Financial Entity.
To qualify for the exception, the particular entity entering into the swap
must not be an SD, MSP or financial end user (as described above).
Notably, even an entity within a corporate group that, on a group-wide
14
See 77 Fed. Reg. 74,284 (Dec. 13, 2012) (“Clearing Requirement Determination”).
15
See CFTC Letter No. 13-02, Comm. Fut. L. Rep. (CCH) ¶32,560 (Mar. 20, 2013).
16
See 77 Fed. Reg. 42,560, 42,590 (July 19, 2012) (“End-User Exception Final Rule”).
9
basis, engages predominantly in non-financial activities may still be a
financial entity depending on the activities of the particular entity in
question (and those of its subsidiaries). However, there are certain cases
where a financial entity is nevertheless eligible for the exception:
• End-User Exception for Affiliates Acting as Agents for Non-Financial End

Users. The end-user exception provides that an affiliate of a non-financial end
user may be permitted to use the exception so long as it acts “on behalf of the
[non-financial end user] and as an agent.” 17
o Covered Affiliates. Financial end users acting on behalf of and as an
agent for the non-financial end user may make use of the end-user
exception. An SD or MSP, however, even if it acts on behalf of and as an
agent for a non-financial end user, may not make use of the end-user
exception.
o Undefined Scope of Agency Requirement. It is unclear whether the
CFTC will interpret the agency requirement narrowly (i.e., the central
affiliate may not act as a riskless principal, as is usually the case with
centralized hedging programs) or in a de facto manner (i.e., to permit a
central affiliate to net the demand of various affiliates and act as principal
with external counterparties, while at the same time entering into
offsetting back-to-back swaps with those affiliates). To address this
ambiguity, the Coalition of Derivatives End Users has requested an
exemption from mandatory clearing for centralized treasury units. 18
o Additional Considerations. A financial end user wishing to rely on an
affiliate’s eligibility to elect the end-user exception may need to enter into
an agency agreement to demonstrate that it is acting as an “agent for” the
non-financial end user. Such an agreement may expose the non-financial
end user affiliate to certain liabilities as a principal to the swap
transaction. In addition, such an agency relationship may affect set-off
rights as among the various parties to the swap transactions. In order to
avoid unanticipated consequences, end users should take care to analyze
any potential agency arrangement from the perspective of common law
principles of agency and the applicable state law governing the
agreement.
17
CEA §2(h)(7)(D).
18
Letter from Coalition of Derivatives End Users to Melissa Jurgens, Secretary, the CFTC, dated
Feb. 22, 2013, available at
http://www.nam.org/~/media/B894FEDC2CE4469FA8974459EA5F9FC9/End_UsersCentralized
TreasuryUnits4c_ExemptiveReliefRequest.pdf.
10
• Special Treatment of Certain Financial Entities. For purposes of the end-user
exception:
o Captive Finance Entities Are Not Financial End Users. A captive
finance entity will be a non-financial entity eligible to make use of the
end-user exception if (i) its primary business is providing financing, (ii) it
uses derivatives for the purpose of hedging underlying commercial risks
related to interest rate and foreign currency exposures, (iii) 90 percent or
more of such exposures arise from financing that facilitates the purchase
or lease of products and (iv) 90 percent or more of such products are
manufactured by the entity’s parent company or another subsidiary of the
parent company.
o Small Financial Institutions Are Not Financial End Users. The CFTC
has exempted certain small financial institutions from the definition of
“financial entity.” Small financial institutions include those banks,
savings associations, farm credit system institutions and credit unions
with total assets of $10 billion or less on the last day of such person’s
most recent fiscal year.
o Certain Foreign Entities Are Not Subject to Mandatory Clearing.
The CFTC has stated that foreign governments, foreign central banks and
international financial institutions are not subject to mandatory clearing.
This exclusion does not apply to sovereign wealth funds or similar
entities that, based on their activities, would likely be considered financial
end users. As a result, sovereign wealth funds must be analyzed like any
other non-sovereign entity.
o The Swap Must Be Used to Hedge or Mitigate Commercial Risk. The
CFTC has defined “hedging or mitigating commercial risk” to include
swaps that are economically appropriate to the reduction of risks in the
conduct and management of a commercial enterprise, excluding any
transactions that are in the nature of speculation, investing or trading or
that are used to hedge another swap, unless that other swap is itself used
to hedge or mitigate commercial risk. The CFTC has indicated that
commercial risk does not refer only to the risk of the end user itself. For
example, the parent entity in a corporate group that is itself eligible for
the end-user exception may make use of the exception when it enters into
a swap for the purpose of hedging the aggregate commercial risk of
affiliates within the corporate enterprise. A swap may also be deemed to
hedge or mitigate commercial risk if the swap qualifies for hedging
treatment under Financial Accounting Standards Board Accounting
Standards Codification Topic 815 (“Derivatives and Hedging”) or
11
Governmental Accounting Standards Board Statement 53 (“Accounting
and Financial Reporting for Derivative Instruments”).
o The End User Must Make an Annual Filing with an SDR or the
CFTC. In order for a non-financial end user to rely on the end-user
exception for a particular swap transaction, one of the parties to the swap
must provide either a swap data repository (“SDR”) or the CFTC with
information regarding “how the end user generally meets its financial
obligations associated with entering into an uncleared swap.” The CFTC
has indicated that this requirement would be satisfied if, on at least an
annual basis, the end user provides or causes to be provided certain
specified information to an SDR or the CFTC, including whether the
entity generally meets its financial obligations associated with its swaps
by (i) a written credit support agreement, (ii) pledged or segregated
assets, (iii) a written third-party guarantee, (iv) its own available
resources or (v) some other means. The SDRs currently registered with
the CFTC include the DTCC Data Repository, ICE Trade Vault LLC and
the Chicago Mercantile Exchange. If an end user does not make an
annual filing, it will need to provide its counterparty with information
regarding how it meets its financial obligations each time it enters into a
transaction in reliance on the end-user exception.
o SEC Filers Must Obtain Certain Board Approvals. If a non-financial

end user is or is controlled by an entity required to file disclosures with
the SEC under the Exchange Act, such end user cannot make use of the
exception unless an “appropriate” committee of the board of directors of
the entity (which could be the board itself) has approved the decision not
to clear the swap. If more than one entity in an end user’s group enters
into swaps, an appropriate committee of the board of directors of each
entity must approve the decision to rely on the end-user exception.
 Annual Committee Resolution Approving Use of End-User

Exception. The board of directors of an end user does not need to
approve each swap transaction with respect to which the end user
elects the clearing exception. Rather, the CFTC has indicated that
an annual certification from the relevant committee of an end
user’s board of directors that it has reviewed and approved the
decision to utilize the exception will suffice.
 Board Approval of a Swap Policy. As a corporate governance

matter, the appropriate boardcommittee may approve a swap
policy that contains sufficiently detailed parameters to
demonstrate that the board committee has exercised appropriate
12
oversight of management’s authority to clear or not clear certain
swaps. For example, the policy could set limits on the types of
counterparties or types of swaps that are pre-approved for the
exception and require that any transaction outside those
parameters be specifically approved by the committee. The
committee could also identify factors that are relevant to the
decision not to clear a swap, which could include credit risk
analysis, the end user’s overall hedging policies, the uniqueness of
the swap, margin requirements, accounting and tax considerations.
 Choosing an Appropriate Committee. The CFTC has indicated

that a board committee would be appropriate for these purposes if
it is specifically authorized to review and approve the end user’s
decision to enter into swaps. While the CFTC provides SEC filers
and their controlled subsidiaries with reasonable discretion to
determine the appropriate committee, for most end users, it is
expected that the audit committee (or other committee responsible
for oversight of treasury activity) would perform this role.
o Reporting Obligation for Each Swap Transaction Relying on End-

User Exception. For each swap between an end user and an unaffiliated
entity in which the end user relies on the exception, the reporting
counterparty 19 will be required to provide the following information to an
SDR or the CFTC: (1) whether the end-user exception has been elected;
(2) which party is the electing counterparty; and (3) whether the electing
counterparty has already provided the information discussed above
through an annual filing.
 End Users Rarely Will Be the Reporting Counterparty. If the
end user’s counterparty is a U.S. or non-U.S. SD or MSP, the
obligation to report this election to an SDR or the CFTC will fall
upon such SD or MSP counterparty.
 Where Both Counterparties are Not SDs/MSPs, and Only One

Counterparty is a U.S. Person, the U.S. Person is the
Reporting Counterparty. If a non-financial end user enters into
a swap with a financial entity that is not a U.S. person and not a
SD or MSP, then the end user has the reporting obligation, unless
otherwise agreed by contract.
19
This memorandum provides a more thorough discussion of reporting obligations in the section
entitled “Will End Users Be Required to Report Their Swap Transactions?”.
13
 Inter-Affiliate Trades. Under no-action relief issued by the
CFTC staff (the “Inter-Affiliate Reporting No-Action
Letter”), 20 end users need not report the information relating to
the end-user exception for swaps with certain affiliates, subject to
conditions described in “Are End Users Required to Report Inter-
Affiliate Transactions?” below. If a non-financial end user is or is
controlled by an entity required to file disclosures with the SEC
under the Exchange Act, the CEA still requires approval of the
use of the end-user exception by the end user’s board or
appropriate committee, and therefore board resolutions may still
be required for end users that only trade with affiliates.
 “Reasonable Basis” Requirement. If the end user is not the

reporting counterparty, then the reporting counterparty must have
a “reasonable basis to believe” that the end user electing the
exception is entitled to do so. The CFTC has not provided an
explicit standard for having “reasonable basis” to believe, but has
stated that reasonableness depends on the applicable facts and
circumstances. The CFTC has clarified, however, that the
standard does not require independent investigation by the
reporting counterparty of information or documentation provided
by an end user. As long as the reporting counterparty has
obtained information, documentation or a representation that on
its face provides a reasonable basis to conclude that the end user
qualifies for the exception, then, absent facts to the contrary, no
further investigation would be necessary.
What Are the Criteria for the Inter-Affiliate Exemption from Mandatory Clearing
and Trading?
• In General. The CFTC has issued rules that exempt from mandatory clearing
swaps between affiliated entities under common majority ownership and whose
financial statements are consolidated with each other, 21 whether or not such
20
See No-Action Relief for Swaps Between Affiliated Counterparties That Are Neither Swap
Dealers Nor Major Swap Participants from Certain Swap Data Reporting Requirements Under
Parts 45, 46, and Regulation 50.50(b) of the Commission’s Regulations, CFTC (APR. 5, 2013).
21
See Clearing Exemption for Swaps Between Certain Affiliated Entities, CFTC,
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister040113.pdf
(last visited Apr. 2, 2013) (the “Inter-Affiliate Exemption Final Rule”). Affiliates are eligible
for this exemption if one counterparty directly or indirectly holds a majority ownership interest in
the other counterparty or if a common entity directly or indirectly holds a majority ownership
interest in each counterparty.
14
entities qualify as non-financial end users or use swaps to hedge or mitigate
commercial risk.
• Eligibility Criteria. To be eligible for the exemption, the affiliates must:
o document their trading relationship consistent with the swap trading
relationship documentation requirements discussed below, or where both
counterparties are not SDs/MSPs, document in writing all terms
governing the trading relationship between the affiliates;
o establish a centralized risk management program with respect to the inter-
affiliate swaps;
o report the election of the exemption to an SDR or the CFTC, along with
the board certification and information regarding how the entity meets its
financial obligations, as is also required for reliance on the end-user
exception (discussed above); and
o satisfy the outward-facing swaps conditions, described below.
• Treatment of Outward-Facing Swaps Condition. In order to qualify for the
exemption, both affiliates to the swap transaction must generally, when entering
into swaps with unaffiliated counterparties, either:
o comply with the mandatory clearing requirement under the CEA;
o comply with an exception or exemption from the mandatory clearing
requirement under the CEA;
o comply with the requirements for clearing swaps under a foreign
jurisdiction’s clearing requirement that is comparable, and comprehensive
but not necessarily identical to the clearing requirement under the CEA,
as determined by the CFTC;
o comply with an exception or exemption under a foreign jurisdiction’s
clearing requirement; or
o clear such swap through a DCO or a clearing organization that is subject
to supervision by appropriate government authorities in the home country
of the clearing organization and that has been assessed to be in
compliance with certain principles for financial market infrastructures
published by the International Organization of Securities Commissions
(“IOSCO”).
• Time-Limited Alternative Compliance Framework. Given that the clearing
requirement will take effect in the United States before other jurisdictions, the
CFTC recognized that it may be difficult for non-U.S. affiliates to meet the
outward-facing swaps condition discussed above as such affiliates’ home
15
jurisdictions may not yet have comprehensive clearing requirements comparable
to those in the United States. As a result, the CFTC has provided a time-limited
alternative compliance framework that will remain in effect until March 11,
2014.
o Affiliates Located in the European Union (“EU”), Japan or
Singapore. Swaps between a U.S. affiliate and an affiliate located in the
EU, Japan or Singapore will be deemed to have met the outward-facing
swaps condition if (i) each affiliate pays and collects full variation margin
daily on all swaps entered into by the affiliate with unaffiliated
counterparties, (ii) each affiliate pays and collects full variation margin
daily on all swaps entered into with eligible affiliate counterparties or (iii)
the affiliates’ common majority owner is not a financial entity and neither
affiliate is affiliated with an SD or MSP.
o Affiliates Not Located in the EU, Japan or Singapore. Swaps between
a U.S. affiliate and an affiliate that is not located in the EU, Japan or
Singapore will be deemed to have met the outward-facing swaps
condition if (i) the aggregate notional value 22 of swaps entered into by the
affiliate counterparty located in the United States with affiliate
counterparties outside of the United States, the EU, Japan or Singapore
that are required to be cleared does not exceed 5% of the aggregate
notional value of all swaps that are required to be cleared and (ii) either
the affiliate located outside the U.S., EU, Japan and Singapore pays and
collects full variation margin daily on all swaps it enters into with
unaffiliated counterparties or both affiliates pay and collect full variation
margin daily on all their swaps with eligible affiliate counterparties.
• Generally speaking, because of the additional conditions to the inter-affiliate
exemption, and because of the additional reporting obligations (discussed below),
an entity eligible for the non-financial end-user exception for a swap with an
affiliate may well find reliance on that exception more straightforward.
 TIMING FOR COMPLIANCE. If an end user does not qualify for either
exception/exemption, then mandatory clearing of the swaps designated by the
CFTC will go into effect on June 10, 2013 for most financial end users and on
September 9, 2013 for non-financial end users. Swaps entered into before those
dates are not subject to mandatory clearing if they are reported in accordance
with the rules for described below.
22
In each instance, the notional value as measured in U.S. dollar equivalents and calculated for each
calendar quarter.
16
Are There Restrictions on Trading Imposed on End Users?
• In General. Unless subject to an exception, end users will be prohibited from
entering into OTC swaps directly with their counterparties if either of the
following two conditions is true:
o Either party is not an “eligible contract participant” (“ECP”); or
o The swap is subject to the mandatory clearing requirement and is made
“available to trade” by a designated contract market (“DCM”) (i.e., a
futures exchange) or a swap execution facility (“SEF”).
• ECP Trading Requirement.
o In General. Under the CEA, any swap transaction with a person other
than an ECP must be entered into on, or subject to the rules of, a DCM.
o Who is an ECP? Generally speaking, for an unregulated corporation,
partnership or other entity to qualify as an ECP, its total assets must
exceed $10 million or, if it is entering into the swap in connection with its
business or to manage risk, $1 million. The term “ECP” also includes
several defined classes of institutions (e.g., banks, insurance companies,
registered investment companies, pension plans, governmental entities,
broker-dealers and FCMs) and natural persons that meet certain asset and
other requirements. 23
o Must All Swap Guarantors be ECPs? The CFTC’s position is that any
guarantee of a swap is, itself, a swap. As a result, each guarantor of a
swap must be an ECP in order to avoid the prohibition on entering into
OTC swaps discussed above. 24 While this requirement may not be
particularly onerous for most swap guarantors, it may present an issue in
the secured financing context, where multiple affiliates (including those
with minimal assets) may guarantee secured obligations that include not
just loan obligations but obligations under related IRS or other swaps. If
a non-ECP guarantees a swap, the non-ECP guarantor could face
enforcement action, the guarantee may be unenforceable (depending on
applicable state law) and the SD counterparty, if any, could face
23
For certain purposes, ECPs also include financial institutions, insurance companies, commodity
pools, governmental entities, broker-dealers, FCMs, floor brokers and floor traders acting as a
broker or performing an equivalent agency function on behalf of another ECP. In addition, ECPs
also include such entities, along with investment advisers, commodity trading advisors and
similarly regulated foreign persons, who are acting as investment manager or fiduciary for
another ECP and who are authorized by that person to commit that person to the relevant
transaction.
24
See CFTC Interpretative Letter No. 12-17, Comm. Fut. L. Rep. (CCH) ¶32,408 (Oct. 12, 2012).
17
enforcement action for failure to verify the ECP status of the guarantor. 25
On February 15, 2013 the Loan Syndications and Trading Association
issued a market advisory describing how parties can draft their secured
loan agreements to ensure that non-ECPs do not guarantee any swap
obligations. 26 An ECP may also provide a keepwell to confer ECP status
on an entity that would otherwise be a non-ECP guarantor.
• Trading Requirement for Cleared Swaps.
o In General. Swaps subject to the mandatory clearing requirement will be
required to be traded on a DCM or SEF unless the swap is not made
“available to trade” by a DCM or SEF.
o When Is a Swap Made “Available to Trade”? The CFTC has indicated
that the mere listing of a swap for trading is not sufficient. 27 Instead, it
has proposed a number of factors, including, but not limited to, the
presence of willing buyers and sellers, the frequency or size of
transactions, the trading volume, the bid/ask spread, the usual number of
resting firm bids or indicative bids and offers and whether a SEF or DCM
supports trading in the swap. 28 A CFTC proposal would allow a SEF or
DCM to determine whether a swap is made “available to trade” and to
submit such determination to the CFTC for approval or certification. The
CFTC has also proposed that, if one SEF makes a swap available to trade,
all “economically equivalent” swaps would be deemed “available to
trade.”
o What is a SEF? Dodd-Frank defines a SEF to include any trading
system or platform in which multiple participants have the ability to
execute or trade swaps by accepting bids and offers made by multiple
participants. SEFs are required to register with the CFTC and are subject
to several core principles and other requirements. In addition, the CFTC
has proposed to interpret the SEF definitions and core principles to
restrict the execution modalities permitted to qualify (e.g., how bids and
25
See “How Does Dodd-Frank Change the Way Swap Transactions Are Documented” below.
26
See Updated Market Advisory: Swap Regulations’ Implications for Loan Documentation, The
Loan Syndications and Trading Association (Feb. 15, 2013). As noted in the advisory, whether
the ECP requirement also applies to a pledgor pledging collateral to secure an affiliate’s swap is
uncertain.
27
See 76 Fed. Reg. 1214, 1222 (Jan. 7, 2011) (“SEF Proposal”) (describing frequency of
transactions and open interest as potential considerations for determining whether a swap is
available to trade).
28
76 Fed. Reg. 77,728 (Dec. 14, 2011) (“Available to Trade Proposal”).
18
offers may or must be disseminated by a qualifying platform and rules
governing order interaction) and to impose certain other requirements on
the types of functionalities that a SEF must offer. 29 These limitations can
be expected to make it more difficult for an end user to execute a large or
complex swap over a SEF without suffering adverse price effects from
exposing its trading interest to a larger number of other market
participants.
o Are There Any Exceptions to the Trading Requirement for Cleared
Swaps?
 Block Trades. The CFTC has proposed to permit a block-sized
swap transaction to be executed off of a SEF through any means
of interstate commerce. As proposed, however, only the largest
trades — estimated to be the top 5-6% in notional amount for IRS
and CDS — would qualify as block trades.
 Swaps Exempt/Excepted from Mandatory Clearing. In
addition, swaps excepted or exempted from mandatory clearing
are not covered.
 TIMING FOR COMPLIANCE. The ECP trading requirement is already in
effect. The requirement that all swap guarantors be ECPs applies to swaps and
guarantees of swaps entered into after October 12, 2012. The trading
requirement for cleared swaps will become effective after the finalization of
CFTC rules governing SEFs and the CFTC proposal regarding when a swap is
“available to trade.”
29
The CFTC has proposed that order book or request for quote (“RFQ”) platforms may qualify as
SEFs, but systems operated by a single dealer and inter-dealer brokerage platforms would not. A
SEF (even an RFQ SEF) would be required to operate an “all-to-all” display functionality. A SEF
participant would be required to send an RFQ to at least five recipients, and any resting orders
would need to be integrated with responses to RFQs.
19
Must End Users Post Collateral with Respect to Their Uncleared Swaps?
• In General. Dodd-Frank requires SDs and MSPs to collect collateral as initial
and variation margin for certain uncleared swaps. Margin requirements for
uncleared swaps will generally be higher than the margin required to be posted to
a DCO in respect of cleared swaps.
• Who Sets Margin Requirements?
o Very generally, the U.S. federal banking regulators (called the
“Prudential Regulators”) 30 are responsible for setting margin
requirements for SDs and MSPs that are banks and the CFTC is
responsible for setting margin requirements for SDs and MSPs that are
not banks. The CFTC and the Prudential Regulators have proposed
margin requirements, but they are not yet finalized. 31
o In an effort to achieve harmonization across jurisdictions and regulators,
the Basel Committee on Banking Supervision and the International
Organization of Securities Commissions (“BCBS-IOSCO”) has issued
two Consultations on margin requirements for swaps that are not centrally
cleared. 32
• Margin Requirements for Non-Financial End Users.
o Proposed Prudential Regulator Rules. The proposal of the Prudential
Regulators would allow SDs and MSPs to set an unmargined threshold
for non-financial end users. Under the Prudential Regulators’ proposal
bank SDs and MSPs would be required to collect from non-financial end
user counterparties any difference between the initial margin amount
specified in the rules and the unmargined threshold.
o Proposed CFTC Rules. The CFTC’s proposed rules include a full
exception from the proposed margin requirements for non-financial end
users, although credit support documentation would still be required to be
executed.
30
The Prudential Regulators are the Board of Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit
Administration and the Federal Housing Finance Agency.
31
See CGSH Alert Memos, “Prudential Regulators Propose Swap Margin and Capital
Requirements” (Apr. 14, 2011) and “CFTC Proposes Uncleared Swap Margin Requirements”
(Apr. 27, 2011).
32
See “Margin requirements for non-centrally-cleared derivatives,” BCBS-IOSCO (July 2012);
Margin requirements for non-centrally cleared derivatives (Second Consultative Document),
BCBS-IOSCO (Feb. 2013).
20
• Margin Requirements for Financial End Users. Both the Prudential
Regulators and the CFTC would effectively divide financial end users into “high
risk” financial end users and “low risk” financial end users. 33 For both categories
of financial end users, margin would not be required to be transferred below a de
minimis minimum transfer amount of $100,000. In addition, if a financial end
user qualifies as a “low risk” counterparty, rather than a “high risk” counterparty,
margin would not be required to be transferred until it exceeds the thresholds
proposed to be set either based on a fixed dollar threshold (between $15 million
and $45 million) or a percentage of the SD’s or MSP’s capital (between 0.1%
and 0.5%).
• Margin Requirements for Certain Foreign Governmental Entities. The
Prudential Regulators’ and CFTC’s proposals would not exempt sovereigns or
central banks from the requirement to post and collect margin. However, the
recent consultative document on margin requirements published by the BCBS-
IOSCO, in which the Prudential Regulators and CFTC were involved, would not
require such entities to post margin.
• How Can End Users Protect the Margin They Post to their Dealer
Counterparties? Dodd-Frank requires SDs and MSPs to notify counterparties,
such as end users, of their right to require that any initial margin that such
counterparties post to guarantee uncleared swaps be segregated at an independent
custodian. The counterparty will be permitted, but is not required, to elect
segregation.
• Foreign Exchange. Current proposals would not impose margin requirements
on foreign exchange swaps and forwards eligible for the Department of the
Treasury exemption for such transactions. 34
 TIMING FOR COMPLIANCE. Final rules implementing these margin
requirements are still pending.
33
A financial end user would be considered “high risk” unless (1) it does not have significant swap
exposure (a level designed to equal half the level of uncollateralized outward exposure that would
require registration as an MSP under the substantial counterparty exposure prong of the MSP
definition), (2) it predominantly uses swaps to hedge or mitigate the risks of its business
activities, including balance sheet or interest rate risk, and (3) it is subject to capital requirements
established by a prudential regulator or state insurance regulator. See 76 Fed. Reg. 27,564 (May
11, 2011) (“Prudential Regulator Capital and Margin Proposal”) and 76 Fed. Reg. 23,732
(Apr. 28, 2011) (“CFTC Margin Proposal”). Notably, under these proposals, sovereigns and
sovereign financial institutions, such as non-U.S. central banks, would be treated as high-risk
financial end users.
34
See Final Treasury Determination, 77 Fed. Reg. 69,694, 69,695 (Nov. 20, 2012).
21
Must End Users Report Their Swap Transactions?
• In General. The CEA requires that all swap transactions that were in existence
as of July 21, 2010 (the date Dodd-Frank was enacted) or entered into after that
date be reported to an SDR or, if no SDR accepts the relevant swap data, the
CFTC. This requirement applies to end users, although the CFTC has issued no-
action relief regarding certain inter-affiliate swaps.
• Public Reporting. The CEA requires that swap transaction and pricing data be
reported to the public in real-time as soon as technologically practicable, subject
to certain delays for block trades as described below. 35 The parties’ identities are
not made public.
• Regulatory Reporting. The CEA also requires that all relevant information
about every swap transaction be reported to an SDR or the CFTC for the entire
life of the transaction. 36 For each swap transaction, the reporting party must
report (i) “creation” data comprised of the primary economic terms of the swap
transaction and all of the terms of the swap in the legal confirmation and (ii)
“continuation” data documenting all of the lifecycle events of the swap
transaction (e.g., a daily snapshot of all primary economic terms data, including
any changes that have occurred since the previous snapshot) and the valuation of
the swap transaction. Such data is maintained for regulatory purposes and will
not be made public.
• Historical Reporting. The CEA requires that the responsible party report
certain information regarding all swaps that were effective as of July 21, 2010,
even if they have already expired. For such swaps that expired prior to April 25,
2011, the reporting party must report information in their possession as of
specified dates relating to the swaps to an SDR in whatever method the party
selects. For swaps still effective as of April 25, 2011, the reporting party must
electronically report minimum primary economic terms data and information that
identifies each counterparty. Such data is maintained for regulatory purposes and
will not be made public. 37
• Reporting Delays for “Block Trades.” The CFTC has provided for certain
delays in real-time public dissemination of swap transaction data for block
trades. Under proposed rules, block trade thresholds and reporting delays differ
depending on the asset class (or sub-asset class swap category), method of
35
See 77 Fed. Reg. 1182, 1243 (Jan. 9, 2012) (“Real-Time Public Reporting Final Rule”).
36
See 77 Fed. Reg. 2136 (Jan. 13, 2012) (“Regulatory Reporting and Recordkeeping Final
Rule”).
37
See 77 Fed. Reg. 35,200 (June 12, 2012) (“Reporting of Unexpired Pre-Enactment Swaps
Final Rule”).
22
execution and status of the parties. If a swap exceeds the applicable block trade
threshold, the public reporting of data on that swap will be delayed for at least 30
minutes and, in some cases, significantly longer. 38 Pending finalization of block
trade thresholds, all swaps are eligible for these delays.
Who Is Responsible for Reporting Swap Transaction Data?
• End Users Are Not Usually Responsible for Reporting. In general, end users
will not be responsible for such reporting with respect to most of their swap
transactions.
o In a transaction in which one of the parties is an SD or MSP and the other
is not, the SD or MSP is responsible for satisfying the reporting
obligation (even if the SD or MSP is a non-U.S. person).
o In a transaction in which one of the parties is a financial end user and the
other is a non-financial end user, the financial end user is responsible for
satisfying the reporting obligation (unless the financial end user is a non-
U.S. person).
o In a transaction in which both parties are non-financial end users, the
counterparties are to agree as a term of the transaction as to which
counterparty is the reporting party (unless the financial end user is a non-
U.S. person).
• End Users Are Responsible for Reporting Transactions with Certain Non-
U.S. Counterparties. The CFTC has stated that, in the case of a swap between a
U.S. and a non-U.S. person, in which neither party is an SD or MSP, the U.S.
person is responsible for reporting, regardless of the statuses of the parties.
Foreign financial institutions that have not registered as SDs may agree by
contract to report swaps on behalf of their U.S. end user counterparties, although
a U.S. end user will ultimately be responsible for ensuring that the swaps are
reported.
Are End Users Required to Report Inter-Affiliate Transactions?
• No-Action Relief from Reporting End-User Inter-Affiliate Transactions. On
April 5, 2013, the CFTC staff issued no-action relief to end users for regulatory
reporting obligations with respect to certain inter-affiliate swaps (including
historical swap reporting and reporting relating to the end-user exception).
Public reporting requirements, which apply to all trades that are “arms’ length,”
are not the subject of the Inter-Affiliate Reporting No-Action Letter. The no-
action relief is not time-limited.
38
See 77 Fed. Reg. 15,460 (Mar. 15, 2012) (“Block Trade Proposal”).
23
• Conditions to the Inter-Affiliate Reporting No-Action Letter. Each aspect of
the relief only applies to bilateral, uncleared OTC swaps where neither
counterparty is an SD, MSP or an affiliate of either. The relief will likely apply
to most inter-affiliate swaps between end users. The relief includes the following
conditions:
o 100% Commonly Owned Affiliates – New Swaps. The no-action relief
from regulatory reporting and end-user exception reporting applies to
swaps between a counterparty that 100% owns the other counterparty or
between counterparties that are 100% commonly owned (directly or
indirectly) by a party that reports its financial statements on a
consolidated basis.
o Majority Commonly Owned Affiliates – New Swaps. For swaps
between a counterparty that owns a majority interest in the other
counterparty or between counterparties that are majority commonly
owned (directly or indirectly) by a party that reports its financial
statements on a consolidated basis, the no-action relief would allow a
party to only report the information required under the regulatory
reporting rule and the end-user exception rule on a quarterly basis (no
more than 30 days after the entity’s fiscal quarter, beginning with the
quarter ending June 30, 2013), as long as public reporting requirements
do not apply to the individual swaps. (As noted above, public reporting
does not apply to trades that are not “arms’ length.”)
o All Affiliates – Historical Swaps. The no-action relief from historical
reporting applies to any swaps between affiliates, whether 100% or
majority owned or commonly owned.
• Recordkeeping Obligations Still Apply. Any end user subject to this relief
must still retain records of all swaps as required by the regulatory reporting and
historical reporting rules.
If an End User Is Not a Reporting Party, Does It Have Any Reporting
Obligations?
• End Users Must Obtain a Legal Entity Identifier. Even in those situations
where end users are not responsible for reporting swap data to the relevant data
repository, the CFTC requires that each counterparty to a swap be identified in
all recordkeeping and all swap data reporting by means of a single legal entity
identifier. As a result, end users must obtain a legal entity identifier for each
legal entity entering into derivatives transactions. 39
39
Legal entity identifiers may be obtained online at https://www.ciciutility.org.
24
• End Users May Need to Provide Consent. In addition to obtaining a legal
entity identifier, an end user may be required, under applicable non-U.S. laws, to
consent to having its data reported to the relevant SDR by its SD or MSP
counterparty.
 TIMING FOR COMPLIANCE.
o Reporting requirements for SDs and MSPs are already in effect.
o Under no-action relief issued by the CFTC staff (the “End-User
Reporting No-Action Letter”), 40 public and regulatory reporting
requirements for non-financial end users, in those instances in which the
end user is the reporting party, are currently scheduled to become
effective with respect to IRS and CDS on July 1, 2013, 41 and with respect
to equity swaps, foreign exchange swaps and commodity swaps, on
August 19, 2013. 42 Historical reporting requirements for non-financial
end users are scheduled to become effective October 31, 2013.
o Under the End-User Reporting No-Action Letter, public and regulatory
reporting requirements for financial end users, in those instances in which
the financial end user is the reporting party, are currently scheduled to
become effective with respect to IRS and CDS on April 10, 2013, and
with respect to equity swaps, foreign exchange swaps and commodity
swaps, on May 29, 2013. 43 Historical reporting requirements for
financial end users are scheduled to become effective September 30,
2013.
40
See Time-Limited No-Action Relief for Swap Counterparties that are not Swap Dealers or Major Swap
Participants, from Certain Swap Data Reporting Requirements of Parts 43, 45 and 46 of the Commission’s
Regulations, CFTC (APR. 9, 2013).
41
Non-financial end users must report by August 1, 2013 any data relating to IRS and CDS from
the period between April 10, 2013 and July 1, 2013.
42
Non-financial end users must report by September 19, 2013 any data relating to equity swaps,
foreign exchange swaps and commodity swaps from the period between April 10, 2013 and
August 19, 2013.
43
Financial end users must report by June 29, 2013 any data relating to equity swaps, foreign
exchange swaps and commodity swaps from the period between April 10, 2013 and May 29,
2013.
25
How Does Dodd-Frank Change the Way Swap Transactions Are Documented?
• In General. Under Dodd-Frank, SDs and MSPs entering into swap transactions
are subject to a host of regulations, some of which require them to make and
receive certain representations and agreements from their counterparties and
receive certain information about their counterparties.
• SDs and MSPs Are Subject to External Business Conduct Standards that
May Have an Impact on End Users. Dodd-Frank provided the CFTC with
mandatory and discretionary rulemaking authority to impose business conduct
standards on SDs and MSPs. 44 Although these standards relate to the conduct of
SDs and MSPs, certain of the requirements may impose indirect obligations on
end users or require the satisfaction of certain pre-execution requirements.
o End Users Will Be Asked to Make Certain Representations to SD and
MSP Counterparties.
 Know Your Counterparty. SDs are required to have policies
and procedures reasonably designed to obtain and retain a record
of essential facts concerning a known counterparty to a swap
transaction. As such, SDs may ask end users for (i) facts required
to comply with applicable law and to ensure compliance with the
SD’s internal credit and operational risk management policies;
and (ii) information regarding the authority of any person acting
for the counterparty.
 True Name and Owner. SDs and MSPs are required to obtain
and retain a record of the true name and address of the
counterparty, guarantors, underlying principals and any persons
exercising control with respect to the positions of such
counterparty.
 Eligibility Verification. Before entering into a swap transaction,
an SD or MSP must (i) verify that its counterparty is an ECP and
(ii) determine whether its counterparty is a Special Entity or
eligible to elect to be treated as a Special Entity.
 Suitability. The CFTC requires that an SD have a reasonable
basis to believe that any swap or trading strategy involving swaps
that it recommends to a counterparty is suitable for such
counterparty. Thus, recommendations trigger a duty by SDs to
undertake “reasonable diligence” to understand the “risks and
44
See 77 Fed. Reg. 9734 (Feb. 17, 2012) (“External Business Conduct Standards Final Rule”).
26
rewards” of a swap and to have a “reasonable basis” to believe the
swap is “suitable” to the counterparty’s needs.
o SD Safe Harbor. For an end user that is not a Special
Entity, suitability requirements are met in circumstances
where (i) the end user or its representative represents it is
exercising independent judgment and (ii) the SD
represents it is not evaluating the suitability of any
recommendation.
o Impact on End Users. In order to rely on the safe harbor,
an SD may request that an end user or its representative
represent that it is exercising independent judgment and is
capable of evaluating the swap transaction.
o Additional Obligations Involving Special Entities. Additional
obligations apply to SDs or MSPs transacting with Special Entities. For
more information, please refer to our April 12, 2012 Alert Memorandum
entitled “CFTC Adopts External Business Conduct Standards.” 45
o SDs and MSPs Must Provide End Users with Certain Information.
 Scenario Analysis. For swaps not subject to Dodd-Frank’s
mandatory SEF trading requirement, an SD must offer to provide
a scenario analysis to end users, and must provide the analysis if
the end user requests it. The SD is required to design the scenario
analysis in consultation with the end user and must also disclose
all material assumptions and calculation methodologies used to
perform the analysis (although it is not required to disclose any
confidential, proprietary information about any model used to
prepare the analysis).
 Clearing. If a swap is subject to mandatory clearing, an SD or
MSP will be required to notify an end user counterparty of its
right to select the DCO. If the swap is not subject to mandatory
clearing, the SD or MSP will be required to notify such
counterparty of its right to elect to require the swap to be cleared
and to select the DCO.
 Certain Disclosures. SDs and MSPs will need to update
documentation to provide end users with information about the
following:
45
Available at: http://www.cgsh.com/files/News/9fd7b0fd-b4a3-417e-950d-
bf5bc2129bab/Presentation/NewsAttachment/59773d07-c3da-4991-baab-
c01701176d7c/CGSH%20Alert%20-%20External%20Business%20Conduct%20Standards.pdf.
27
o material risks;
o material contract characteristics of the swap transaction;
o material incentives and conflicts of interest; and
o notification that an end user counterparty has the right to
receive the DCO’s daily mark for a cleared swap.
 TIMING FOR COMPLIANCE. The CFTC has extended the date by which
SDs/MSPs must comply with most of the External Business Conduct Standards
until May 1, 2013. 46
• Swap Trading Relationship Documentation. CFTC rules require that SDs and
MSPs, but not end users, comply with certain swap trading relationship
documentation requirements. These rules require that SDs and MSPs establish
policies and procedures reasonably designed to ensure that they execute written
(electronic or otherwise) swap trading relationship documentation with their
counterparties that includes, among other items, all terms governing the swap
trading relationship and all credit support arrangements. 47
o Requirement for Financial End Users to Agree to a Valuation
Process. For swap transactions with financial end users, the financial end
user and its SD or MSP counterparty must have written documentation in
place in which the parties agree on the process for determining the value
of each swap. Non-financial end users do not have a similar requirement,
although they may request such documentation.
o Documentation of Any Exception to or Exemption from Mandatory
Clearing and Trading. Swap documentation must state whether an end
user is relying on an exception or exemption from mandatory clearing and
trading for a particular transaction.
• Portfolio Reconciliation. If an end user enters into swap transactions with an
SD or MSP, such SD or MSP may request that an end user perform portfolio
reconciliation on either a quarterly or annual basis (depending on the level of
swap activity with the counterparty). Portfolio reconciliation is the process by
which the counterparties to a swap (i) exchange the terms of all swaps between
them, (ii) exchange valuations (i.e., the current market value or net present value)
of each swap between them as of the close of business on the immediately
preceding business day, and (iii) resolve any discrepancies in material terms
(including the swaps’ primary economic terms) and valuations.
46
See 78 Fed. Reg. 17 (Jan. 2, 2013) (“Extension of Compliance Dates”).
47
See 77 Fed. Reg. 55,904, 55,961–64 (Sept. 11, 2012) (“Swap Documentation Final Rule”).
28
• Portfolio Compression. SDs and MSPs are required to establish written policies
and procedures for portfolio compression with end users. Thus, although end
users are not required to engage in portfolio compression, SDs and MSPs may
ask end users to engage in compression from time to time. Portfolio compression
is the process by which an SD or MSP and one or more counterparties wholly
terminate or change the notional value of some or all of the swaps being
considered in the compression process and, depending on the methodology being
employed, replace the terminated swaps with other swaps whose combined
notional value (or some other measure of risk) is less than the combined notional
value (or some other measure of risk) of the terminated swaps being considered
in the compression process.
• Swap Confirmation. The CFTC enacted rules requiring that SDs and MSPs
send post-trade acknowledgments to swap counterparties as well as execute post-
trade confirmations for each swap transaction into which they enter (other than
those cleared with a DCO or traded on a DCM or SEF). In general, end users
will not be responsible for confirming swap transactions. That said, in order to
satisfy its own obligations, an SD or MSP may request that an end user take
certain actions, such as signing an acknowledgment of the legally binding terms
of a swap transaction.
• Request for Draft Acknowledgment. An end user may request a pre-trade draft
acknowledgment from an SD or MSP prior to entering into a swap transaction.
 TIMING FOR COMPLIANCE. The Swap Confirmation and Portfolio
Compression rules are already in effect. Compliance with the Swap Trading
Relationship Documentation and Portfolio Reconciliation rules has been delayed
until July 1, 2013. 48
How Does the Market Plan to Implement Such Changes in Required
Documentation?
• ISDA’s Dodd-Frank Protocols. ISDA has completed two new protocols in
order to provide standardized agreements, representations and information
necessary to make the parties who subscribe to them compliant with Dodd-
Frank. 49
o The August 2012 DF Protocol. The August 2012 DF Protocol is
intended to help parties to swap transactions comply with certain of the
requirements under Dodd-Frank, including the External Business
Conduct Standards. The framework is meant to supplement new or
48
See Extension of Compliance Dates.
49
Information on the Protocols may be found on ISDA’s website at:
http://www2.isda.org/functional-areas/protocol-management/open-protocols/.
29
existing swap agreements (documented via an ISDA master agreement or
other long-form confirmation) with SDs and MSPs in order to bring them
into compliance with the initial set of rules finalized by the CFTC. 50
o The March 2013 DF Protocol. The March 2013 DF Protocol is intended
to bring new or existing swap agreements into compliance with additional
rules finalized by the CFTC since the August 2012 DF Protocol,
including the Swap Trading Relationship Documentation, Portfolio
Reconciliation, Portfolio Compression and Swap Confirmation rules. 51
o Ongoing Process. As the CFTC continues to finalize its rulemaking
process, parties to swap transactions will need to update their
documentation to remain in compliance with applicable regulations.
• Impact on End Users. The CFTC rules covered by the ISDA Dodd-Frank
Protocols do not directly apply to end users. Rather, Dodd-Frank imposes certain
obligations on SDs and MSPs. In order to continue to deal in swaps with SDs
and MSPs once compliance with Dodd-Frank’s swap regulatory rules are
required, end users will either need to enter into the Dodd-Frank Protocol, amend
their ISDA master agreements with such SDs and MSPs, or otherwise enter into
separate agreements or supplements to provide individualized representations
and disclosures. SD or MSP counterparties may not be able to continue to
transact with end users who do not sign on to the August Dodd-Frank Protocol or
execute alternative bilateral documentation by May 1, 2013.
• Adhering to the Dodd-Frank Protocols. In order to take advantage of the
Dodd-Frank Protocols, end users must submit an adherence letter to ISDA in
which the end user agrees to certain of the terms that comprise the Dodd-Frank
Protocols. Submission of the adherence letter will not, however, amend existing
agreements with SD or MSP counterparties. In order to amend existing
agreements, each end user must complete a questionnaire that includes
representations about the legal status of the end user. The end user can choose
which counterparties will receive its completed questionnaire. When an end
user’s questionnaire is matched to its SD or MSP counterparty, the existing swap
transaction is amended to conform to the those requirements of the Title VII
regime covered by the Protocol.
• Limited Flexibility of the Dodd-Frank Protocols. The Dodd-Frank Protocols
are not negotiable. If either party to a swap does not wish to enter into a
protocol, then the parties must enter into a bilateral agreement to bring the swap
50
Parties may access information about August 2012 DF Protocol at:
http://www2.isda.org/functional-areas/protocol-management/protocol/8.
51
Parties may access information about March 2013 DF Protocol at:
http://www2.isda.org/functional-areas/protocol-management/protocol/12.
30
agreements into compliance with the applicable CFTC regulations. There is,
however, some flexibility built into the Dodd-Frank Protocols in that parties to
each Protocol need only adopt those optional schedules applicable to their
particular swap transaction. End users should consult with both their SD or MSP
counterparties and counsel in order to determine the parameters of any
amendments.
 TIMING FOR COMPLIANCE. There is currently no cut-off date for
adherence to the Dodd-Frank Protocols. That said, many of the rules that give
rise to the need for the August 2012 DF Protocol and the March 2013 DF
Protocol become effective on or before May 1, 2013 and July 1, 2013,
respectively.
31
Does Dodd-Frank Impose New Recordkeeping Obligations?
• General Recordkeeping Requirements for End Users. CFTC rules require
end users that conduct swaps to “keep full, complete, and systematic records,
together with all pertinent data and memoranda” with respect to each of their
swaps for a period of five years following termination of the swap. Records can
be kept in either paper or electronic form, as long as the records are retrievable
upon request by the CFTC within five business days.
• CFTC Large Swap Trader Reporting. Dodd-Frank enacted and the CFTC
implemented certain “large swap trader reporting” requirements applicable to
persons that enter into swaps linked to specified physical commodity futures
contracts. While the relevant CFTC rules impose these reporting requirements
on DCOs, clearing members and SDs, certain end users that own or control 50 or
more gross all-months-combined futures equivalent positions in the relevant
types of physical commodity swaps are required to keep records related to those
swaps and must produce them upon request by the CFTC. 52
 TIMING FOR COMPLIANCE. Requirements for the retention of swap data
records are already in effect.
.
52
See 76 Fed. Reg. 43,851 (July 22, 2011).
32
Does Dodd-Frank Impose New Rules With Respect to Position Limits?
• In General. Dodd-Frank allows the CFTC to set aggregate position limits on
futures and options on physical commodities and economically equivalent swaps.
It also narrowed the definition for bona fide hedging transactions exempted from
position limits. 53 As a result, the CFTC adopted rules that would have applied
maximum aggregate position limits across twenty-eight designated listed
physical commodity futures contracts and economically equivalent swaps.
• Position Limit Rules Currently Invalid. On September 28, 2012, the District
Court for the District of Columbia enjoined and vacated the CFTC rules
regarding position limits. The CFTC has approved an appeal of the District
Court’s decision. It remains possible that the CFTC will propose new position
limit rules.
 TIMING FOR COMPLIANCE. Not yet applicable.
53
CEA § 4a(a).
33
How Will Dodd-Frank’s New Antifraud and Antimanipulation Rules Affect End
Users?
• In General. End users, even those making use of certain exceptions or
exemptions discussed in this memorandum, are subject to the CFTC’s antifraud
and antimanipulation provisions.
• New CFTC Rules Prohibiting Fraudulent Activity. With respect to swaps,
Dodd-Frank amended the CEA to prohibit fraudulent activity, including material
misstatements and omissions in connection with futures contracts, options on
futures contracts and swaps. The CFTC’s rules harmonize the scope of liability
for deceitful behavior and CFTC enforcement under the CEA with fraud liability
and SEC enforcement under Section 10(b) of the Exchange Act.
• New CFTC Rules Prohibiting Manipulation. Dodd-Frank amended the CEA,
and the CFTC has adopted rules, to provide that no person is permitted to engage
in any manipulative or deceptive behavior related to any swap, commodity or
futures contract or to attempt to manipulate the price of any swap, commodity or
futures contract. 54
• Do the CFTC Rules Impose New Disclosure Obligations? In its adopting
release, the CFTC noted that its new rules do not impose any new disclosure
obligations on market participants. That said, market participants could violate
the rules due to a breach of other disclosure requirements in the CEA or
associated CFTC rules, or by trading on material non-public information (i) in
breach of a pre-existing duty (established by law, agreement, or understanding)
or (ii) that was obtained through fraud or deception. The application of this
guidance to the non-securities derivatives markets, where market participants
often trade on the basis of non-public information for hedging purposes, remains
unclear.
 TIMING FOR COMPLIANCE. These rules are already in effect.
54
CFTC Regulations §180.1-180.2; see also 76 Fed. Reg. 41,398 (July 14, 2011) (“Antifraud
Final Rule”). In applying the rule prohibiting price manipulation, the CFTC noted that it will use
a four-part test, specifically, that: (i) the accused had the ability to influence market prices, (ii) the
accused intended to create a price or price trend that does not reflect legitimate forces of supply
and demand, (iii) artificial prices existed and (iv) the accused caused the artificial prices. See
Antifraud Final Rule, 76 Fed. Reg. 41,398, 41,407 (July 14, 2011).
34
Will Dodd-Frank Impose Requirements on Swaps Between Non-U.S. Persons?
• In General. The CFTC has issued a release regarding the cross-border
application of its rules in the form of proposed interpretive guidance in June 2012
(the “Proposed Guidance”). 55 In addition, on December 21, 2012, the CFTC
issued an exemptive order that would delay the effectiveness of certain
provisions of Dodd-Frank until July 2013 (the “Exemptive Order”). 56 The
Exemptive Order and the Proposed Guidance would define which entities qualify
as U.S. persons and are therefore generally subject to rules under Dodd-Frank.
In addition, the Proposed Guidance would define the circumstances under which
non-U.S. persons would be required to register with the CFTC as SDs or MSPs
(as well as which of the rules applicable to SDs and/or MSPs would apply).
• Who Is a U.S. Person? Under the Proposed Guidance and Exemptive Order,
whether CFTC rules apply to an end user largely depends on whether either it or
its counterparty is a U.S. person. Under the Exemptive Order, a “U.S. person”
includes:
(i) any natural person who is a resident of the United States;
(ii) any corporation, partnership, limited liability company, business or
other trust, association, joint-stock company, fund, or any form of
enterprise similar to any of the foregoing, in each case that either (A)
is organized or incorporated under the laws of the United States
(“legal entity”) or (B) for all such entities other than funds or
collective investment vehicles, has its principal place of business in
the United States;
(iii) any individual account (discretionary or not) where the beneficial
owner is a U.S. person;
(iv) a pension plan for the employees, officers, or principals of a legal
entity with its principal place of business in the United States; and
(v) an estate or trust, the income of which is subject to United States
income tax regardless of source.
The Proposed Guidance included a broader U.S. person definition,
particularly with respect to the coverage of funds organized outside the U.S. The
CFTC continues to consider what final definition to adopt.
55
See 77 Fed. Reg. 41,214 (July 12, 2012). See also CGSH Alert Memo, “CFTC Proposes
Guidance on Cross-Border Application of Title VII of the Dodd-Frank Act” (July 3, 2012).
56
See 78 Fed. Reg. 858 (Jan. 7, 2013).
35
• Requirements Applicable to Non-U.S. Persons.
o Under the Exemptive Order, non-U.S. persons are only subject to
requirements with respect to swaps with U.S. persons. However, under
the Proposed Guidance, swaps with non-U.S. persons whose obligations
are guaranteed by a U.S. person and non-U.S. persons who are deemed
“conduits” of a U.S. person would also be subject to Dodd-Frank under
certain circumstances. A non-U.S. person would be considered to operate
as a “conduit” for swaps in which (i) the non-U.S. person is majority-
owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person
regularly enters into swaps with one or more U.S. affiliates or subsidiaries
of the U.S. person; and (iii) the financials of the non-U.S. person are
included in the consolidated financial statements of the U.S. person.
o Therefore, a non-U.S. end user would generally be subject to clearing,
trade execution, business conduct, swap trading relationship
documentation, portfolio reconciliation and compression, real-time public
reporting, regulatory reporting, trade confirmation, margin and swap data
recordkeeping only in the case of swaps with U.S. persons. 57
o Although the CFTC has proposed to treat foreign branches of U.S.
persons as U.S. persons, the CFTC has temporarily exempted swaps
entered into by non-U.S. persons and foreign branches of U.S. swap
dealers from compliance with certain requirements, such as clearing and
trading, margin and segregation for uncleared swaps, swap trading
relationship documentation, portfolio reconciliation and compression,
public reporting, trade confirmation, daily trading records and external
business conduct standards. 58
o Other requirements, such as antifraud and antimanipulation rules and
position limits, would apply to all of a non-U.S. person’s swaps,
including swaps with non-U.S. person counterparties.
* * *
57
The Prudential Regulators’ proposal regarding margin for uncleared swaps is similar to the
CFTC’s Proposed Guidance. The Prudential Regulators’ margin collection requirements would
not apply to a transaction between a non-U.S. domiciled counterparty (other than a branch or
office of a U.S. person or a counterparty whose obligations are guaranteed by a U.S. affiliate) and
a foreign registered swap dealer or major swap participant. However, for these purposes, a
foreign registered swap dealer or major swap participant would not include a branch or office of a
U.S. person or an entity controlled by a U.S. person. Depending on the territorial scope of CFTC
registration requirements, the proposed margin rules could result in a significant expansion in the
extraterritorial application of U.S. law that could intensify the competitive disparities faced by
U.S.-domiciled bank holding companies operating outside the United States.
58
See Exemptive Order, 78 Fed. Reg. 858, at 880.
36
Please call any of your regular contacts at the firm or any of the partners and
counsel listed under Derivatives in the Practices section of our website
(www.cgsh.com) if you have any questions.
CLEARY GOTTLIEB STEEN & HAMILTON LLP
37
Appendix A: Summary of Dodd-Frank Requirements
Applicable to Non-Financial End Users
Requirement Summary description Are non-financial end Compliance date? Applies to end users
users generally required who are not “U.S.
to comply with the persons” (under the
requirement? Exemptive Order)?
Registration as Certain parties will need to No, if activity does not December 31, 2012 Yes, in calculating
SD/MSP register with the CFTC, exceed relevant thresholds thresholds, must
triggering a host of include transactions
regulations where a counterparty
is U.S. person other
than the non-U.S.
branch of a U.S. SD
Mandatory CFTC will require that No, if swap is for hedging September 9, 2013 for Yes, if counterparty
Clearing certain designated or mitigating commercial non-financial end is U.S. person other
derivatives be cleared risk by non-financial end users for swaps not than the non-U.S.
through a DCO users excepted. June 10, branch of a U.S. SD
2013 for financial end
users for swaps not
excepted.
Rules have only been
finalized with respect
to certain IRS and
CDS
Mandatory CFTC will require that No, if swap is for hedging Rules have not been Yes, if counterparty
Trade certain designated or mitigating commercial finalized is U.S. person other
Execution derivatives be traded on a risk by non-financial end than the non-U.S.
DCM or SEF users branch of a U.S. SD
ECP Trading In general, only ECPs can Yes Already in effect Yes, if counterparty
Requirement enter into OTC swaps or is U.S. person other
guarantee such swaps than the non-U.S.
branch of a U.S. SD
Margin for Counterparties will generally Requirement is relaxed for Rules have not been Yes, if counterparty
Uncleared need to post margin to SDs end users finalized is U.S. person other
Swaps and MSPs than the non-U.S.
branch of a U.S. SD
Real-Time The reporting party must Yes, although SD and Already in effect Yes, if counterparty
Public make report trade MSP counterparties will is U.S. person other
Reporting information in real-time to generally be responsible than the non-U.S.
SDRs or the CFTC branch of a U.S. SD
Regulatory The reporting party must Yes, although SD and Already in effect Yes, if counterparty
Reporting make report trade MSP counterparties will is U.S. person
information in real-time to generally be responsible (including the non-
SDRs or the CFTC U.S. branch of a U.S.
SD)
Recordkeeping Counterparties must retain Yes Already in effect Yes, if counterparty
records and documents is U.S. person
related to trades (including the non-
U.S. branch of a U.S.
SD)
38
Requirement Summary description Are non-financial end Compliance date? Applies to end users
users generally required who are not “U.S.
to comply with the persons” (under the
requirement? Exemptive Order)?
Swap Trades must be documented The requirements imposed Swap confirmation Yes, if counterparty
Documentation pursuant to CFTC rules on end users are limited and portfolio is U.S. person other
compression rules are than the non-U.S.
already in effect. branch of a U.S. SD
Swap trading
relationship
documentation and
portfolio reconciliation
rules are delayed until
at least July 1, 2013
External SD and MSP counterparties The requirements imposed May 1, 2013 (for most Yes, if counterparty
Business will respect that end users on end users are limited standards) is U.S. person other
Conduct provide certain than the non-U.S.
Standards representations branch of a U.S. SD
Position Limits CFTC’s rule regarding Unclear Unclear Yes, if ultimately
position limits has been adopted
vacated
Antifraud and CFTC rules prohibit fraud Yes Already in effect Yes
antimanipulati and manipulation involving
on swaps
39
Appendix B: Key CFTC Rulemakings Affecting End Users
• In General
o Product Definitions Final Rule, 77 Fed. Reg. 48,208 (August 13, 2012)
o Final Treasury Determination, 77 Fed. Reg. 69,694 (Nov. 20, 2012)
o Registered Swap Entity Final Rule, 77 Fed. Reg. 30,596 (May 23, 2012)
• Clearing
o Mandatory Clearing Requirement for Certain Interest Rate Swaps and
Credit Default Swaps Proposal, 77 Fed. Reg. 47,170 (Aug. 7, 2012)
o Clearing Requirement Determination, 77 Fed. Reg. 74,284 (Dec. 13,
2012)
o End-User Exception Final Rule, 77 Fed. Reg. 42,560 (July 19, 2012)
o Inter-Affiliate Exemption Final Rule,
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/fede
ralregister040113.pdf (last visited Apr. 2, 2013)
• Trade Execution
o SEF Proposal, 76 Fed. Reg. 1214 (Jan. 7, 2011)
o Available to Trade Proposal, 76 Fed. Reg. 77,728 (Dec. 14, 2011)
• Margin
o Prudential Regulator Capital and Margin Proposal, 76 Fed. Reg. 27,564
(May 11, 2011)
o CFTC Margin Proposal, 76 Fed. Reg. 23,732 (Apr. 28, 2011)
• Reporting
o Real-Time Public Reporting Final Rule, 77 Fed. Reg. 1182, 1243 (Jan. 9,
2012)
o Regulatory Reporting and Recordkeeping Final Rule, 77 Fed. Reg. 2136
(Jan. 13, 2012)
o Reporting of Unexpired Pre-Enactment Swaps Final Rule, 77 Fed. Reg.
35,200 (June 12, 2012)
o Block Trade Proposal, 77 Fed. Reg. 15,460 (Mar. 15, 2012)
• Documentation & Business Conduct
o Swap Documentation Final Rule, 77 Fed. Reg. 55,904, (Sept. 11, 2012)
o External Business Conduct Standards Final Rule, 77 Fed. Reg. 9734
(Feb. 17, 2012)
o Internal Business Conduct Standards Final Rule, 77 Fed. Reg. 20,128
(Apr. 3, 2012)
o Extension of Compliance Dates, 78 Fed. Reg. 17 (Jan. 2, 2013)
• Recordkeeping
o Regulatory Reporting and Recordkeeping Final Rule, 77 Fed. Reg. 2136
(Jan. 13, 2012)
• Antimanipulation
o Antifraud Final Rule, 76 Fed. Reg. 41,398 (July 14, 2011)
40
• Cross-Border Application
o Cross-Border Proposed Guidance, 77 Fed. Reg. 41,214 (Jul. 12, 2012)
o Final Exemptive Order Regarding Compliance with Certain Cross-
Border Swap Regulations, 78 Fed. Reg. 858 (Jan. 7, 2013)
o Further Proposed Guidance Regarding Compliance with Certain Cross-
Border Swap Regulations, 78 Fed. Reg. 909 (Jan. 7, 2013)
41
Swaps: Dodd-Frank Memories
Amid repeated Dodd-Frank extensions, swaps end-users may need an aide-mémoire

2013-07-02, by Gordon E. Goodman
Things are seldom what they seem,

Skim milk masquerades as cream;
Highlows pass as patent leathers;
Jackdaws strut in peacock's feathers.
-- "HMS Pinafore," Gilbert & Sullivan, 1878
At this point in the process of implementing the changes that were required by the Dodd-Frank
Wall Street Reform and Consumer Protection Act -- with respect to recordkeeping, reporting and
governance -- almost everything was supposed to have been completed by now. A final piece of
the puzzle was to have occurred during April 2013, when real-time and general reporting was to
have begun. However, as with many of the early Dodd-Frank schedules, the reporting deadline
was extended through a "no-action" letter issued by the Commodity Futures Trading
Commission (CFTC) during early April.
The CFTC's repeated extensions may have lulled the risk community into a sense that perhaps
it would all go away. This is not the case. So, for risk managers who may have forgotten the
many changes required by Dodd Frank (and in particular for the non-swap dealers, non-major
swap participants, non-financial entities and end-users), the following is a refreshed to-do list,
an aide-mémoire.
This article is intended to cover many of the issues and questions confronted by "end-users."
End-user is the generic term that I will use in this article when talking about the "nons" generally,
but please note that though speculative traders and end-users are both "nons," they have quite
different requirements under Dodd-Frank with respect to mandatory clearing.
Each end-user should consider its own circumstances in designing an appropriate compliance
program, because this article does not cover every minute detail.
End-User Qualification
To begin, in order to qualify as an end-user (Category 3), a company must be neither a swap
dealer nor a major swap participant (Category 1). Nor can the company be a "financial entity"
(Category 2). In a subsequent article, I will provide more detail on financial entities (one of the
less discussed terms in Dodd-Frank), but for present purposes, they are persons predominantly
engaged in activities that are financial in nature, as defined by the Federal Reserve under the
Bank Holding Company Act.
With respect to the first part of the end-user requirement (i.e., being neither a swap dealer nor
an MSP), this can only be determined by running the "de minimis" tests that determine whether
a company is a swap dealer and the various MSP tests that determine whether a company is a
major swap participant.
In particular, end-users should make sure that they are not dealing in significant quantities of
swaps with "special entities" (primarily government organizations) under Dodd-Frank. At a
minimum, end-users should stay well under the de minimis thresholds that apply to swap trades
with special entities. The $8 billion threshold that generally applies under the de minimis test
drops to $800 million for special entities that engage in utility operations and to just $25 million
for non-utility special entities (all calculated on gross notional amounts).
One additional point for foreign companies to keep in mind is that the definition of a "financial
entity" is based on the percentage of their assets and income that are derived from financial
activities (sometimes called the "85/85" test). This calculation can be significantly influenced by
how derivatives are treated within the company's financial statements -- U.S. Generally
Accepted Accounting Principles present derivatives on a net basis while the European
International Financial Reporting Standards present derivatives on a gross basis.
End-User Next Steps
Assuming a company qualifies for the end-user exemption from mandatory clearing (see
above), companies that are subject to SEC reporting obligations (generally, U.S. public
companies) must then adopt annual board resolutions to make this election. These resolutions
can be adopted by the board itself or by a suitable committee of the board -- e.g., the audit
committee or the finance committee.
Though there is no statement within Dodd-Frank about companies that are not subject to SEC
reporting obligations, it is a best risk practice for all companies that claim end-user status to
adopt these same board resolutions. Swap dealers will probably be asking for proof of end-user
status to all of their customers under Dodd-Frank's "know your counterparty" (KYC) rules that
apply to swap dealers, so companies claiming end-user status should adopt appropriate board
resolutions.
Under CFTC rules, the annual board resolution must be filed with a swap data repository (SDR).
For non-reporting end-users (i.e., end-users whose counterparties will do the swap reporting),
this may be an issue if they do not have an existing relationship with an SDR. Based on recent
discussions, at least one of the SDRs is working on providing a filing mechanism for the non-
reporting end-users at this time.
Keep in mind that the purpose of filing a board resolution with an SDR is to claim an exemption
from the mandatory clearing requirement, but to date there have been few swap categories
listed by the CFTC that are actually subject to mandatory clearing. In particular, the CFTC has
yet to include any of the energy commodity swaps in the list of swaps subject to mandatory
clearing -- so the timing for adoption of a board resolution has been extended (originally, this
was due to be in place by September 2013).
Hedging
As part of this board resolution, a company claiming end-user exemption from mandatory
clearing must represent that it uses swaps to hedge or mitigate commercial risk arising from its
underlying physical business -- e.g., oil and gas production or gasoline refining. An important
point to consider is that the board resolution itself is necessary, but not sufficient, to receive an
exemption from mandatory clearing.
The transactions themselves must be used for hedging purposes. What this means is that even
after making an election and filing the annual board resolution with an SDR, a company can still
only be exempted from mandatory clearing if its swaps are really being used for hedging
purposes.
Assume for a moment that a company uses swaps for two purposes within its business: to
hedge its physical oil and gas production and to engage in some limited speculative trading
activity. In effect, it is an end-user when it is hedging its physical transactions, but it is a trader
when it engages in speculative activity (for which the exemption from mandatory clearing is not
available).
A company like this should still proceed to pass an appropriate board resolution claiming
exemption from mandatory clearing, but only for those transactions that are being used as
hedges (and not for its speculative trading activity). Remember that end-users and speculative
traders are both "nons," but they have different results under Dodd-Frank with respect to the
mandatory clearing exemption rules.
Another point to consider is that qualifying swaps are also excluded from certain parts of the de
minimis and MSP tests. In order to qualify as a hedge, swaps must come under one of the
following standards: the "mitigation of commercial risk" standard (the Dodd-Frank standard), the
"bona fide hedge" standard (the Commodities Exchange Act standard) or the accounting hedge
standards set by FASB.
De Minimis and MSP Tests
Going forward, the de minimis and MSP tests described previously have to be run on a regular
basis. A company that passes these tests today (and therefore can initially qualify for end-user
status) may fail these same tests next year or the year after. So building a robust mechanism for
running these tests as part of a company's base risk system is an important consideration.
The de minimis calculations are run on a trailing 12-month basis in relation to the gross notional
amount of a company's dealing swaps, while MSP tests are run on a quarterly basis looking at
current and expected future exposures (MTMs) of the company's swaps (but only looking at the
negative MTM values).
The de minimis tests currently have three thresholds: an $8 billion threshold for all entities, an
$800 million threshold for utility special entities and a $25 million threshold for non-utility special
entities. The CFTC has indicated that these thresholds will apply during a "phase-in" period that
will last about five years. At the end of the phase-in period, the CFTC may reduce its de minimis
thresholds to lower levels.
The MSP tests are more complicated than the de minimis tests, but they have been set at levels
that should only capture the very largest swap market participants. The details of the MSP tests
will be studied in more detail in a subsequent article.
It is logical to anticipate that if any company expects to fail the MSP test for a quarterly period, it
would probably file an election to become a swap dealer, since the MSP status carries most of
the burdens with few of the benefits associated with swap dealer status.
Meeting Financial Obligations
In the board resolution electing end-user exemption from mandatory clearing, a company must
indicate how it will meet its financial obligations. For companies that have historically set the
margin thresholds in their ISDA credit support annex (CSA) at relatively high levels in order to
avoid the need for daily exchanges of margin, they may want to reconsider the best levels to set
under Dodd-Frank.
One of the surprising issues to consider is that unused thresholds within CSAs (i.e., the
difference between a company's actual exposure and its collateral threshold levels) are
considered to be a form of credit facility that can get included in some of the MSP test
calculations. (The MSP tests can also be calculated under an alternative methodology that
excludes these unused thresholds, but this alternative methodology has some of its own issues,
which will be discussed further in a subsequent article.)
There are five methods set by the CFTC for meeting financial obligations within a board
resolution under Dodd-Frank: (1) a written credit support agreement (this could be the CSA
attached to the ISDA); (2) pledged or segregated assets (including posting or receiving margin
pursuant to a credit support agreement or otherwise); (3) a written third-party guarantee; (4) the
electing counterparty's available financial resources (this is an alternative to the CSA route); or
(5) means other than those described.
Who Has the Reporting Obligation?
In general, if a transaction is concluded on an exchange, no further reporting is required.
For off-exchange (OTC) transactions, one of the two parties to a swap must report the
transaction to an SDR. If a Category 3 entity (i.e., an end-user) does a swap transaction with a
Category 1 entity (swap dealers and MSPs) or a Category 2 entity (a financial entity), then the
Category 1 or Category 2 counterparty has the reporting obligation (and not the end-user).
The question arises: what happens when two end-users do a swap with each other? The
answer is that if one of the end-users is a "U.S. entity" (as that term is defined under Dodd-
Frank) and the other is not a U.S. entity, then the end-user that is a U.S. entity has the reporting
obligation.
A second question naturally arises: what happens when both are U.S. entities or both are not
U.S. entities? The answer is that the parties have to agree on who will do the reporting. The
main point to keep in mind is that for all swaps, someone has to do the reporting to the SDR.
There is no free lunch.
When is the Reporting Required?
Originally, all swaps were subject to reporting requirements that were to have begun on 4/10/13.
This included "pre-enactment" swaps (swaps that were in effect on 7/21/10, when Dodd-Frank
was enacted) and "transition" swaps (swaps that were executed after 7/21/10 but before
4/10/13).
This original schedule was revised for non-financial counterparties (i.e., end-users) under a "no-
action" letter issued by the CFTC during early April 2013 (Letter No. 13-10).
The revised Dodd-Frank reporting schedule for end-users is now as follows (please note that
the Dodd-Frank standard for reporting transaction data is generally in "real time," but this term is
defined differently for different types of swap participants):
• Credit/interest rate swaps entered into after 7/21/13: subject to Dodd-Frank standards
• Credit/interest rate swaps entered into from 4/10/13 to 7/21/13: 8/1/13
• Equity/FX/ commodity swaps entered into after 8/19/13: subject to Dodd-Frank
standards
• Equity/FX/ commodity swaps entered into from 4/10/13 to 8/19/13: 9/19/13
• All historical swaps that were in existence from 7/21/10 to 4/10/13: 10/31/13
Dodd-Frank Recordkeeping for End-Users
End-users must keep full, complete and systematic records of all their swap transactions. The
recordkeeping requirements apply to pre-enactment, transition and post-4/10/13
records. Records should be kept in electronic format unless they were originally created in
paper format and have been maintained as such. Records must be kept for five years from the
termination date of the swap, with the exception of audio records, which must be kept for one
year from termination date.
Please note that these same recordkeeping requirements apply to certain related physical
transactions. Specifically, these are the physical transactions that are the hedged items for
which hedge treatment is being claimed with respect to an end-user's hedging swaps.
Final Issues and Parting Thoughts
End-users should obtain legal entity identifiers (LEIs or CICIs) for each corporate entity that
trades in swaps. End-users should also consider possible adherence to the August 2012 ISDA
protocol.
Though this article has discussed many of the more common issues that have arisen for end-
users trying to comply with the new Dodd-Frank requirements, inevitably there will be some
important issues that have not been covered.
There will also inevitably be additional "no-action" letters and further changes in the Dodd-Frank
regulatory structure before all is said and done. For this reason, this article is intended only as
the first in a series of similar articles dealing with additional specific Dodd-Frank issues.
Dodd-Frank’s Impact on Financial Entities, Financial Activities and
Treasury Affiliates
Swaps compliance requirements are complex

2013-10-23, by Gordon E. Goodman
The compliance requirements for the Dodd-Frank Act (DFA) are complex. On one end of the
spectrum, we have DFA "end users" that are not subject to the act's mandatory clearing rules,
but are subject to certain reporting and record-keeping requirements. On the opposite end,
there are swap dealers, major swap participants and "financial entities" -- three categories of
companies that are subject to mandatory clearing, along with much more rigorous reporting and
record-keeping requirements.
The financial entities category is perhaps the most intriguing, partly because it is the least
discussed of the types of companies under the DFA that cannot seek exceptions from the
mandatory clearing requirement. Mandatory clearing is the obligation to clear swaps at a
regulated entity (like an exchange or derivatives clearing organization (DCO)) and post full
collateral. Financial entities also have the obligation to report swaps to swap data repositories
(SDRs) when they are trading with end-users and other non-financial entities.
In the DFA, a "financial entity" is described by Congress as any company that is " …
predominantly engaged in activities … that are financial in nature, as defined in the Bank
Holding Company Act of 1956." The DFA, in turn, requires the Board of Governors of the
Federal Reserve System (the Board) to establish the requirements for determining whether a
company is "predominantly engaged in financial activities."
Given the broadness of the Board's definition of "financial activities," the financial entities
category may actually include more companies than the two more widely-discussed DFA
categories of swap dealers and major swap participants.
Moreover, for many purposes, being labeled a "financial entity" under the DFA may be
burdensome -- especially for companies that do not particularly consider themselves to be
"financial" companies. Surprisingly, a significant number of subsidiary companies that centrally
execute financial instruments for large diversified corporations may be considered financial
entities under the DFA, but they may also qualify for an exception under the CFTC's recent no-
action letter on "treasury affiliates."
What is a Financial Entity?
Under the DFA, just like swap dealers and major swap participants, financial entities (most of
them, at least) are excluded from making an election that is otherwise available to end-users to
be exempt from the DFA's mandatory clearing requirements.
The broader term "financial company" within the DFA includes not only financial entities but also
bank holding companies and certain non-bank financial companies that are supervised by the
Board.
Very large (or significant) non-bank financial companies can also be determined to be
systemically important under the DFA. As a result, they can become subject to additional
regulation, like the Orderly Liquidation Act (OLA).
What are Financial Activities?
In its final rule on the definition of "Predominantly Engaged in Financial Activities," issued in
April 2013, the Board determined that certain investing and trading activities should be
considered activities that are financial in nature under the Bank Holding Company Act.
Since the Board's definition of financial activities also covers activities that are not regulated
under the DFA (e.g., trading in forward contracts), it is not yet clear how these two sets of
related regulations (i.e., the Board's rules on financial activities and the CFTC's rules on the
exception from clearing) will be interpreted. For example, should trading in forward contracts be
included or excluded from the "predominantly engaged" tests that are described below?
The DFA provides that a company will be considered to be predominantly engaged in financial
activities if more than 85% of its annual gross revenues or if more than 85% of its consolidated
assets are financial in nature. For companies that do not have a centralized subsidiary used for
their corporate hedging activities, the two 85% tests may not be a problem, but a review should
be conducted for all corporations that trade in swaps.
What are Captive Finance Companies and Treasury Affiliates?
In its so-called final rule for the "End-User Exception to the Clearing Requirement for Swaps,"
the DFA provides a potential exception for captive finance companies that have been deemed
financial entities. That rule states that a financial entity does not include any company whose
"primary business is providing financing."
In order to qualify for this fairly limited exception for captive finance companies, a company must
use derivatives for the purpose of hedging its underlying commercial risks related to interest rate
or foreign exchange exposures. In addition, 90% or more of these risks must arise from
financing that facilitates the purchase or lease of products manufactured by the parent company
or a subsidiary of the parent company.
More importantly for many diversified companies, in June 2013, the CFTC's Division of Clearing
and Risk issued a no-action relief letter for certain treasury affiliates. If not for this letter, these
affiliates might have been categorized as financial entities, and would therefore have been
ineligible for an exception from the mandatory clearing requirement.
The no-action letter basically expands the existing exception within DFA that originally only
covered treasury affiliates that act as agents for related subsidiaries. It includes treasury
affiliates that act as principals when executing swaps for related subsidiaries. In order to claim
the exception from mandatory clearing for treasury affiliates, a company must comply with all
the requirements described in the no-action letter and also make the necessary filings with an
SDR (similar to the annual filings that are required of end-users).
A final exception to consider for certain cooperatives is one that the CFTC announced in August
2013. The CFTC, in its "Final Rule on the Clearing Exemption for Certain Swaps Entered Into by
Cooperatives," determined that a cooperative whose members were all end-users would not be
deemed a financial entity only because of the swaps that it executed for its member companies
(even when acting as a principal).
Closing Thoughts
The definition of financial entities is the least well understood of the three categories of
companies (swap dealers, major swap participants and financial entities) that are the most
heavily regulated under the DFA. But for the CFTC's recent no-action letter on treasury
affiliates, many diversified companies with centralized subsidiaries that execute financial
instruments would have been subject to the DFA restrictions placed on financial entities.
Companies should carefully review their use of swaps to determine whether they will be
considered financial entities, as well as whether they may qualify for the treasury affiliate
exception.
Gordon E. Goodman is currently a consultant with the Alliance Risk Group. He previously held senior
positions at both E.I. DuPont de Nemours & Co., where he served as president of its DuPont Power
Marketing subsidiary, and at Occidental Petroleum Corporation, where he served as the trading control
officer for its Occidental Energy Marketing subsidiary. He was the founding chairman of the American
Petroleum Institute's (API's) Risk Control Committee, and he also served on the API's General Committee
on Finance. He was a member of the Financial Accounting Standards Board's (FASB's) Valuation
Resource Group (VRG) and earlier was a member of its Energy Trading Working Group (ETWG). He is
currently on GARP's Energy Oversight Committee, which administers the Energy Risk Professional (ERP)
certificate. His prior contributions to GARP's "Risk Review," "Risk Professional," and "Risk News &
Resources" publications have included the following articles: "Dodd Frank Memories" (2013); "The
Liquidity Risk Sweepstakes" (2012); "The Ethics of Business" (2012); "How to Value Guarantees" (2008);
and "Credit Risk: Will the Bubble Burst?" (2007).

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2014 Energy Risk Professional

ERP Exam Course Pack

READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE

Readings for Financially Traded Energy Products and Structured Transactions

Energy Derivatives: Overview of Products, Market Mechanics and Applications

© 2014 Global Association of Risk Professionals. All rights reserved.

Energy Commodity Exchanges and OTC Derivative Trade Process

Global Regulatory Developments

© 2014 Global Association of Risk Professionals. All rights reserved.

5. Gordon Goodman. “Swaps: Dodd-Frank Memories.” (July 2, 2013)

6. Gordon Goodman. “Dodd-Frank’s Impact on Financial Entities, Financial Activities and

© 2014 Global Association of Risk Professionals. All rights reserved.

The Mechanics of the

1. INTRODUCTION TO DERIVATIVES ................................................................................................... 4

2. FORWARDS AND FUTURES................................................................................................................ 12

6. GLOSSARY OF THE DERIVATIVES MARKET TERMS....................................................................... 36

1.1 Basics of Derivatives

1.2 Types of Derivatives

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2. FORWARDS AND FUTURES

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2.2.1 Contract Specifications

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18‐Feb 100 50 000

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2.3 Hedging Using Futures Contracts 4

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2.4 Basis Risk

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6. GLOSSARY OF THE DERIVATIVES MARKET TERMS7

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the market, except at sharply higher prices (see Squeeze, Corner); (2) in technical analysis, a period of

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