OTC Derivatives

OTC Derivatives Product History and Regulation

September 2009

Introduction
What is a Derivative?
History, Purposes, Types

Common Types of Swaps

Swap Documentation

OTC Derivatives Regulatory

History of Derivatives
Derivatives are not really products and they are not really traded

Simply views or bets on future price movements

Rice derivatives traded in Japan in 15th C Stock options traded in the 1800s Corn and wheat futures traded on the CME today

What is a Derivative?
Definition of a Derivative
a financial instrument (swap, put, call, cap, floor, collar, or similar option) for the purchase or sale of, or whose value is based on, one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind

Definition of an Over-the-Counter (OTC) Derivative

a derivative that is not traded through an exchange or other regulated market but through a bilateral negotiation between two parties and thus executed off-exchange The Securities Exchange Act and the Commodities Exchange Act regulate exchanges

Purposes and uses of OTC Derivatives

Risk transfer Hedging Investment Exposure to different markets Change an assets balance sheet character Speculation Leverage

Common Types of Derivatives

Options Futures Forwards Warrants Swaps Other

Options
Options Holder can buy or sell a security/commodity at a set price on, or prior to, expiration of the option
calls or puts, caps or floors European versus American Style Exercise/Strike Price Options on stocks; pork bellies

Options also are embedded, for example, in Convertible Bonds

Holder can convert bond into shares of stock or other securities in the issuing company

Structured Notes
Holder can receive a return of principal greater than original investment if Notes embedded option has adequately increased in value

Futures
Futures Futures contract obligates a person to buy or sell a commodity, security (equity) or financial instrument, or a basket of them (S&P 500 index), at a set price, on a set date (or dates) in the future
Standardized contracts only (i.e., exchange traded)
only trade specific contracts supported by the exchange contracts are usually cash settled

Futures have only market risk due to daily re-margining through the exchange

Forwards
Forwards
Like a futures contract, an agreement to buy or sell an asset at a specified future time and price Customized between parties and not exchange traded
Can be for any underlier Can be for any settlement date

Forwards are different from futures

Forwards entail credit risk exposure to your counterparty Market risk on the trade unless negotiated re-margining

Warrants
Warrants Holder can buy securities of the issuing company at a specified price that is usually higher than the stock
Usually given as consideration of another transaction; sometimes purchased outright with a premium payment Generally traded over the counter and have longer maturities than options

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Swaps
Swaps A cash settled OTC derivative between two counterparties to exchange two streams of cash flows
Fundamental purpose is to change character of an asset or liability on one persons balance sheet without liquidating that asset or liability Usually subject to ISDA documentation including master agreement, confirmation, and product definitions

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Exchange Traded vs. OTC Derivatives

Exchange Traded
exchange central clearing house (CCH) acts as counterparty on both sides of the transaction credit risk exposure to CCH margin as required by CCH rules limited number of standardized products Transparent end-of-day valuation simple liquidation

OTC private transaction between two parties creates counterparty credit risk to be managed collateral negotiated between the parties valuation based on models using various and at times differing assumptions (witness AIGFP) negotiated liquidation and early termination thus more complex outside of bankruptcy; sometimes skewed in bankruptcy

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Common Types of Swaps

Interest Rate Swaps Currency (FX) Swaps Commodity Swaps Credit Default Swaps (CDS) Equity Swaps Total Return Swaps (TRS) Other Types

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Interest Rate Swaps

Interest rate swaps developed in 1981 to alleviate mismatch on capital rates, investment returns and improve issuer balance sheet management

European companies could raise money with fixed rate Eurobonds, but European investments paid floating rates
US companies often used commercial paper and other floating rate capital markets while investments, such as Treasury, paid fixed returns.

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Interest Rate Swaps Use and Structure

Banks, funds and corporations use interest rate swaps to reduce mismatched interest exposure on other investments or speculate on interest rate movement Interest rate swaps are standardized/very liquid
Notional Amount= $500 million Fixed Interest Rate (e.g., 3%)

A
Floating Interest Rate (e.g., LIBOR + 50 bps)

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Interest Rate Swap Payment Summary

Each payment is based on a notional amount, but the notional amount is not transferred
One party makes a stream of payments calculated like interest that would be paid on notional amount with a fixed (or floating) interest rate Other party does the same but based on another interest index (typically a floating rate such as LIBOR, but can be based even on another fixed rate interest index)

Fixed and Floating payments

typically match on same day (otherwise credit risk) can be made monthly, quarterly, semi-annually etc.

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Currency (FX) Swaps

Originally developed as back to back loans in the 1970s in the UK to avoid government charges on U.S. dollar based loans. In 1981, Salomon Brothers created first direct currency swap between World Bank and IBM
IBM swapped U.S. dollars to the World Bank for Swiss francs and German deutschemarks

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FX Swaps Use and Structure

Banks, funds and other financial institutions use FX swaps to reduce currency risk on other investments or to speculate on currency fluctuations Currency swaps are standardized and very liquid
5% on $10 Million USD

A
LIBOR + 2% on $1.2 Billion JPY

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FX Swaps Payment Summary

Parties exchange streams of payments in different currencies to reduce exposure to currency risk

Multiple currency combinations are possible and some transactions have different currencies swapped based on exchange rate or other factors
Often used in conjunction with interest rate swaps where underlying liabilities are financing transactions

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Commodity Swaps
The Chase Manhattan Bank introduced commodity swaps in 1986
Commodity futures were common for many years, but swaps provided advantages in products and maturity

The first swaps referenced oil, but the commodity swap market has expanded
natural gas, electricity, coal, other energy products, as well as metals, agriculture and other commodities
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Commodity Swaps Use and Structure

Commodity users use swaps to protect themselves from risk of price swings Banks and financial institutions use commodity swaps to hedge market exposure to such commodities or to speculate on future price movement
Depreciation on Referenced Commodity

Appreciation on Referenced Commodity Fixed or Floating Payment or other Commodity returns

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Commodity Swap Payment Summary

Transaction relates to a certain amount of a particular commodity
Commodity amount may be for a one time settlement or multiple settlements at set time periods

One party pays an amount based on change in price of commodity

Other party pays a fixed/floating amount on each settlement date These are cash settled and commodity is almost never transferred

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Credit Default Swaps (CDS)

Developed in 1994 by JPMorgan to overcome bank capital restrictions on outstanding Exxon loans
By transferring Exxon credit risk, JPM could reduce bank capital required to be held against Exxon loans

Credit derivatives expanded to reference loans, corporate, sovereign and fixed income notes, indices, etc. How is it different from financial guaranty insurance?
CDS buyer need not have an insurable interest

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CDS Use and Structure

Banks, funds and other financial institutions use CDS
to hedge credit risk on investments gain leveraged exposure to loans, debt etc. engage in capital structure arbitrage arbitrage credit markets
Fixed Payments
Reference Entity DEFAULT

Buyer
Par Value of Reference Obligation

Seller

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Structure of Original 1994 JPM CDS (BISTrO)

Loan portfolio ($9.7 Bn) U.S. Treasuries
Return Credit default swap Fee (X bp p.a.) Par

Morgan Guaranty Trust (MGT)

Net losses

Special Purpose Vehicle (SPV)

Treas return + X Par

Par (minus net losses) at maturity

Capital market investors

0.3 % first loss (equity)

J.P. Morgan retains ownership of loans, but sheds credit risk

Credit default swap between MGT and SPV transfers risk Investment proceeds invested in U.S. Treasuries, which collateralize credit default swap (but not entire $9.7 Bn underlying amount)

BISTrO notes exposed to credit risk of larger reference portfolio

US $697 MM of BISTrO notes exposed to risk of $9.7 Bn portfolio
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CDS Payment Summary

CDS between Buyer and Seller of credit protection on a Reference Obligation
Buyer makes periodic payments (typically monthly or quarterly) to the Seller which terminate upon Credit Event Upon the occurrence of a Credit Event, Seller pays Buyers loss resulting from Credit Event
Settled by physical delivery of a Deliverable Obligation or cash settled by difference between par (100%) and Final Price Credit Events include Bankruptcy, Failure to Pay, Obligation Acceleration, Repudiation, Moratorium and, for some transactions, Restructuring

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Equity Swaps

Developed in late 1980s to avoid premium tax rates on investments in foreign securities ISDA publishes Confirmations and Definitions for equities and equity indices (including variance indices) for most countries and exchanges

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Equity Swaps Use and Structure

Banks, funds and corporations use equity swaps
gain exposure to equities or indices to avoid tax or transaction costs gain exposure to illiquid markets hedge investments
Depreciation on Referenced Equity

Appreciation on Referenced Equity Fixed or Floating Payment or other Equity returns

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Equity Swap Payment Summary

Transaction relates to a certain number of shares of a particular equity
Equity amounts may be for a one time settlement or multiple settlements at set time periods

One party pays an amount based on change in price of an equity security

Other party pays a fixed/floating amount on each settlement date These are cash settled and equity security is almost never transferred

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Total Return Swaps (TRS)

TRS have been around since at least 1987, when Salomon Brothers offered the first Mortgage Swap Agreement
TRS allows Buyers to invest in otherwise unavailable markets, gain leveraged exposure to assets or arbitrage cost of funding expenses TRS Sellers can hedge against investment exposure and profit from cost of funding differential between the parties TRS used in many structured investment vehicles (SIVs) that collapsed at front-end of the Financial Crisis
SIVs were rated not on underlying asset quality but rather on Swap Counterparty credit rating

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TRS Use and Structure

Increase in Value of Asset Interest payments from Asset

TRS Buyer

Interest Payment (LIBOR + Spread) Loss in Value of Asset

TRS Seller

Interest payments Reference Asset (e.g., bonds, indices, equities, etc.)

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TRS Payment Summary

TRS Buyer pays a rate of interest on notional amount of Reference Asset
Interest rate typically less than TRS Buyers cost of funding

TRS Seller can hedge exposure to asset and receive interest payments that are typically greater than TRS Sellers cost of funding
Allows TRS Buyer to derive the benefit of owning an asset without having the asset on balance sheet, and gives TRS Seller protection from loss in value

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Other Swaps and Derivatives

Other common derivatives:

weather derivatives electricity derivatives life settlement indices sovereign debt

There is no limit on products referenced

parties can create derivatives to precisely fit their investment needs and goals

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Exotic Derivatives
Parties can also combine derivative instruments to create new instruments
A Swaption is an option to enter into a swap and is a common derivative instrument

Parties also modify payment structure to fit investment goals

Swaps can be drafted to be effective only under certain conditions (interest rate, exchange rate, equity price triggers) or limit parties exposure to certain percentages of loss or gain
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Questions?
Are there any questions?

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Swap Documentation
OTC Derivatives are traded under Master Agreements Master Agreements by their terms:
net all transactions
Master Agreement nets all transactions for one aggregate liability or asset of a party

provide for representations, covenants, and events of default methodology for terminating all transactions and calculating a final settlement amount

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Swap Documentation - Bankruptcy

Protected features under the Bankruptcy Code
Debtor generally has the ability to avoid
pre-petition preferences (S. 547) fraudulent transfers (S. 548) unperfected security interests (S. 547) pre-petition set-offs (S. 553) and post-petition transfers (S. 549)

Trustee generally has the right to assume or reject executory contracts

Gives the trustee the power to cherry-pick

assume transactions favorable to debtor reject transactions favorable to counterparty

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Swap Documentation - Bankruptcy

Master Agreements are protected contracts under Bankruptcy Code (S. 560)
ISDA was very active in lobbying for these changes to the US Bankruptcy Code and in some 50+ other countries

Other protected contracts include

securities contracts (S. 555) commodities contracts (S. 556) forward contracts (S. 556) repurchase agreements (S. 559) master netting agreements (S. 561)

These contracts protected to maintain integrity of financial markets

In Lehman bankruptcy there were 930,000 outstanding swaps 918,000 terminated soon after the bankruptcy filings (September 2008)
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Swap Documentation - Bankruptcy

A party with a protected contract (including Swap Agreements (S. 362(b)(17)), notwithstanding the automatic stay, trustees powers, or any order of the Bankruptcy Court:
may terminate, liquidate, or accelerate the agreement offset or net termination values, payment amounts or other transfer obligations foreclose on collateral

Under a Swap Agreement, a party may be able to suspend performance under a transaction without terminating the agreement (Section 2(a)(iii))
interest accrues

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Swap Documentation - Termination

Under 1992 ISDA Master Agreement, parties elect either Market Quotation or Loss
Market Quotation: based on (i) average of two middle bids obtained from 4 reference market makers or (ii) the middle bid of 3 bids so obtained poses problems in times of market turmoil Loss: cost of unwinding hedges related to the terminated transactions under the Swap Agreement unilateral if reasonable determination of non-defaulting party

2002 ISDA Agreement adopts single damages measurement defined as the Close-out Amount
requires a good faith determination, using commercially reasonable procedures, of the losses or gains that are or would be realized in providing for the economic equivalent of the material terms of and option rights of the parties under the terminated transactions
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Simplified ISDA Structure

ISDA Master Agreement

Short form Confirmation(s)

Long form Confirmation(s)

Definitions Definitions
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ISDA Agreement Structure (2009)

Credit Support Documents: to reduce credit risk 2001 Margin Supplement (incorporating 2001 Margin Provisions) 1995 Credit Support Annex (Transfer-English law) 1994 Credit Support Annex (New York law)
Annexes ISDA Global Physical Coal Annex US Emissions Annex EU Emissions Annex North American Power Annex North American Gas Annex GTMA Annex (UK Power) European Gas Annex US Crude Oil and Refined Petroleum Products Annex

Bridges 2002 Energy Agreement Bridge 2001 Cross-Agreement Bridge 1996 FRABBA Bridge 1996 BBAIRS Bridge Definitions: for use in documenting Transactions 2007 Property Index Derivatives
Definitions
2006 Definitions 2006 Inflation Derivatives Definitions 2006 Fund Derivatives Definitions 2005 Commodity Definitions

1995 Credit Support Deed (Security Interest-English law) 1995 Credit Support Annex (Japanese law) 2002 Master Agreement Protocol

1992/2002 Master Agreement

Confirmations Long form confirmations Confirmations Short form confirmations Master confirmation agreements

2003 Credit Derivatives Definitions 2002 Equity Derivatives Definitions 1998 Euro Definitions 1998 FX and Currency Option Definitions 1997 Government Bond Option

Definitions
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OTC Derivatives Regulatory

History of OTC Derivatives Regulation Discussion of Over-the-Counter Derivatives Markets Act of 2009

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Arguments for regulating OTC Derivatives

Speculative nature of the transactions cause market integrity issues
Lack of transparency or opaqueness Precise nature of risk and scope unknown to regulators
Leads to potential increased systemic risk Viewed as having exacerbated the Financial Crises

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Early Derivatives Regulation

Originally regulated in US and UK by common-law rules against difference contracts

could wager anything you wanted, but to go to court to enforce it had to demonstrate at least one party had a real economic interest in the underlying and was using the derivative to hedge against a risk to that interest akin to insurance law concept of insurable interest

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Early Derivatives Regulation

Didnt mean you couldnt use derivatives to speculate, rather needed to come up with ways to make sure counterparts paid on their bets if they had no economic interest in the underlying
Private exchanges created with membership, margin, and netting requirements designed to make sure speculators would make good on their contracts Control increased with imposition of government regulators
CFTC and SEC

ISDA Swap Agreements essentially created an OTC derivatives private exchange with netting benefits

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CFTC
In 1974 Congress created the Commodities Futures Trading Commission (CFTC) Congress gave CFTC exclusive jurisdiction over all contracts having the character of futures contracts and mandated that such contracts, with certain exemptions, only be traded on CFTC-regulated exchanges CFTC given exclusive jurisdiction over all futures and options on futures whether underlying was a physical or financial commodity

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1974 Treasury Amendment

Treasury Amendment proposed over concerns of scope of CFTCs jurisdiction
Amended CEA to exempt (so long as not conducted on a board of trade):
transactions in foreign currencies government securities mortgages

While these exemptions covered the exclusion of a number of private markets of concern to Treasury, a large number of derivative transactions would not fit into CEA/CFTC statutory exclusions or exemptions

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1982 Shad/Johnson Accord

1982 Shad/Johnson Accord attempted to clarify the regulatory jurisdiction over futures and options based on securities and stock indices between the CFTC and the SEC Banned futures contracts on single stocks and narrow-based stock indices
thus viewed as a prohibition on equity derivatives

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1982 Shad/Johnson Accord

CFTC retained authority over futures contracts and options on future contracts on
commodities (including exempt securities (other than munis)) foreign currencies not traded on a national securities exchange certificates of deposit broad-based indices of securities

SEC retained authority over options on

securities (including certificates of deposit) certain securities indices foreign currencies traded on a national securities exchange

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1989 CFTC Swap Policy Statement

Reflected CFTCs view:
that most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the CEA as futures or commodity options

Enacted prior to CFTC having authority to exempt futures contracts from being required to be traded on CFTC approved contract markets Swap Policy Statement viewed by some as indication that swaps covered by the Swap Policy Statement were not futures contracts

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1989 CFTC Swap Policy Statement

To meet the Swap Policy Statement safe harbor, the swap agreement must:
have individually negotiated terms be entered in conjunction with the swap parties line of business not be terminable without the consent of the other party

If a high net worth individual enters into a swap agreement, what is his/her line of business?

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1989 CFTC Statutory Interpretation Concerning Certain Hybrid Instruments

Excluded from CEA regulation certain instruments (debt or equity) whose repayment was linked to a commodity component Rule tested the commodity independent yield and commodity dependent yield
commodity independent yield of the hybrid instrument had to be between 50% to 150% of the estimated yield on a comparable non-hybrid instrument Rule led to a number of regulatory uncertainties when it was applied

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Futures Trading Practices Act of 1992

Granted the CFTC authority to grant exemptions from the CEA regulation Again did not specifically address whether a swap agreement is a futures contract or an option on a futures contract

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1993 CFTC Swap Exemption

CFTC exempted swap agreements that were:
entered into with eligible swap participants (ESPs) not part of a fungible class of agreements that are standardized as to their material terms creditworthiness of the parties is a material consideration swap agreement is not traded through a multilateral transaction execution facility

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1993 CFTC Swap Exemption

Since swaps were exempt and still not held to not be futures, CFTC still retained anti-fraud and antimanipulation authority over exempted swap agreements Swap Exemption applied to most common interest rate, currency and commodity swaps
cast doubt on the legality of equity derivatives (which continued to rely on the Swap Policy Statement)

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1993 CFTC Hybrid Exemption

Eliminated a hybrid instruments commodity independent yield test for a predominance test Predominance test requires
the debt and equity component of a hybrid instrument (commodityindependent component) must exceed the value of the option-like or futures-like commodity component of the instrument (commodity-dependent component) CFTC prescribed a method by which the commodity indexation had to be decomposed by assigning premium values to be assigned to the commodity options varying assumptions used produced considerable regulatory uncertainty

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Post 1993
Two developments led market participants to believe that the CFTC might seek to modify the Swap Exemption
Comment letter on SECs broker-dealer lite proposal stated that the SEC proposal created potential conflict with the CEA to the extent that certain OTCs fall within the ambit of the CEA and are subject to the exclusive authority of the CFTC CFTC 1998 Concept Release requesting comment of whether OTC derivatives regulation is appropriate and if so what form should it take raising uncertainty about the Swap Exemption

1998 Legislation enacted at request of Treasury, Fed, and SEC limited CFTCs rule-making authority with respect to swaps and hybrid instruments until March 30, 1999
essentially froze the pre-existing legal status of swaps and hybrids entered into in reliance on prior CFTC policy statements and exemptions

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2000 CFMA
In 1999-2000 need was recognized to overhaul OTC derivative regulation
1993 Swap Exemption could be revoked by CFTC at any time

CFMA declared OTC derivatives exempt from both CFTC and SEC regulation CFMA provided legal certainty
No OTC derivative contract would be unenforceable under the CEA or any other federal or state law for failure to comply with exemptions or exclusions provided by CEA OTC derivatives excluded from requirement to be executed on a regulated trading facility Repealed Shad-Johnson to permits US trading of security futures
futures on individual non-exempt securities futures on narrowly-based groups or indices of non-exempt securities
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2000 CFMA
Provided that swap agreements entered into with eligible contract participants that are not executed on a trading facility are excluded from the CEA
ECPs
corporations with $10 million in assets natural persons with $5 million in assets entered into to manage risk

Much more effective than 1993 Swap Exemption

can be modified only by Congress applies to transactions and not just master agreements ECPs were broader than ESPs Swap Exemption non-fungibility and creditworthiness requirement eliminated

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2000 CFMA
Also amended the securities laws to define securitybased and non-security based swaps agreements.
security-based swap agreement is a swap agreement of which a material term is based on the price, yield, value or volatility of any security or any group or index of securities non-security based swap agreement means any swap agreement that is not a security-based swap agreement.

CFMA made security-based swaps agreement subject to anti-fraud, anti-manipulation and anti-insider trading provisions of the 1933 Act and 1934 Act

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2000 CFMA
However, SEC had no regulatory authority over security based swap agreements
SEC could propose no reporting or record-keeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation or insider trading with respect to any security-based swap agreement certainly could not require the registration of security-based swap agreements under Section 5

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2000 CFMA
Excluded from CEA jurisdiction identified banking products to deal with CFTC and banking regulators jurisdictional issues
includes certificates of deposit bank loans loan participations sold to qualified investors credit swaps equity swaps sold to qualified investors

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2000 CFMA
Also provided that CFMA preempts any state or local laws regulating gaming or bucket shops
eliminates concern that excluded or exempt transactions may be voided for violating these state or local laws

Contained a savings clause that no transaction between ECPs, and no hybrid instrument, shall be void, voidable or unenforceable solely because it fails to comply with the terms of an exemption or exclusion Thus with CFMA 2000, OTC derivatives regulatory regime and enforceability was set in stone

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Over-the-Counter Derivatives Markets Act of 2009 (proposed August 11, 2009)

Significant changes to the regulatory structure

Significant changes to the way OTCs are cleared

Significant rule-making to come

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OTC DMA of 2009 - Overview

Eliminated the unregulated status of OTC derivatives and implemented a new regulatory authority
carved up regulatory authority over swaps between SEC and CFTC

Created registration requirements for swap dealers and major swap participants Legislated mandatory clearing requirements
for standardized swaps

Legislated registration requirements for swap clearing houses

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OTC DMA of 2009 - Overview

Expansion of regulatory authority over swaps
CFTC
would have exclusive jurisdiction over all swaps except security-based swaps swaps include options but does not include foreign exchange swaps and foreign exchange forwards CFTC would be limited to regulating entities dealing in swaps and to enforcing anti-manipulation and anti-fraud provisions

SEC
would have exclusive jurisdiction over security-based swaps security based swap are swaps based on a single security, loan or a narrow-based security index SEC would maintain authority over anti-fraud, short-swing profits, and insider trading

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OTC DMA of 2009 Credit Default Swaps

Allocates jurisdiction over credit-default swaps to the CFTC and SEC

SEC has jurisdiction over security-based swaps
single security, loan (CDS) or narrow-based security index (including narrow-based CDS index)

CFTC has jurisdiction over all other swaps

includes broad based securities indicies (including CDS)

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OTC DMA of 2009 Standardized and Non-Standardized Swaps

Distinguishes between standardized swaps and nonstandardized swaps
standardized swaps will be required to be cleared through a central clearing house non-standardized swaps will be subject to higher capital and margin requirements on derivatives dealers and major swap participants

CFTC and SEC to define standardized swaps within 180 days of enactment
define as broadly as possible, after taking into account
terms of the trade volume extent to which a swap is similar to other centrally cleared swaps economically similar to other centrally cleared swaps in a manner to reduce avoidance schemes

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OTC DMA of 2009 - Rulemaking

Where SEC and CFTC cannot agree on rulemaking as required by the Act, Treasury is authorized to impose rule until agencies reach agreement SEC and CFTC cannot make rules unless as strict or stricter than those of prudential banking regulators Proposal also grants limited exemptive authority
only where expressly authorized
thus no work around fixes legislative acts would be required

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OTC DMA of 2009 Registration Requirements

Registration Requirements
requires swap dealers and major swap participants to register with the CFTC requires security-based swap dealers and major security-based swap participants to register with the SEC

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OTC DMA of 2009 Swap Dealer Definition

Who is a swap dealer?
swap dealer is any person who is engaged in the business of buying or selling swaps for its own account, excluding persons who do not engage in this activity as part of a regular business (trader exemption)
if trader exemption interpreted consistent with Exchange Act would potentially exclude many end users such as hedge funds, insurance companies, and operating companies

No bank exemption as presently under the 1934 Act for Banks Brokers of security-based swaps will also be required to register under the 1934 Act

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OTC DMA of 2009 Major Swap Participant Definition

Who is a major swap participant?

a person who is not a swap dealer but who maintains a substantial net position in outstanding swaps, excluding persons who engage in trading swaps to maintain an effective hedge under GAAP
GAAP hedges is pretty narrowly defined as an accounting matter

Many financial companies, banks, insurance companies, investment companies likely to meet this definition
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OTC DMA of 2009 Swap Dealer Provisions

Swap dealer and major swap participant are required to
meet minimum capital and margin requirements to be established by
Fed/OCC or FDIC for Banks SEC and CFTC jointly (for non-banks) capital requirements would be higher for non-standardized swaps than for swaps
Bank regulators would set a floor for SEC and CFTC requirements

initial and variation margin set by Bank regulators would also set floor for SEC and CFTC requirements

comply with various reporting and record-keeping requirements

must require daily records of swaps, cash, recorded conversations, including email and IMs a complete audit trail

conform to certain business conduct, documentation and back office standards comply with requirements relating to position limits, disclosure, conflicts of interest, and antitrust
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OTC DMA of 2009 Swap Dealer Provisions

Major security-based swap participants required to register with SEC potentially resulting in dual registration (for e.g., may be regulated by the OCC or under the Investment Company Act)
SEC and CFTC are required to jointly define major swap participant

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OTC DMA Act of 2009 Mandatory Clearing

Mandatory clearing
requires all standardized swaps to be traded on a designated contract market or alternative swap execution facility (ASEF)
ASEF must provide that all swaps with same terms and conditions are fungible and may be offset with each other

these mandatory trading requirements would not apply to swaps if

no clearing agency accepts the swap for clearing one of the parties to the swap is not a swap dealer or a major swap participant swap dealer or major swap participant does not meet the eligibility requirements of any clearing organization that clears such transactions

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OTC DMA of 2009 Trading Facilities

ASEFs for trading of standardized swaps or standardized securitybased swaps required to register with CFTC or SEC, as appropriate
As an ASEF, would be subject to
trading procedures deterrence of trading abuses financial integrity of transactions

ASEFs would have core regulatory principles, and subject to

enforcement, position limits emergency powers recordkeeping and reporting conflicts of interest
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OTC DMA of 2009 Trading Facilities

ASEFs subject to comparable comprehensive supervision/regulation by another domestic/foreign regulator could be exempted by the Agency ASEFs would make publicly available aggregate data on swap trading volumes and positions (without disclosing business transactions or individual market positions)

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OTC DMA of 2009 Swap Repository

Parties who enter into non-standardized (uncleared) swaps are required to report such swaps to a registered swap repository
registered swap repositories are required to register with the appropriate Agency
would be required to accept, maintain and make available data to the Agency would be subject to inspection and examination deterrence of trading abuses

financial integrity of transactions seems more like a governmental function raising private market issues

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OTC DMA of 2009 Final Reporting

Finally, persons whos trades are not cleared or not reported to a registered swap repository would be subject to certain reporting and recordkeeping requirements
Institutional investment managers would be required to report security-based swap agreements aggregated with their cash positions on SEC Form 13F CFTC and SEC would be required to publicly report aggregated position information (without disclosing business transactions or individual market positions) derived from
clearing organizations swap repositories persons otherwise required to report directly to the Agency
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OTC DMA of 2009 Position Reporting

CFTC given power to establish aggregate position limits for contracts listed by a DCM/ASEF and swap contracts that perform or affect a significant price discovery function, allowing for hedging exemptions SEC has similar authority for
position limits for securities listed on a national securities exchange and security-based swaps that perform or affect a significant price discovery function with respect to regulated markets large trader reporting requirements for security-based swaps that perform or affect a significant price discovery function with respect to regulated markets

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OTC DMA of 2009 Sections 13d and 16

Sections 13 and 16 would apply also to securitybased swaps and any other derivative instrument the SEC may determine
Section 13 turns on beneficial ownership s power to dispose or to vote which is generally not present in a cash settled security-based swap

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OTC DMA of 2009 ECP Definition

ECP definition would be modified
government entities that invest on a discretionary basis $50m (previously $25m) individuals with $10m in assets invested on a discretionary basis (previous just $10m in assets)

Mandatory exchange clearing provisions would not apply to swaps entered into by ECPs

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OTC DMA of 2009 Retail Regulated Swaps

Unlawful for anyone other than an ECP (i.e., retail) to enter into a swap unless
a swap subject to a regulated futures exchange a security-based swap entered into on a national securities exchange and the trade was registered under the 1933 Act

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Questions
Are there any questions?

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Bill Satchell, Partner

Bill Satchell is a partner in OMelveny's Washington, DC office and a member of the Firms Securities Enforcement and Regulatory Counseling Practice. He advises financial services organizations in connection with transactional, litigation, and regulatory matters. Bills practice extends to a broad range of issues, including structured finance, financial institution mergers and acquisitions, privacy, anti-money laundering, residential mortgages, the regulation of financial products, derivatives, and financial product distribution.

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Demetri Xistris, Senior Counsel

Demetrios Xistris is a Senior Counsel in OMelvenys New York office and a member of the Firms Investment Funds and Securitization Practice. He is highly experienced in financial products and derivatives transactions including equity, credit, fixed income, commodities and hedge fund derivatives. He has extensive knowledge of structured products, hedge fund structures and activities, financing and credit enhanced vehicles, corporate, monetization and hedging transactions, prime brokerage, synthetic prime brokerage, structured repo, equity finance and proprietary trading and has worked on a number of asset acquisitions related to derivative and financial products trading businesses. Demetrios is also an authority on master agreements, netting and collateral documentation. Prior to joining OMelveny, Demetrios spent 15 years on Wall Street at various investment banks as the senior lawyer where he managed the legal, regulatory enforcement, trading, and marketing aspects of the firms' US equities and equity derivatives businesses. Most recently, Demetrios was a managing director and legal head of the US Equities and Equity Derivatives division of Socit Gnrales, the worlds largest (by revenue) equity derivatives house where he chaired the Global Legal Departments Hedge Fund Working Group, was a member of its Global Equity Derivatives and ISDA Master Agreements Working Groups, and participated on the firms US New Products Committee for all new equity products. His experience also includes working in similar capacities at BNP Paribas, where he was a managing director responsible for all legal matters relating to the firm's US Equities and Equity Derivatives business, and at JPMorgan, where he was that banks first equity derivatives lawyer. During his work at the investment banks, Demetrios was also very active on FINRAs Derivatives Products Committee. He was, and continues to be, a member of various ISDA committees, including the Equity Derivatives Committee. He co-chaired ISDAs 2006 Fund Derivatives Definitions project and is a founding member of the Structured Products Association.

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