BREAKFAST SEMINAR: An Update on Proposed OTC Derivative
Regulation in the EU and U.S.
Martin Cornish, Vanessa Edwards, Stuart Fross,
Stephen Moller – 10 May 2011
Copyright © 2011 by K&L Gates LLP. All rights reserved.
Introduction
An Update on Proposed OTC Derivative
Regulation in the EU and U.S.
•The policy background
•Summary of proposals
•Current status
•Timing
•Impact on Funds and Advisers
•Possible interaction between EU and U.S. regulation
2
EMIR – the proposed EU regulation on derivatives
Vanessa Edwards
Partner, K&L Gates London
Copyright © 2011 by K&L Gates LLP. All rights reserved.
EU legislative process
Two arms of legislature
Council of Ministers (Member States)
European Parliament (elected deputies)
European Commission proposes
Council and Parliament debate and amend in
parallel
European Council and influence of Presidency
4
Legislative timetable
Friday 13th …
This week in Strasbourg …
Next week in Brussels …
Parliament Plenary vote 5 July
Council adoption
Publication
Entry into force
Delegated rule-making
5
European Markets Infrastructure Regulation
(EMIR)
Regulating the activities of central counterparties
- i.e. derivative clearing houses (central
counterparties; CCPs) and trade repositories
(TRs)
In broad terms, all standardised derivative
contracts (DCs) must be cleared through an
authorised or recognised CCP
The clearing obligation applies to financial
counterparties (FCPs) and (subject to threshold)
non-financial counterparties (NFCPs)
“Article 7(2) NFCPs”
6
EMIR - contents
Regulation on derivative transactions, central
counterparties and trade repositories
clearing obligation, risk mitigation and reporting
obligation
authorisation and supervision of CCPs
requirements for CCPs
interoperability arrangements
registration and surveillance of trade repositories
requirements for trade repositories
common requirements on professional secrecy,
exchange of information for the authorities
7
Scope
options, futures, swaps, forward rate agreements and any other DCs relating to securities,
currencies, interest rates or yields, or other derivatives instruments, financial indices or
financial measures which may be settled physically or in cash
options, futures, swaps, forward rate agreements and any other DCs relating to commodities
that must be settled in cash or may be settled in cash at the option of one of the parties
(otherwise than by reason of a default or other termination event)
options, futures, swaps, and any other DC relating to commodities that can be physically
settled provided that they are traded on a regulated market and/or a multilateral trading facility
(MTF)
options, futures, swaps, forwards and any other DCs relating to commodities, that can be
physically settled not otherwise mentioned in (c) and not being for commercial purposes, which
have the characteristics of other derivative financial instruments, having regard to whether,
inter alia, they are cleared and settled through recognised clearing houses or are subject to
regular margin calls;
derivative instruments for the transfer of credit risk;
financial contracts for differences;
options, futures, swaps, forward rate agreements and any other DCs relating to climatic
variables, freight rates, emission allowances or inflation rates or other official economic
statistics that must be settled in cash or may be settled in cash at the option of one of the
parties (otherwise than by reason of a default or other termination event), as well as any other
DCs relating to assets, rights, obligations, indices and measures not otherwise mentioned,
which have the characteristics of other derivative financial instruments, having regard to
whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled
through recognised clearing houses or are subject to regular margin calls.
8
Principal regulatory players and methods
Commission
ESMA
EU competent authorities (CAs)
Third country (t/c) CAs
Implementing technical standards (ITSs)
9
Eligibility for clearing obligation
Where EU CA has authorised CCP to clear given class of
derivatives, must notify ESMA
Where t/c CCP has been recognised by ESMA, t/c CA
must notify ESMA when that CCP has been granted the
right to provide clearing services to EU members/ clients
ESMA must notify Commission and develop ITSs
determining whether and from when a class of derivatives
to be subject to the clearing obligation
ESMA must identify and notify Commission of classes that
should be subject to clearing obligation but for which no
CCP is yet authorised; Commission may call for proposals
for clearing such classes
ESMA must keep up-to-date register of classes of
derivatives subject to clearing obligation on its website
10
Criteria for “whether”
With the overarching aim of reducing systemic risk, ESMA shall
prepare the draft ITSs based on the following criteria:
[impact on level of counterparty credit risk in market,
within the relevant class of derivatives and between
classes, as a result of applying an obligation to the
relevant class]
degree of standardisation of relevant class of derivative
contractual terms and operational processes
volume and liquidity of relevant class of derivatives
availability of fair, reliable and generally accepted pricing
information in the relevant class of derivatives
[impact on competition]
11
Criteria for “from when”
With the overarching aim of reducing systemic risk, ESMA shall
prepare the draft ITSs based on the following criteria:
expected volume of relevant class of derivatives
ability of relevant CCPs to handle expected volume and
manage resulting risk
type and number of counterparties active/expected to be
active for relevant class of derivatives
period of time counterparty subject to clearing obligation
needs to put in place arrangements to clear
risk management, legal and operational capacity of
counterparties active in market for relevant class of
derivatives that would have to be cleared
12
Clearing obligation: substance
FCs and Article 7(2) NFCs to clear all derivatives
pertaining to a class of derivatives declared
subject to the clearing obligation and concluded
with another FC/Article 7(2) NFC or with t/c
entities which would be subject to the clearing
obligation if established in EU
Clearing must be in a CCP authorised or
recognised to clear that class of derivatives
Intragroup exemption
13
Clearing obligation - timing
Clearing obligation applies to contracts entered
into or novated on or after:
Date from which clearing obligation takes effect or
Date of entry into force of EMIR but before the
date from which the clearing obligation takes
effect if the contracts have a remaining maturity
higher than the minimum remaining maturity
determined by Commission
14
Clearing obligation - NFCs
NFC who takes positions in derivatives pertaining to same
class of derivatives which together exceed clearing
threshold
Must notify ESMA and CA
Becomes subject to clearing obligation for future contracts if
positions have exceeded thresholds continuously during one
month
In calculating positions, derivatives entered into by NFC or
entities in same group which are objectively measurable
as reducing risks directly related to commercial activity of
NFC/group not to be taken into account
Commission to adopt ITSs specifying criteria for above
and setting values of clearing thresholds
15
Risk mitigation techniques for derivatives not
cleared by CCP
FCPs and NFCPs shall ensure appropriate procedures and
arrangements are in place to measure/monitor/mitigate
operational and credit risk including at least:
timely confirmation of terms, where available via electronic means;
robust, resilient and auditable processes to reconcile portfolios,
manage risk, identify and resolve disputes and monitor value of
outstanding contracts.
FCPs and Article 7(2) NFCs shall mark-to-market the value of
outstanding contracts on daily basis; where market conditions
prevent marking-to-market, reliable and prudent marking-tomodel to be used.
For non intragroup transactions, risk management procedures
set up by FCPs or Article 7(2) NFCs shall require timely,
accurate and appropriate exchange of collateral and FCPs shall
hold appropriate and proportionate amount of capital.
Where there has been exchange of collateral, each
counterparty, if requested by the other, shall distinguish in
accounts the assets provided by the other party.
16
Reporting obligation
Counterparties and CCPs to ensure that details of any
derivative concluded and any modification/termination are
reported to TR or ESMA
Details to be reported no later than working day following
conclusion/modification/termination
Obligation applies to derivatives:
entered into before, and outstanding on, entry into force of
EMIR
entered into on or after entry into force
Commission to adopt ITSs to determine details, type,
format, frequency and date of reports
17
Access to a CCP
Authorised CCPs shall accept clearing derivatives on a nondiscriminatory and transparent basis, regardless of venue of
execution
A CCP may require those venues of execution to comply with its
operational and technical requirements
The home CAs of the requesting venue of execution and CCP
may deny the venue access to the CCP only where such access
would threaten the smooth and orderly functioning of markets
A CCP which has received an access request from a venue of
execution shall:
reply within [three] months
provide full reasons for any refusal and notify the venue
make access possible within three months of a positive response
18
Access to a venue of execution
A venue of execution must provide trade feeds on a
non-discriminatory and transparent basis to any CCP
authorised to clear derivatives traded on that venue
on request
The home CAs of the requesting venue of execution
and CCP may deny the CCP access to the venue
only where such access would threaten the smooth
and orderly functioning of markets
A venue of execution which has received an access
request from a CCP shall:
reply within three months
provide full reasons for any refusal and notify the CCP
make access possible within three months of a positive
response
19
Third country issues
A CCP established in a t/c may provide clearing services to
clearing members and their clients in the EU only where it is
recognised by ESMA
ESMA may, after consultation with specified CAs and other
authorities, recognise a CCP established in a t/c that has
applied for recognition where
Commission has adopted Decision determining that legal and
supervisory arrangements of the t/c ensure that CCPs authorised
there comply with laws equivalent to EMIR and are subject to
ongoing and effective supervision and enforcement and that legal
framework of t/c provides for effective equivalent recognition or
access of CCPs authorised under EMIR
CCP is authorised in, and subject to, effective supervision ensuring
full compliance with applicable prudential requirements
co-operation agreements have been established
20
Third country issues contd
ESMA must establish cooperation agreements with
relevant CAs of t/cs whose legal and supervisory
frameworks have been so recognised as equivalent by
Commission, specifying:
mechanism for exchange of information between ESMA and
CA of t/cs concerned, including access to all information
regarding CCPs there authorised that ESMA requests
mechanism for prompt notification to ESMA where a t/c CA
deems a CCP it is supervising to be in breach of conditions
of authorisation or applicable legislation
mechanism of prompt notification of ESMA by t/c CA when
CCP it supervises has been granted right to provide clearing
services to clearing members and/or clients established in
EU and
procedures for coordination of supervisory activities
including, where appropriate, on site inspections
21
Dodd-Frank the new US regulation on derivatives
Stuart Fross
Partner, K&L Gates Boston
Copyright © 2011 by K&L Gates LLP. All rights reserved.
New Regulatory Regime
Dodd-Frank Wall Street Reform and Consumer Protection Act
completely restructures the trading of OTC derivatives in the
United States.
Title VII is separately called the “Wall Street Transparency
and Accountability Act of 2010”
DF - Title VII establishes new requirements for reporting,
registration, clearing, exchange trading, margining, trade data
collection and preservation, and business conduct for
derivatives.
Dodd-Frank’s derivatives provisions, with few exceptions, will
become effective on July 16, 2011, 360 days following the
enactment of the new law.
23
New Regulatory Regime
Disclaimer: The breadth and complexity of Dodd-Frank’s
statutory regime for derivatives cannot be fully summarized in a
short presentation. This program is intended to provide only a
high level overview
24
Key Statutory Features
New Product Definitions: New definitions of “Swap,”
“Security-Based Swap” (“SB Swap”) and “Mixed Swap”
New Regulatory Jurisdiction: Regulatory authority divided
among the Commodity Futures Trading Commission (“CFTC”),
Securities and Exchange Commission (“SEC”), and banking
regulators
Rulemaking: Authorizes broad rulemaking authority for
these agencies
On-Exchange Trading: Requires Swaps and SB Swaps
be traded on regulated exchanges or a new statutory
entity called Swap and SB Swap Execution Facilities,
unless an exemption applies
Clearing and Margining: Requiring clearing and margining of
Swaps and SB Swaps, unless exemption applies
25
Key Regulatory Features (cont’d.)
Transaction Reporting: Requires reporting of all Swaps and SB
Swaps to a new regulated entity called a “Swap Data Repository”
or to the CFTC or SEC
Public Reporting: Mandates public reporting of aggregate Swap
and SB Swap transaction data
New Regulatory Requirements: Registration, capital,
disclosure, suitability, record-keeping, etc., for dealers and major
swap participants
New Protections for “Special Entities”: Imposes new
regulatory duties on swap advisors of “Special Entities” (e.g.,
employee benefit plans, endowments, government entities, and
governmental plans)
New Liability Standards: Creates new civil and criminal
proscriptions and liabilities and whistleblower incentives
26
Derivatives Market Regulators
Commodity Futures Trading Commission (“CFTC”)
Swaps and Mixed Swaps
Swap Dealers, Major Swap Participants, Futures Commission Merchants, Swap Clearing Organizations, Exchanges,
Swap Execution Facilities, and Swap Data Repositories,
Securities and Exchange Commission (“SEC”)
Security-Based Swaps (“SB Swaps) and Mixed Swaps
SB Swap Dealers, Major Security-Based Swap Participants, Broker-Dealers, Security-Based Swap Clearing Agencies,
Security-Based Swap Exchanges, Security-Based Swap Execution Facilities, Security-Based Swap Data Repositories
Banking Regulators (“Prudential Regulators”) -- Federal Reserve Board, Office of the
Controller of the Currency, Federal Deposit Insurance Corporation, Farm Credit
Administration, and Federal Housing Finance Agency
Regulate standards of conduct of and regulatory requirements for banks’ and other direct regulatees in Swaps, SB Swaps
and Mixed Swaps
Financial Stability Oversight Counsel
Mediates any jurisdictional disputes between CFTC and SEC
Federal Energy Regulatory Commission
Potentially overlapping enforcement jurisdiction with the CFTC with respect natural gas and electric power markets
27
Swap and SB Swap Market
Participants
COUNTERPARTIES
INTERMEDIARIES
CLEARING ORGANIZATIONS/
AGENCIES
End Users
Repositories
Regulated Exchanges
Regulated Clearing Organizations
Financial Entities
(Hedge funds, commodity
Swap Execution Facilities
pool operators, mutual funds) SB Swap Execution Facilities
REPORTING
AGENCIES
Swap Data
SB Swap Data
Repositories
Futures Commission Merchants
Broker-dealers
Major Swap Participants
Swap Dealers
SB Swap Dealers
Major SB Swap Participants
Special Entities
(E.g., endowments,
governmental investment plans)
Pension Plans
28
Features For Limiting Risk and
Improving Transparency
Margin – Generally, parties will be required to post
margin for their Swaps and SB Swaps
Minimum margin requirements for centrally cleared
Swaps and SB Swaps will be set by registered
exchanges, execution facilities and clearing
organizations/agencies.
Minimum margin requirements for OTC Swaps and
SB Swaps will be set by the CFTC and SEC,
respectively; if Swap dealer, SB Swap dealer, major
swap participant or major SB swap participant is a
bank, banking regulator will set margin
29
Current Swap Market Structure
Counterparty
Counterparty
(Clearing available for
some Swaps only upon
election of both parties)
A. Private bilateral terms set exclusively
by the parties (including definition of
default)
B. Any margin/collateral requirements
and terms of custody set by the
parties in the contract
C. Three ways to execute:
1. Direct communications
CFTC Regulated
Clearing Organization
becomes
counterparty to each
side of transactions
2. Unregulated trading platforms where
buyers and sellers can discover
and accept each other’s bids and
offers and form agreements
3. Voice brokers
30
NEW SWAP MARKET STRUCTURE
A. Example of OTC Swap between End
User and Regulated Swap Counterparty
Commercial
End User
(must be eligible
contract participant)
•
•
Non-cleared Swap
Cleared Swap
End User must notify
CFTC how it will meet
financial obligations
For public companies,
board approval
required to enter into
non-cleared swaps
1. Clearing at election of
Commercial End User
2. Swap Dealer/MSP
Submits Swap to CFTC
Regulated Clearing
Organization for
clearing
Reporting
Non-cleared Swap
Swap Dealer/MSP
reports Swap to Swap
Data Repository or
CFTC
DC-1471559
Swap Dealer/ Major Swap Participant
(“SD”)
(“MSP)
Reporting
Cleared Swap
Clearing organization
reports swap to Swap
Data Repository
1. CFTC Registration as SD or MSP
2. Capital Requirements
3. Verification that counterparty is
eligible contract participant
4. Disclosure of material risks/material
incentives/conflicts of interest/daily
market.
5. Recordkeeping
6. Audit Trail
7. Risk management systems
8. Internal information gathering
systems
9. Establishment of Chief Compliance
Officer
10.CFTC Registration as Futures
Commission Merchant if it holds End
User’s margin/collateral for swap
31
NEW SWAP MARKET STRUCTURE
B. Example of Exchange-Traded Swap
Swap
Counterparty
CFTCRegistered
Futures
Commission
Merchant
imposes margin
requirements
and holds
customer margin
collateral
CFTC
Regulated
Exchange
Provides for
execution of
trade and
sets minimum
margin
requirements
Reporting
Exchange Reports
Swap to Swap Data
Repository or CFTC
CFTC-Registered
Futures
Commission
Merchant
imposes margin
requirements and
holds customer
margin collateral
Swap
Counterparty
Clearing
CFTC-Regulated
Clearing
Organization clears
the trade
32
New Definition of “Swap”
“Swap” is broadly defined to include any “agreement, contract or transaction” that:
-- Options: Is an option based upon the value of one or more commodities, currencies,
interest or other rates, securities, debt instruments, indices, quantitative measures, “or
other financial or economic interests or property of any kind.”
-- Event contracts: Provides for the purchase, sale, payment or delivery that is dependent
on the occurrence or non-occurrence, or the extent of an occurrence, of an event or
contingency with a potential financial, economic or commercial consequence.
-- Exchanges of financial risk: Provides for an exchange of payments based upon the
value of one or more currencies, commodities, interest or other rates, securities, debt
instruments, indices, quantitative measures “or other financial or economic interests or
property of any kind” and that transfers financial risk, but not ownership of an asset or
liability.
-- Common understanding: Is commonly known as a swap (e.g., “interest rate swap,” a
“currency swap,” a “total return swap,” an “equity index swap,” an “equity swap,” a “debt
index swap,” a “debt swap,” a “credit default swap”)
-- Any combination or permutation, or option on, any of the foregoing transactions
33
New Definition of Swap (cont’d.)
EXCLUSIONS:
-- Futures and options on futures
-- Forwards on physical commodities: Any sale of a “nonfinancial
commodity or security for deferred shipment or delivery, so long as
the transaction is intended to be physically settled.”
-- Security-based swaps
-- Contracts with the federal government: Agreements where the
counterparty is a Federal Reserve bank, the Federal Government,
or a Federal agency that is expressly backed by the full faith and
credit of the United States.
34
Clearing Process and Documentation
1)
Documentation for this is evolving.
Under one “futures style” model, the relevant documentation includes
Normal ISDA documentation between the customer and the executing
dealer;
The rules of the clearing entity;
A futures account agreement between the customer and the clearing
broker;
An addendum to the futures account agreement, adapting that agreement
for clearing of derivatives transactions; and
A tri-party give-up agreement, under which the customer trade is to be
given-up to the clearing entity.
35
Strategic and Compliance Issues for
Investment Managers
Investment companies registered (or that seek
registration) under the 1940 Act that use Swaps must
reconsider their regulatory status and may need to
reconsider their investment strategies.
Unregistered funds must consider the implications of
possibly being caught up in multiple regulatory
schemes.
Note CFTC proposals to eliminate important
exemptions found in current CFTC rules for hedge
funds
Many uses of swaps may have to register as CPOs
36
Strategic and Compliance Issues for
Investment Managers (cont’d.)
Swaps based on commodities (including broadbased securities indices) are excluded from the
definition of security, but subject to CFTC jurisdiction.
A fund that primarily invests in Swaps based on a
broad based securities index now may be treated as
a fund that does not invest in “securities,” and is
specifically subject to CFTC jurisdiction.
37
Enforcement Liability and Private
Claims
New Liability for a Counterparty’s Fraud. CEA § 4c(a) is amended
to make it unlawful for any person to enter into a swap “knowing, or
acting in reckless disregard of the fact,” that its counterparty “will use
the swap as part of a device, scheme, or artifice to defraud any third
party.”
CEA Fraud Provision Expanded. Swaps are now added to the
general anti-fraud proscriptions of Section 4b of the CEA. CEA § 4b
also is expanded to include a new anti-fraud provision modeled on
SEC Rule 10b-5. It proscribes, among other things, conduct that
“operates as a fraud” that will apply to any futures contract or option
thereon or any swap on a group or index of securities (or any interest
therein or based on the value thereof).
⎯ It is unclear whether Congress intended this provision to reach
unintentional deceptive acts or, like SEC Rule 10b-5, is limited to acts
performed with a mental state embracing intent to deceive, manipulate,
or defraud.
38
Enforcement Liability and Private
Claims (Cont’d.)
Disruptive Practices. Section 4c(a) of the CEA is amended
to include prohibitions against “disruptive practices” which
include any conduct on or subject to the rules of a registered
entity that (1) violates bids or offers; (2) “demonstrates
intentional or reckless disregard for the orderly execution of
transactions during the closing period”; or (3) “is or is of the
character of or is commonly known to the trade as ‘spoofing’
(bidding or offering with the intent to cancel the bid or offer
before execution).”
The express private right of action in § 22 of the CEA is
amended to include transactions in Swaps.
39
Martin W Cornish
Partner
London
Tel: +44.20.7360.8162
martin.cornish@klgates.com
Stephen Hans Moller
Partner
London
Tel: +44.20.7360.8212
stephen.moller@klgates.com
Stuart E Fross
Partner
Boston
Tel: (617) 261-3135
stuart.fross@klgates.com
Vanessa C. Edwards
Partner
London
Tel: +44.20.7360.8293
vanessa.edwards@klgates.com
40
