Counterparty Risk Seminar
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Counterparty Risk Seminar Thursday, March 5, 2009 Presented by: Gordon F. Peery, Of Counsel, Investment Management, K&L Gates Daniel F. C. Crowley, Partner, Public Policy and Law, K&L Gates Chad Dale, Partner, Bankruptcy, K&L Gates Brian Gallagher, Asset Management Industry Professional Practice Director, Deloitte Van Hatziyianis, Head of US OTC Services, NYSE Euronext Marisol Collazo, Vice President, Business Development, Deriv/SERV Trade Information Warehouse Program Agenda Welcome and Introductory Remarks The state of the $684 trillion OTC market Major industry, legal and exchange developments K&L Gates LLP Program Design and Your Questions Submit additional questions to swaps@klgates.com Presenters 1 1 Overview Of The Current Economic Crises & Prospects For Market Reform Presenter: Daniel F. C. Crowley Partner, Public Policy and Law K&L Gates 2 Overview The Bush Bailout The New Administration Obama Financial Stability Plan TALF Treasury Blueprint Recommendations G30 Report Recommendations Legislative Reform Issues Derivatives Regulation Hedge Fund Registration The Playing Field 3 2 The Bush Bailout Emergency Economic Stabilization Act (EESA) Troubled Asset Relief Program (TARP) Capital Purchase Program (CPP) Targeted Investment Program (TIP) Automotive Industry Financing Program (AIFP) Federal Reserve “Liquidity Facilities” TAF/FSLF/PDCF/AMLF/CPFF/MMIFF/TALF FDIC Liquidity Guarantee Programs 4 The New Administration President Barack Obama & Vice President Joe Biden The Agenda Revive the economy (stimulus) Provide affordable, accessible health care to all Strengthen the public education and social security systems Define a clear path to energy independence and tackle climate change End the war in Iraq responsibly and finish the mission in Afghanistan 5 3 Economic Policy Team President of the Federal Reserve Bank of New York (2003–2008) Under Secretary of the Treasury for International Affairs (1998–2001) Ben Bernanke Chairman (until 2010) Board of Governors of the Federal Reserve Lawrence Summers Director National Economic Council Timothy Geithner Secretary Department of the Treasury Secretary of the Treasury (1999–2001) Deputy Secretary of the Treasury (1995–1999) Under Secretary of the Treasury for International Affairs (1993–1995) Member of Board of Governors of the Federal Reserve (2002–2005) Professor at Princeton University (1985–2005) and Stanford University (1979–1985) 6 Financial Industry Regulators Mary Schapiro Chairman Securities and Exchange Commission CEO of the Financial Industry Regulatory Authority (FINRA) (2007–2008) Chairman & CEO of NASD (2006–2007) Chairman of CFTC (1994–1996) Gary Gensler Chairman Commodity Futures Trading Commission Under Secretary of the Treasury for Domestic Finance (1999–2001) Assistant Secretary of the Treasury (1997–1999) 7 4 Key Congressional Leaders - Priorities Chairman Chris Dodd (D-CT) Chairman Barney Frank (D-MA) Senate Banking Committee Oversight of Emergency Economic Stabilization Act implementation Develop financial regulatory system that ensures institutions are regulated and supervised Consumer protection in the areas of mortgage lending, credit card lending, and investor rights Housing House Financial Services Committee Oversight of Emergency Economic Stabilization Act implementation Increase affordable housing and access to loan modification Executive compensation 8 Key Congressional Leaders - Priorities Chairman Collin Peterson (D-MN) Chairman Tom Harkin (D-IA) House Agriculture Committee Senate Agriculture Committee 2008 Farm Bill implementation Agriculture payments Child Nutrition Conservation Commodities trading 2008 Farm Bill implementation and current agricultural conditions Agricultural-based renewable fuels Conservation and environment Federal crop insurance and risk management Agriculture trade and international food aid Agriculture research and promotion Biotechnology 9 5 Obama Financial Stability Plan (FSP) – 2/10/09 Capital Assistance Program (CAP) – 2/24/09 Supervisory Capital Assessment “Stress Test” for top 19 banks with assets >$100B “Cumulative mandatory convertible preferred stock” CPP equity convertible to CAP equity Financial Stability Trust Public-Private Investment Fund – (tbd) Public-Private Capital: Initially $500 billion; up to $1 trillion Private sector pricing of assets Consumer and Business Lending Initiative Expansion of TALF to include additional ABS collateral Up to $1 trillion – 3/3/09 Launch (3/17/09 Subscription Date) 10 Obama Financial Stability Plan Transparency, Accountability, Monitoring, and Conditions Tougher standards for firms receiving “exceptional assistance” Require plans to generate new lending, monthly reports Require commitment to mortgage foreclosure mitigation Restrict dividends, stock repurchases, and acquisitions Prohibitions on lobbying, contracts posted on financialstability.gov Homeowner Affordability and Stability Plan Low cost refinancing for “responsible” borrowers through GSEs $75B Homeowner Stability Initiative for “at risk” borrowers Drive down overall mortgage rates (purchase of GSE MBS and debt) Small Business and Community Lending Initiative under SBA 11 6 Term Asset-backed Securities Facility (TALF) 11/25/08 – $200B; 2/10/09 – $1 Trillion Auto loans, small business loans, credit card receivables, student loans; MBS, other? Non-recourse loan $10M minimum 3 yrs; fixed (100 BPS over 3-yr Libor) or floating (100 BPS over 1-mo Libor) rate Borrowers eligible for 1 floating and 1 fixed rate loan/mo Haircuts from 5% to 16%, depending on ABS 12 Treasury Blueprint Recommendations Merge CFTC and SEC Develop objectives-based regulatory structure: Market stability regulator to address overall financial market stability (Federal Reserve) Regulatory quid pro quo for governmental capital/liquidity Principles based vs. rules based regulation Business conduct regulator to address standards for business practices and consumer protection Create Optional Federal Charter for Insurance 13 7 G30 Report Recommendations Require systematically significant financial institutions be subject to prudential oversight; banks should be supervised by one prudential regulator Improve effectiveness of prudential regulation through international coordination; enhance resources available to regulators and central banks Strengthen institutional policies and standards Increase transparency and realign risks of financial markets and products 14 Legislative Reform Issues Capital Markets Regulation Credit Rating Agencies Defined Contribution Plans Hedge Funds and Other Alternative Investments Private Equity and Sovereign Wealth Funds CDS and Other OTC Derivatives Trading Credit Card Issuers Mortgage “Cram Down” by Bankruptcy Judges Federal Tax Issues – the 2010 “Train Wreck” 15 8 Derivatives Regulation H.R. 977, the Derivatives Markets Transparency and Accountability Act of 2009 (Peterson) All prospective OTC transactions settled and cleared though a CFTCregulated designated clearing organization Empowers CFTC to suspend trading in naked credit default swaps Authorizes CFTC to initiate and prosecute criminal violations of Commodity Exchange Act S.272, the Derivatives Trading Integrity Act of 2009 (Harkin) Eliminates distinction between “excluded” and “exempt” and regulated commodities Re-categorizes most swaps as futures contracts Requires that all futures contracts trade on designated contract market or a derivatives transaction execution facility 16 Hedge Fund Registration S. 344, the Hedge Fund Transparency Act (Grassley/Levin) Requires hedge funds to register and file annual disclosure forms with SEC Requires hedge funds to comply with the SEC record-keeping standards H.R. 713, the Hedge Fund Study Act (Castle) Requires the President's Working Group on Financial Markets to conduct a study on the hedge fund industry 17 9 The Playing Field Financial power has shifted from NYC to WDC Activist, unified government Pendulum shift towards “re-regulation” Multiple stakeholders: Labor unions, consumer groups, trial lawyers Regulators, trade associations, the “commentariat” Financial services providers (a/k/a competitors) Goal is to navigate and favorably influence reforms 18 Bankruptcy, Administration and Insolvency Proceedings, and Key Accounting Issues • An update on the Lehman proceedings • A typical fact pattern that implicates critical bankruptcy, accounting and documentation issues ….and the path forward. 19 10 The Lehman Trade Fail 20 Recovering Customer Property from LBI (Lehman Brothers, Inc.) Two Deadlines in 2009 for LBI Claims Who is a “Customer” and what is a “Customer Claim” ? Negotiating the Release of Property LBIE-related Issues Involving Property Release 21 11 22 Practical Fixes in Legal Documentation Derivatives Documentation Basic Brokerage Documentation “Suites” of Prime Brokerage Documentation Securities Lending Documentation New Models that Challenge Traditional Prime Brokerage 23 12 Practical Recommendations for Handling Negotiations with the SIPC Trustee to Release LBI Property Handling “the Phone Call” from Lehman Negotiating with SIPC Trustee Counsel Handling the SIPC Trustee LBI Client Documentation presented by Outside Counsel to the SIPC Trustee 24 Recent Auditing, Valuation, and Reporting Issues Related to Credit Exposure Presenter: Brian Gallagher Asset Management Industry Professional Practice Director Deloitte 25 13 Auditing Issues Audit of Existence of claims or balances held at counterparty Individuals not available to respond Audit of Valuation of amounts due from counterparty Valuations based on likelihood of collectability Consideration of guarantees or indemnifications from third parties 26 Valuation Issues- Credit Value Adjustments FAS 157 requirements to consider nonperformance risk Requirements are not industry specific, and affect all institutions, especially from a derivatives perspective However, the following categories of Investment Management clients are affected to varying degrees, to the extent derivative portfolios exist Highly leveraged hedge funds Non-leveraged funds 27 14 Valuation Issues- Credit Value Adjustments Credit spreads are a measure of the intensity of credit risk; Used (with Recovery Rate) to derive “hazard curve” (default) Credit Risk is bilateral (in a FAS 157 world) Certain derivatives (or portfolios of derivatives) are two-way contracts for which either party could wind up as the obligor For two-way derivatives, the potential exposures (positive and negative) describe the extent to which each party is exposed to the other Collateral arrangements and other credit enhancements can mitigate credit risk in one or both directions Both credit spreads (intensity) and exposures have term structure 28 FASB Staff Position No. FAS 133-1 and FIN 45-4, Disclosures About Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 • Scope The FSP applies to credit derivatives, which is defined as “a derivative instrument (a) in which one or more of its underlyings are related to the credit risk of a specified entity (or a group of entities) or an index based on the credit risk of a group of entities and (b) that exposes the seller to potential loss from credit-risk-related events specified in the contract.” Examples: •credit default swaps; •credit index products and •credit spread options. • Effective date Effective for reporting periods (annual or interim) ending after November 15, 2008. 61 29 15 FASB Staff Position No. FAS 133-1 and FIN 45-4, Disclosures About Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 The FSP requires a seller of credit derivatives to provide additional disclosures, for each credit derivative (or for groups of similar credit derivatives), even if the likelihood of making payments is remote: • • the nature of the credit derivative: ¾ approximate term of derivative the maximum potential amount of future payments (undiscounted) the seller could be required to make under the credit derivative (or the fact that there is no limitation to the maximum potential future payments) • the fair value of the derivative • the nature of any (1) recourse provisions and assets held as collateral or by third parties that would allow the seller to recover all or portion of the amounts paid under the credit derivative and (2) any assets held as either as collateral or by third parties 62 30 FSP FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities Appendix B - Disclosure Requirements for Public Entities: B6. Disclosure requirements for collateral: If the entity has entered into repurchase agreements or securities lending transactions, its policy for requiring collateral or other security If the entity has pledged any of its assets as collateral, the carrying amount and classification of those assets and associated liabilities as of the date of the latest statement of financial position presented, including qualitative information about the relationship(s) between those assets and associated liabilities. For example, if assets are restricted solely to satisfy a specific obligation, the carrying amount of those assets and associated liabilities, including a description of the nature of restrictions placed on the assets, shall be disclosed. 31 16 FSP FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities Appendix B - Disclosure Requirements for Public Entities: B6. Disclosure requirements for collateral: If the entity has accepted collateral that it is permitted by contract or custom to sell or repledge, the fair value as of the date of each statement of financial position presented of that collateral and of the portion of that collateral that it has sold or repledged, and information about the sources and uses of that collateral. 32 The Role of Derivatives in Crises and the Reform of the Over-the-Counter Derivatives Market Presenter: Gordon F. Peery Of Counsel, Investment Management K&L Gates Boston 33 17 Agenda for this Presentation The Role of Credit Derivatives in the Current Crisis CDOs and Credit Default Swaps Systemic risk posed by CDS Documentation Challenges and the Push to Standardize CDS Principal Reforms in 2009 Industry Initiatives The 100/500 CDS Contract The Big Bang Protocol Auction Settlement Determination Committee Questions to swaps@klgates.com 34 2008: The Perfect Storm 35 18 THE CHANGING FACE OF STRUCTURED FINANCE Promissory Note Mortgage k Ban Pools of Mortgages CDO Investor Promissory Notes CDO es ch an Tr $ A AA Investor AA Promissory Note Trust Depositor A- Mortgage Investor $ k Ban BB BB Promissory Note Swaps B Investor Mortgage $ k Ban Interest rate swaps, credit default swaps Investor 36 The Credit Default Swap An agreement where whereby one party pays the other a fixed periodic payment for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs, at which point CDSs are either physically settled or settled by cash payment. Contingent Payment upon “Credit Event” Protection Seller Reference Entity or Entities Protection Buyer Fixed Fee (in bps per period) The key is how a swap is settled (cash or physical settlement), the problems that result from physical settlement, and the protocols that resulted. 37 19 In Order to Understand March 2009 ISDA Initiatives, Some Background in CDS is Necessary How is a derivatives trade documented ? How is a derivatives trade processed ? How is a derivatives trade assigned ? Who trades CDS … and why that’s a problem; The CDS market today (and tomorrow); How a CDS is settled: the “Bond Squeeze”; …..and other processing problems; and, What the Fed and ISDA are doing about all of this. 38 How a Derivatives Trade is Documented (correctly): 1992 (or 2002) Master Agreement •Governs legal and credit relationship between the parties •Includes representations, events of default/termination events, covenants •Incorporates schedule and confirmation Credit Support Documents Schedule •Makes elections and changes to standard provisions •Incorporates credit support annex •1994 Credit Support Annex (New York law) •1995 Credit Support Annex (Transfer-English law) •1995 Credit Support Deed (Security Interest-English law) Definitions (e.g.) Confirmations • • • • • • Incorporate Definitions Specify economic terms of each Transaction Include Transaction-specific modifications ISDA PAUG Confirmation Templates Master confirmations Incorporate definitions and annexes 2003 Credit Derivatives Definitions 2002 Equity Derivatives Definitions 2000 Definitions 2008 U.S. Emissions Allowance Transaction Annex 2004 Gas Annex 2003 Power Annex Annexes (e.g.) 39 20 How is a Derivatives Trade Processed ? 40 How is a Derivatives Trade Processed ? 41 21 Who Trades CDS and how this Creates Systemic Risk ISDA 42 One Look at the CDS Market with an Exchange Dealers (as “Members”) ISDA, with modifications 43 22 How a CDS is settled and the “Bond Squeeze” With Physical Settlement, after a Credit Event, the Protection Buyer must provide “Deliverable Obligations” If the Buyer doesn’t own them, they must be purchased; If CDSs outnumber bonds, a “Bond Squeeze” occurs. 44 …and Other Problems Presented by CDS CDS are customized and difficult to process through an exchange; CDS processing and paper confirmation problems; and CDSs were novated without consent of the remaining party. 45 23 What the Fed and ISDA are doing about all of this: Electronic Processing Initiatives Source: Operations Management Group 46 What the Fed and ISDA are doing about all of this: CDS Novations Processing Email is discontinued for consent to credit derivatives novations. After December 31, 2008, the names of Major Dealers’ customers continuing to request novations by email are to be submitted to each Major Dealer’s primary regulator; and After February 28, 2009, Major Dealers will only accept novation consent requests on eligible products submitted on electronic platforms and will not accept paper or email. Currently, the following electronic novation consent solutions are available to all industry participants: DTCC Deriv/Serv. DTCC’s novation consent application is currently available via GUI or MQ line. Electronic consent requests through DTCC can also be submitted via another service provider, including the following platforms, which will themselves feed the messages through DTCC accordingly: Bloomberg, Markit and Tradeweb; T-Zero. 47 24 Early March 2009: The ISDA Big Bang Protocol New, North American CDS Contract Referred to as the “100/500 contract” Purpose: standardize variables 100 or 500 basis point spreads 60-day lookback for Credit Events 90-day lookback for Succession Events The status of the Modification Credit Event Auction Hardwiring Adherence Details and Timing Available TODAY Supplement to the 2003 Credit Derivatives Definitions The Determinations Committee 48 Systemic risk: Central CDS Clearing Competing conceptions of a central clearinghouse: Central clearinghouse: transparency Central counterparty: centralized credit and collateral The Trade Information Warehouse is not a clearinghouse. Central clearinghouses (e.g., NYSE Euronext Liffe) already exist for various types of trades; Liffe works for iTraxx Europe. CME / Citadel – not live for CDS (yet) ICE / C-Corp – not live for CDS (yet) NYSE Euronext Liffe / LCH.Clearnet – Bclear platform (live) 49 25 ANY QUESTIONS? Please submit questions via email to: swaps@klgates.com 50 European Central Clearing of CDS and Status of Central Clearing in the United States Presenter: Van Hatziyianis Head of US Wholesale Services NYSE Euronext - CDS on Bclear 51 26 NYSE Euronext Operates The World’s Leading and Most Liquid Exchange Group United States • • • • • • Cash Equities Options Futures Fixed Income Listings Market Data Europe • • • • • • Cash Equities Asia & S. America • Qatar: 25% stake Options Futures • Fixed Income Listings • Market Data • • 1. in the Doha Securities Market1 China: opened Beijing office India: 5% stake in both National Stock Exchange and Multi Commodity Exchange Japan: strategic alliance with Tokyo Stock Exchange Brazil: BM&F Bovespa investment Expected to close in Q1'09, subject to regulatory and other approvals Other Cooperation Agreements: • Abu Dhabi • Luxembourg Selected Technology Arrangements: • Doha Securities Market • Tokyo • Bursa Malaysia • Philippines • Warsaw • BM&F Bovespa 52 NYSE Euronext Revenues Are Highly Diversified Software and Technology Other Services 5% 6% Derivatives Trading 24% Listings 14% Market Data 15% US Cash Trading 12% European Cash Trading 22% Note: Based on Q3 ‘08 non-GAAP pro forma results for NYSE Euronext. Net revenues exclude activity assessment fees, liquidity payments and routing and clearing fees. Source: NYSE Euronext. 53 27 CDS Clearing via NYSE Liffe 54 Key Points – CDS Clearing via Bclear The only CDS clearing solution live today (iTraxx European Index as of Dec. 22, 2008) Regulated by the FSA in London, approved by the SEC for US customers A pre-negotiated market that adds all the benefits of processing and clearing, without forcing you the market on to an exchange traded model Processed using Bclear, our proven solution for OTC derivatives Account segregation, allowing customer accounts to be isolated from dealer positions Key agreements in place with ISDA and Markit Fully cleared by LCH.Clearnet Ltd. 31 major banks and brokers have signed up to the revenue sharing scheme for CDS 55 28 NYSE Liffe CDS - A Pre-negotiated, Truly Multilateral Market A centralized clearing house serves as the seller to every buyer and buyer to every seller, eliminating direct counterparty risk found in the bilateral market. AAA 30 AAA 35 20 30 25 BBB 30 10 60 40 DDD CCC BBB 25 40 CCC 5 LCH.Clearnet Ltd. 45 10 EEE Bilateral market 45 DDD EEE Multilateral market 56 NYSE Liffe CDS – Summary of Clearing Benefits Streamlined Front to Back Operations Virtually all trades are confirmed on T+ 0 Initial trade notifications in your back office within minutes Novation are no longer required Multilateral market with all positions held against LCH.Clearnet, novation between counterparties become redundant Give-up/take-up model allow positions to be passed between counterparties easily Compression and balance sheet capital efficiencies All trades in the same product are netted daily, significantly reducing outstanding notional Additional balance sheet benefits via cross-margining with other Liffe CDS contracts Central clearing through LCH.Clearnet Ltd The most experienced global clearer of OTC markets, active and well capitalised Mark-to-market Valuations and RED Markit provide daily market-to-market valuations for 4pm London time Liffe CDS trades and positions are stamped with RED identifiers Both are provided to users at no additional cost 57 29 NYSE Liffe CDS – A Standardised Contract Liffe credit default swaps reference ISDA 2003 credit event definitions, and cash settle into the results of ISDA credit event auctions In order to deliver a true multilateral centrally cleared environment, our approach features additional standardisation: A defined determinations process for credit events, to which all contracts are bound Automatic application of subsequent ISDA updates and amendments to existing contracts Cash settlement for all contracts, with a facility for physical settlement when pan-European settlement infrastructure will allow This standardised multilateral approach allows trading with a wider range of counterparties, even without ISDA bilateral agreements in place Our member relationships and account structure fully support the sell and buy side, and offers account segregation 58 NYSE Liffe CDS – Credit Event Determinations For a multilateral centrally cleared environment, a binding credit event decision process is essential Determinations for Liffe cleared contracts will be made by an independent credit event Adjudicator: A leading financial QC appointed by Liffe to make an independent determination Decisions will be based on the existing ISDA concepts of Publically Available Information, the facts of the potential credit event, issuance of ISDA protocols, and other market events Liffe Clearing Members (typically major CDS broker/dealers) will be able to participate in a Market Advisory Group (MAG) call to present additional facts to the Adjudicator The Adjudicator’s Terms of Reference have been specifically developed to minimise the risk that a decision would diverge from market consensus Full details are available in Liffe’s contract documentation We stand ready to adopt universal market determinations when they become available, and strongly encourage the development of such standards 59 30 NYSE Liffe CDS – Trade Entry Example 60 NYSE Liffe – CDS Trade Flow Example Buy-side firm Dealing desk Broker-Dealer 1. Pre-negotiated trade Liffe Sales trading 3. Trade arrives at Exchange for validation and processing 2. Trade input to proprietary systems or directly into Bclear Risk / trade capture Risk / trade capture systems systems API Bclear Bclear Bclear Bclear 4. Electronic trade confirmation back to trader Operations Operations 7. Clearing and margining – statements to customers in T+1 viewable online Clearing Clearing & margining & margining systems systems 5. Trade details viewed and claimed via Exchange’s Trade Registration System (TRS) within seconds of trade validation by the Exchange or via back office systems linked to Exchange’s systems Trade Trade Registration Registration System (TRS) System (TRS) LCH.Clearnet Clearing Clearing Processing Processing System System Regardless of method trades are confirmed T+0 DTCC Trade Information Trade Information Warehouse Warehouse Bronze’ record sent to DTCC ‘ 61 31 LCH.Clearnet as Central Clearer 62 LCH.Clearnet - Risk Management A global leader in clearing, LCH.Clearnet is the: Global #1 Clearing House in OTC interest rate swaps Global #2 Clearing House in OTC fixed income and repos Global #3 Clearing House in exchange traded futures and options LCH.Clearnet will carry out risk management of CDS Index products using the same proven framework as other exchange traded, OTC and Liffe products This framework for managing counterparty risk has been tried and tested and most recently utilised during the default of Lehman Brothers in September 63 32 LCH.Clearnet - Risk Management The following are the key instruments used for risk management: Membership Criteria: these act as an entry hurdle for membership and ensure that members have sufficient financial resources and operational capabilities; members are monitored daily and are subject to credit reviews and visits, margins are often increased based on this monitoring. LCH.Clearnet monitors the ratio of Initial Margin levels to net capital at a member level, and takes action if this exceed certain levels Variation Margin: VM is the daily mark to market mechanism for these contracts, enacted via changing Net Liquidating Value (NLV) Initial Margin: IM ensures that there are sufficient funds to cover potential losses in a default in normal market conditions; calculated using SPAN, back-tested and reviewed regularly, IM has always been sufficient to manage defaults that have occurred Intra-day Margin: to cater for large intra-day position or price movements, LCH monitors positions, prices and changes in margin liabilities; LCH can and regularly does call for additional margin when this is deemed prudent Stress testing: all positions for all members are stress tested daily utilised circa 120 historical and theoretical scenarios to ensure adequacy of the post default backing 64 LCH.Clearnet – Default Management LCH.Clearnet focuses extensively on default management, and utilised this tried and tested process during the management of the Lehman Brothers International and Lehman Brothers Special Financing defaults Apply Macro Hedges, as required Transf er customer positions to other CMs, wherever possible Close residual positions, individually or via a portf olio auction This process enables business as usual for the remaining clearing members, while protecting customers of the defaulting member wherever possible LCH.Clearnet is the only CCP with a highly formalised process for OTC products through the SwapClear service for Interest Rate Swaps This involves significant member participation in the hedging and auction activities; this process was tested during LBSF default, for a $9 trillion portfolio, and resulted in significant collateral being returned to the administrators As the CDS service expands we will continue to evaluate the default management process, with a potential to introduce a more formal auction process similar to that used for SwapClear 65 33 LCH.Clearnet – Post-Default Backing As stated, Initial Margin has always been sufficient in previous defaults. However, should this be insufficient there are further protections, as illustrated below TYPE AMOUNT February 2009 DESCRIPTION Defaulter’s margin collateral $x (dependent on the size of the defaulter’s positions) Cash, securities or bank guarantees Calculated by bespoke algorithms for each sector to cover inherent market risk in relation to positions Revalued and collected at least daily Recourse is to margin collateral provided by the defaulter Defaulter’s own default fund contribution $x (dependent on the size of the defaulter’s positions) Default fund contribution is assessed relative to the size of the member’s positions LCH.Clearnet Ltd. capital Up to $30M Before drawing on other members’ default fund contributions LCH.Clearnet Ltd would employ up to $30M of that year’s retained earnings Default fund ~$850M The LCH.Clearnet Ltd default fund currently stands at ~$850M The level of the fund is stress tested daily to ensure its adequacy under abnormal market conditions The adequacy of the Default Fund is stress tested daily and LCH.Clearnet is able to withstand the default of its largest member under the most extreme conditions, far surpassing the market events of September 2008 66 Looking Forward 67 34 Proposed Product Timeline Q1/Q2 2009 CDX IG, Crossover and HiVol Launched on 22nd Dec 2008 iTraxx Europe, Crossover and HiVol Q4 2008 Single name CDS Initially index constituents Q1 2009 Mid 2009 Other contracts will be considered according to customer demand (for example, index tranches, sovereign CDS) 68 Euronext refers to Euronext N.V. and any company which is at least a 50% owned subsidiary of Euronext N.V. and references to Euronext below includes each and any such company as the context dictates. Euronext is part of the NYSE Euronext group. Liffe is the brand name of the derivatives business of Euronext, comprising the Amsterdam, Brussels, London, Lisbon and Paris derivatives markets. All proprietary rights and interest in this publication shall be vested in Euronext and all other rights including, but without limitation, patent, registered design, copyright, trademark, service mark, connected with this publication shall also be vested in Euronext. LIFFE CONNECT® is a trademark of LIFFE Administration and Management and is registered in Australia, Hong Kong, Singapore, the United States, Japan, the United Kingdom and as a European Community Trade Mark. No part of this publication may be redistributed or reproduced in any form or by any means or used to make any derivative work (such as translation, transformation, or adaptation) without written permission from Euronext. Euronext shall not be liable (except to the extent required by law) for the use of the information contained herein however arising in any circumstances connected with actual trading or otherwise. Neither Euronext, nor its servants nor agents, is responsible for any errors or omissions contained in this publication. This publication is for information only and does not constitute an offer, solicitation or recommendation to acquire or dispose of any investment or to engage in any other transaction. All information, descriptions, examples and calculations contained in this publication are for guidance purposes only, and should not be treated as definitive. Those wishing either to trade in any products available at Liffe or to offer and sell them to others should consider both their legal and regulatory position in the relevant jurisdiction and the risks associated with such products before doing so. Potential users of Liffe contracts should familiarise themselves with the full contract specification of the product concerned and any associated information. Bclear is operated as a clearing service by LIFFE Administration and Management, which is regulated by the Financial Services Authority as a Recognised Investment Exchange. Afirm and Cscreen are operated by LIFFE Services Limited, which is authorised and regulated by the Financial Services Authority as a service company. Those wishing to use the wholesale services should consider their regulatory position in the relevant jurisdiction before doing so. 69 35 OTC Derivatives Infrastructure Presenter: Marisol Collazo Vice President, Business Development DTCC Deriv/SERV LLC 70 Agenda DTCC Corporate Structure and Governance DTCC Deriv/SERV Services Trade Information Warehouse Auction Hardwiring New CDS Contract 100/500 Confidential 71 71 36 DTCC Corporate Structure The Depository Trust & Clearing Corporation (DTCC) MarkitSERV (pending joint service offering with Markit Group Ltd.) Omgeo Joint Venture with Thomson Financial National Securities Clearing Corporation (NSCC) The Depository Trust Company (DTC) DTCC Deriv/SERV LLC DTCC Solutions LLC Fixed Income Clearing Corporation (FICC) European Central Counterparty, Ltd. (EuroCCP) 72 DTCC Deriv/SERV LLC Governance User Governing Committee Authority delegated by DTCC Board 12 representatives from major market participants 50% from European institutions 9 Barclays, BNPParibas, Credit-Suisse, Deutsche Bank, Societe Generale, UBS (Other institutions represented: Bank of America, Bank of New York/Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley) 50% of individual representatives are resident in Europe Operates on a not-for-profit basis – user governance approves tariffs and rebate of excess revenue, spend, strategic direction and new products 73 37 DTCC Deriv/SERV LLC Services Electronic Confirmation/Matching (to be contributed to MarkitSERV) Covers OTC credit, rate and equity derivatives 9 Greater than 90% of credit derivative market worldwide (including all single name, index, index tranche, CDS on loans and loan indices, CDS on ABS, CMBS and RMBS and asset backed and commercial mortgage indices) Trade Information Warehouse (for credit derivatives) Central trade registry and public reporting of positions and turnover 9 All electronically confirmed CDS are registered in Warehouse (4.4 million sides; 29.2 trillion gross notional value in USD equivalent) Central hub for life-cycle event processing and facilitation of other infrastructure providers (e.g., CCPs, trade compression providers, etc.) Central payment calculation, netting and settlement (through link with CLS Bank), including net cash settlements for credit events 74 DTCC Deriv/SERV Architecture Confidential 75 75 38 Trade Information Warehouse (TIW) Central Trade Registry Industry commitment (from Oct. 31 Letter) – TIW to be the “single, centralized source of industry portfolio statistics” We publish weekly positions and turnover for: 9 Top 1,000 single names (of 3,000 total names in Warehouse), both gross and net 9 All indices, both gross and net 9 Aggregates, on a gross basis We currently provide additional data to FRB, ECB and FSA in support of their own regulatory missions (and have committed to provide data to all interested regulators) 76 Trade Information Warehouse (TIW) Central Processing Hub Industry commitment (from Oct. 31 Letter) – will “process major life-cycle events in the TIW for all electronically eligible confirmable trades including: • Clearing automatically processed through the TIW, where applicable. • Compression and tear-ups automatically processed through the TIW. • Credit Events automatically processed through the TIW. • Successor events automatically processed through the TIW. • Maturities, expires and exercises automatically processed through the TIW. • Bulk events such as mass terminations and novations automatically processed through the TIW.” 77 39 Trade Information Warehouse (TIW) Central Processing Hub – Use to Date • Working with 4 CCPs to support clearing efforts (ICE, Eurex, LIFFE, CME) • Supporting the two leading compression and tear-up providers • 13 other service providers linked to the Warehouse • Centrally processed 9 credit events last year, with 10 new credit events currently being processed on a simultaneous basis - enabling TIW to calculate payments based on auction rates and settle through CLS where applicable • Successor event processing in place, one event processed last year, with 3 more pending resolution of legal issues by ISDA • All maturities are automatically processed • 4 bulk transfers and mass terminations processed last year (including Lehman), with 3 currently pending 78 Trade Information Warehouse (TIW) Central Settlement Processing Industry commitment (from Oct. 31 Letter) – “By Nov 30, 2009: 96% of settlement volume on electronically matched transactions across market participants settled via TIW and CLS.” Includes regular fee and coupon payments as well as net cash settlement for credit events Currently all major global dealers centrally settle via TIW and CLS 9 All major currencies 9 Multi-lateral net funding of obligations 9 Creates settlement certainty 9 Eliminates nostro breaks Example - Lehman credit event had a $72 billion in gross obligations, which netted to $5.2 billion in net funding obligations. Efforts underway to on-board non-OMG banks and buy-side globally 79 40 Auction Hardwiring Big Bang Protocol Scheduled for adherence to begin on March 12nd and to close on April 7th. It will become effective as of April 8th covering trades with a trade date of BEFORE April 8th and effective date ON or BEFORE April 8th . This Supplement establishes the Credit Derivatives Determinations Committees, adds the Auction Supplement Settlement provisions, and creates Credit and Succession Event backstop dates Determination Committee (DC) There will be 5 different DCs by region (Americas, Europe Middle East Africa [EMEA], Asia ex-Japan, Japan, and Australia New Zealand). Each DC has 15 voting members: 8 Global Dealers, 2 Regional Dealers, 5 buy-side firms. 80 Auction Hardwiring “Covered” transactions subject to the DC’s rulings Excluded transactions are at a high-level: • ABS & related indices (ABX/CMBX) • LCDS/ELCDS & related indices (LCDX and LevX) • CDS on Muni & related indices (MCDX) • Bespoke portfolios based on CLNs • CDS on CDO 81 41 Auction Hardwiring 60/90 day look-back: The 60/90 day limit on event notification will not be effective under the protocol as of April 7th. it will be effective as of a second implementation date – June 20th During this intermediate period, new transactions will have the 60/90 day look back applicable but the historic portfolio won’t. This document covers historical transactions between protocol adherent firms Credit Events will have a 60 day look-back period Successor Events will have a 90 day look-back period 82 Auction Hardwiring Adherence to Protocol Firms can begin to sign up for the Protocol on March 12th. Adherence is free through ISDA; Firms send both a signed and a confirmed Adherence letter to ISDA. Adhering Parties to the Protocol, do not need to amend the bilateral MCAs. The Protocol automatically amend market standard MCA based on the terms of the March 2009 Supplement. 83 42 100/500 New CDS contract Standard North American CDS contract Standardize Single Name trading Investment Grade names trading on a 100 bps spread and quoted with a flat curve spread High Yield names trading on a 500 bps spread and quoted as points up-front Confirmation of “SNAC” contracts ¾ Matrix: ISDA will publish an updated Matrix that includes a new "Standard North American Corporate" Transaction Type. ¾ Master Confirmation Agreement (MCA): Firms can trade “SNAC” contracts using existing MCA’s ¾ Paper Confirmations: A standard long-form template is under development to ensure that paper trades match the intended terms of the 100/500 trades. 84 100/500 New CDS contract Changes to DTCC DerivSERV Operating Procedures Procedures to be amended to incorporate Supplement to all transactions with a Trade Date or Novation Date on or after April 8, 2009. For transactions prior to April 8, 2009, parties must adhere to the ISDA Protocol for the Supplement to apply Note, regardless of adherence or non-adherence to the ISDA Protocol for the Supplement, DerivSERV will perform credit event or successor event processing for all affected transactions, including those with a trade date prior to April 8, 2009. Firms will still have the option to exclude these transactions from processing for the particular event. 85 43 100/500 New CDS contract Changes to Existing Template There are no new fields or changes to any of the various messaging templates. The FpML committee has agreed on the valid value for the matrix as Matrix: StandardNorthAmericanCorporate MCA: ISDA2003StandardCreditNorthAmerican DTCC will overwrite several fields including: Effective date Payment frequency First Fixed Rate Payer Payment Date, Single Payment Date Restructuring 86 Question & Answer Session Also submit questions to: swaps@klgates.com 87 44 Panelist Contact Information Gordon Peery Of Counsel 617.261.3269 gordon.peery@klgates.com Daniel F. C. Crowley Partner 202.778.9447 dan.crowley@klgates.com Charles A. Dale III Partner 617.261.3112 chad.dale@klgates.com Van Hatziyianis Head of US OTC Services NYSE Euronext 212.656 5122 vhatziyianis@nyx.com Marisol Collazo Vice President, Business Development Deriv/SERV Trade Information Warehouse 212.855.2670 mcollazo@dtcc.com 88 45
