Emerging Derivatives Reforms
Under the Dodd-Frank Act
February 23, 2011
Christopher J. DeLise
Anthony R.G. Nolan
Copyright © 2011 by K&L Gates LLP. All rights reserved.
Agenda
 Impact of Dodd-Frank on structure of regulation and trading
 Jurisdiction of SEC and CFTC over OTC derivatives markets
 Regulated Swap Entities
 Transactions with “Special Entities”
 Clearing, Trade Execution and Documentation
 Margin and Collateral Segregation
 Bankruptcy issues
 Strategic and Compliance Issues
1
Introduction
 The “Dodd-Frank Wall Street Reform and Consumer Protection Act”
(“Dodd-Frank”), through Title VII, the “Wall Street Transparency and
Accountability Act of 2010” (“Title VII”), completely overhauls the
trading of over-the-counter (“OTC”) derivatives in the United States.
 OTC derivatives change from being essentially unregulated to being
regulated by the SEC, the CFTC or both (or banking regulators).
 New requirements for trading, clearing, margining, reporting, and
trade data collection of OTC derivatives, as well as the registration of
parties to these transactions, which will make the parties subject to
capital and business conduct standards.
2
Introduction
 Commercial end-users are exempt from all but the reporting
requirements and possibly requirements to post margin.
 Title VII will generally become effective on July 16, 2011, 360 days
following the enactment of the new law.
 Title VII has generated a blizzard of proposed regulations and
interim final rules promulgated by the SEC and the CFTC.
3
Process
 Dodd-Frank legislative process
 Completed June 21, 2010
 Legislative approach: broad goals, defer to regulators
 Speed bumps; unrealistic deadlines
 Dodd-Frank rulemaking process
 Multiple agency coordination;
 Swaps primarily led by SEC and CFTC
 Dynamics:
 Aggressive positions of CFTC
 Staffing and budgetary constraints
 Congressional oversight in light of the 2010 elections
 Focus in House Banking Committee and Ag Committee
 End-users; cost to industry; effect on jobs
4
CFTC Proposed Rules on Swaps in 2011
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17 CFR Part 23 Orderly Liquidation Termination Provision in Swap Trading Relationship Documentation for Swap Dealers and Major Swap Participants
Closing Date: 4/11/2011
17 CFR Part 23 Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants
Closing Date: 4/11/2011
17 CFR Parts 3, 32, 33, and 35 Commodity Options and Agricultural Swaps -- Closing Date: 4/4/2011
17 CFR Parts 1, 150 and 151 Position Limits for Derivatives Closing Date: 3/28/2011
17 CFR Part 39 Risk Management Requirements for Derivatives Clearing Organizations Closing Date: 3/21/2011
17 CFR Part 37 Core Principles and Other Requirements for Swap Execution Facilities Closing Date: 3/8/2011
17 CFR Parts 1, 37, 38, 39, and 40 Governance Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution
Facilities; Additional Requirements Regarding the Mitigation of Conflicts of Interest Closing Date: 3/7/2011
17 CFR Part 165 Implementing the Whistleblower Provisions of Section 23 of the Commodity Exchange Act Closing Date: 2/4/2011
17 CFR Part 23 Confirmation, Portfolio Reconciliation, and Portfolio Compression Requirements for Swap Dealers and Major Swap Participants
Closing Date: 2/28/2011
117 CFR Part 49 Swap Data Repositories Closing Date: 2/22/2011
17 CFR Part 39 End-User Exception to Mandatory Clearing of Swaps Closing Date: 2/22/2011
17 CFR Parts 23 and 155 Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties Closing Date: 2/22/2011
17 CFR Part 1 Securities and Exchange Commission 17 CFR Part 240 Further Definition of "Swap Dealer," "Security-Based Swap Dealer," "Major Swap
Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant" Closing Date: 2/22/2011
17 CFR Parts 1, 21, and 39 Information Management Requirements for Derivatives Clearing Organizations Closing Date: 2/14/2011
17 CFR Parts 1 and 39 General Regulations and Derivatives Clearing Organizations Closing Date: 2/11/2011
17 CFR Part 43 Real-Time Public Reporting of Swap Transaction Data Correction Closing Date: 2/7/2011
17 CFR Part 23 Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants Closing Date: 2/7/2011
17 CFR Part 45 Swap Data Recordkeeping and Reporting Requirements Closing Date: 2/7/2011
17 CFR Part 43 Real-Time Public Reporting of Swap Transaction Data Closing Date: 2/7/2011
17 CFR Part 165 Implementing the Whistleblower Provisions of Section 23 of the Commodity Exchange Act Closing Date: 2/4/2011
17 CFR Parts 23 and 190 Protection of Collateral of Counterparties to Uncleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity
Broker Bankruptcy Closing Date: 2/1/2011
17 CFR Part 44 Reporting Certain Post-Enactment Swap Transactions Closing Date: 1/18/2011
17 CFR Part 190 Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies Closing Date: 1/18/2011
Public Input for the Study Regarding the Oversight of Existing and Prospective Carbon Markets Closing Date: 12/17/2010
Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants Closing Date: 1/24/2010
17 CFR Part 23 Implementation of Conflicts of Interest Policies and Procedures by Swap Dealers and Major Swap Participants Closing Date: 1/24/2010
17 CFR Parts 3, 23 and 170 Registration of Swap Dealers and Major Swap Participants Closing Date: 1/24/2010
17 CFR Part 3 Designation of a Chief Compliance Officer; Required Compliance Policies; and Annual Report of a Futures Commission Merchant, Swap Dealer, or
Major Swap Participant Closing Date: 1/18/2010
5
Current Swap Market Structure
Counterparty
Counterparty
(Clearing available for
some Swaps upon
election of both
parties)
CFTC Regulated
Clearing Organization
becomes counterparty
to each side of
transactions
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. Two ways to execute:
1. Direct communications
2. Unregulated trading platforms
where buyers and sellers can
discover and accept each other’s
bids and offers and form
agreements
6
New Swap Market Structure
A. Example of OTC Swap between End User and Regulated Swap
Counterparty
Commercial
End User
(must be eligible
contract participant)
•
•
Swap Dealer/ Major Swap Participant
(“SD”)
(“MSP)
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
Reporting
Cleared Swap
Swap Dealer/MSP
reports Swap to Swap
Data Depository or CFTC
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
7
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
8
SEC and CFTC Jurisdictions
 Prior to Dodd-Frank over-the counter swaps were largely exempt from
substantive regulation:
 Swaps or other agreements that were individually negotiated between eligible
contract participants were outside of CFTC jurisdiction
 SB Swaps were exempt from most requirements of the Securities Act and
Securities Exchange Act
 Dodd-Frank brings all swaps under SEC or CFTC regulation:
 CFTC has jurisdiction over “Swaps”
 SEC has jurisdiction over “SB Swaps”
 SEC and CFTC have joint jurisdiction over “mixed Swaps”
 To be determined:
 FX – Treasury determination
 Stable value contracts – SEC determination
9
SEC and CFTC Jurisdictions
 “Swap” includes any agreement, contract or transaction that:
 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.”
 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.
 Provides for an exchange of payments based upon the value of one or more
currencies, commodities, 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.
 Is “commonly known” as a Swap.
10
SEC and CFTC Jurisdictions
 Swaps do not include:
 Futures and options on futures.
 Sales of a nonfinancial commodity or security for deferred shipment or
delivery, so long as the transaction is intended to be physically settled.
 Securities, including any option on a security, certificate of deposit, group or
index of securities, and foreign currency options entered into on a national
securities exchange.
 Agreements providing for the purchase or sale of one or more securities on a
contingent basis, any note, bond or evidence of indebtedness that is a
security, and any SB Swap other than a “mixed Swap.”
 Agreements with a Federal Reserve bank, the Federal Government or a
Federal agency that are expressly backed by the full faith and credit of the
United States.
11
SEC and CFTC Jurisdictions
 “SB Swap”: any “Swap” based on:
 A narrow-based securities index (i.e. with nine or fewer component
securities), including any interest therein or on the value thereof;
 A single security or loan, including any interest therein or on the value thereof;
or
 The occurrence, non-occurrence, or extent of an occurrence, of an event
relating to a single issuer of a security or the issuers of securities in a narrowbased security index, provided that such event directly affects the financial
statements, financial condition, or financial obligations of the issuer.
 SB Swap is a “security” under the Securities Act and the Securities
Exchange Act (but not the Investment Company Act or Investment
Advisers Act).
12
SEC and CFTC Jurisdictions
 “Mixed Swap”: an agreement, contract or transaction based on:
 The value of one or more of the components of an SB Swap and
 The value of one or more of the following:
 Any non-securities component of a Swap (e.g., interest or other rates,
currencies, commodities, instruments of indebtedness); or
 the occurrence, non-occurrence, or the extent of the occurrence of an event
or contingency associated with a potential financial, economic, or commercial
consequence that is not otherwise within the definition of SB Swap.
 The definition generally would include agreements where one
counterparty receives a return based on a single security or loan or a
narrow-based securities index and the other counterparty receives a
return based on the value of a non-securities-based measure (e.g., a
commodity index).
13
Definition of Swap Dealer, SB Swap Dealer
 Dodd-Frank defines a Swap Dealer as: “any person who (1) holds itself out as
a dealer in Swaps; (2) makes a market in Swaps; (3) regularly enters into
Swaps with counterparties as an ordinary course of business for its own
account; or (4) engages in any activity causing the person to be commonly
known in the trade as a dealer or market maker in Swaps.”
 Swap Dealer does not include a person that enters into Swaps for such
person’s own account, either individually or in a fiduciary capacity, but not as
part of a regular business.
 A person may be designated as a Swap Dealer for a single type or single
class or category of Swap, but not for other types, classes, or categories of
Swaps.
 The definition of SB Swap Dealer is similar to Swap Dealer, with references to
SB Swaps appearing in place of Swaps and references to the SEC appearing
in place of the CFTC.
14
Definitions of Swap Dealer, SB Swap Dealer
 The SEC and the CFTC have proposed a rule that would focus on
market activities to determine whether a person is a dealer.
 Proposed “core tests” of dealer status:




Do you accommodate demand for transactions from others?
Do you enter into transactions to facilitate others?
Do you propose terms rather than request terms from counterparty?
Do you arrange customized terms on request?
 Note differences in approach between CFTC and SEC
 Factors that may indicate a person holding self out as a dealer
include:
 contacting potential counterparties to solicit interest in transactions;
 developing or marketing new types of instruments;
 membership in ISDA in a category reserved for dealers.
15
Definitions of Swap Dealer, SB Swap Dealer
 De Minimis Exception.
 A person would not be a dealer under the proposed rules if over the prior
12 months (i) it entered into Swaps or SB Swaps with an aggregate effective
gross notional amount not greater than $100 million and with no more than
15 counterparties (other than SB Swap dealers but including affiliates); and
(ii) it executed 20 or less Swaps or SB Swaps as a dealer.
 Self Determination.
 The SEC and CFTC expect market participants to make their own
determinations as to whether their activities make them a Swap dealer or SB
Swap dealer”
 Nonetheless, they will have authority to take enforcement actions in response
to a Swap or SB Swap dealer’s failure to register.
16
Definitions of Major Swap Participant and
Major SB Swap Participant
 Title VII defines a Major Swap Participant as a non-Swap Dealer that:

Maintains a “substantial position” in Swaps for any major category (excluding positions
to hedge or mitigate (i) commercial risk or (ii) risks directly associated with operation of
an employee benefits plan);

Has substantial counterparty exposure that could have serious adverse effects on
financial stability of U.S. financial system; or
Is a financial entity, is highly leveraged relative to its capital, is not subject to the federal
bank regulatory capital requirements, and has a substantial position in outstanding
Swaps in any major category.

 The definition of Major SB Swap Participant is similar to Major Swap
Participant, with references to SB Swaps appearing in place of Swaps and
references to the SEC appearing in place of the CFTC.
 A person may be designated as a Major Swap Participant for one or more
categories of Swaps or SB Swaps, without being classified as a Major Swap
Participant for all classes of Swaps.
17
Definitions of Major Swap Participant and
Major SB Swap Participant
 Two proposed tests for measuring “substantial position”:
 Daily Average of Current Uncollateralized Net Outward Exposure
 $1 billion in major categories of SB Swaps and commodity Swaps
(including credit and equity Swaps, as applicable);
 $3 billion in rate swaps category.
 Daily Average Current Uncollateralized Net Outward Exposure Plus
Potential Future Net Uncollateralized Outward Exposure.
 $2 billion in major categories of SB Swaps and commodity Swaps
(including credit and equity Swaps, as applicable);
 $6 billion in the rate swaps category.
18
Definitions of Major Swap Participant and
Major SB Swap Participant
 Two proposed tests for measuring “substantial counterparty
exposure:”

CFTC standard: Swap positions equal or exceed either:
 $5 billion in daily average aggregate uncollateralized outward exposure; or
 $8 billion in daily average aggregate uncollateralized outward exposure
plus daily average aggregate potential outward exposure.
 SEC standard: SB Swap positions would equal or exceed:
 $2 billion in daily average aggregate uncollateralized outward exposure; or
 $4 billion in daily average aggregate uncollateralized outward exposure
plus daily average aggregate potential outward exposure.
19
Definitions of Major Swap Participant and
Major SB Swap Participant
 Exclusions
 Financing Affiliates of Product Manufacturers: The definition excludes
financing affiliates of product manufacturers, provided that their primary
business is to provide financing and they use derivatives to hedge
commercial risks related to interest rate and currency exposures, where at
least 90 percent of the exposures arise from financing that facilitates the
purchase or lease of products, if 90 percent or more of the products are
manufactured by the entity’s parent company or another subsidiary of the
parent company.
 Employee Benefit Plans
20
Duties of Regulated Swap Entities
 Regulated Swap Entities have the following statutory duties, which
have been further elaborated by proposed rules of the SEC and
CFTC:
 Registration with one or both Commissions
 Capital and margin requirements
 Verifying status of counterparty




Disclosure to counterparties
Fair dealing
Recordkeeping, reporting and documentation of transactions
Risk management systems
 Conflict-of-Interest protections
 Chief Compliance Officer requirement
 SEC and CFTC have also proposed anti-manipulation rules that apply
particularly to Regulated Swap Entities
21
Transactions With “Special Entities”

Regulated Swap Entities are subject to heightened business
conduct standards when acting as an advisor or counterparty to a
“Special Entity.”

“Special Entity:”
i. a Federal agency,
ii. a state, state agency, city, county, municipality, or other political
subdivision of a state,
iii. an employee benefit plan or a governmental plan as defined in
Section 3 of ERISA, or
iv. any endowment, including an endowment that is an organization
described in Section 501(c)(3) of the Internal Revenue Code.
22
Transactions With “Special Entities”
 Regulated Swap Entities acting as advisers to Special Entities may
not engage in any act that “operates as a fraud or deceit” on any
Special Entity or prospective customer that is a Special Entity.
 Swap Dealers and SB Swap Dealers must
 Act in the best interests of the Special Entity,
 Make reasonable efforts to obtain information (including information
relating to financial status, tax status, investment and financing
objectives) as is necessary to make a reasonable determination that any
Swap or SB Swap recommended by the Swap Dealer or SB Swap Dealer
is in the best interests of the Special Entity.
23
Transactions With “Special Entities”
 A Regulated Swap Entity that acts as a counterparty (but not as an
advisor) to a Special Entity must have a reasonable basis to believe
that the Special Entity has an “independent representative” that:
 has sufficient knowledge to evaluate the transaction and risks;
 is not subject to a statutory disqualification;
 is independent of the Regulated Swap Entity;
 undertakes a duty to act in the best interests of its counterparty;
 makes appropriate disclosures;
 provides written representations to the Special Entity regarding fair pricing
and the appropriateness of the transaction; and
 in the case of an employee benefit plan subject to ERISA, is a fiduciary as
defined in Section 3 of ERISA.
24
Transactions With “Special Entities”
 A Swap Dealer or SB Swap Dealer must disclose in writing to the
Special Entity the capacity in which it is acting prior to initiation of the
transaction.
 The CFTC and the SEC have proposed a rule with other requirements
for those dealing with Special Entities. The proposed regulation
includes restrictions on political contributions by Regulated Entities to
Special Entities that are governmental entities.
 The special duties owed to a Special Entity do not apply to
transactions initiated by a Special Entity on an exchange or Swap
execution facility if the Regulated Swap Entity does not know the
identity of the counterparty to the transaction.
25
Transactions With “Special Entities”
 Dodd-Frank requires that a Special Entity be advised by an
independent representative for Swaps and SB Swaps.
 Dodd-Frank expressly requires that an independent representative
must be “independent of” the Regulated Swap Entity but not of the
Special Entity itself.
 Special Entity provisions generally are structured to provide greater
protection to Special Entities only from activities of Regulated Swap
Entities, not protection from themselves.
 Many types of Special Entities are widely known to have highly
sophisticated internal investment expertise that would satisfy the
qualifications of an independent representative. Nothing indicates
Congress intended to require Special Entities to contract with third
parties for that expertise.
26
Transactions With “Special Entities”
 Implications:
 Added layer of pay-to-play regulation on Regulated Swap Entities
 Compliance cost for certain Special Entities
 Risk that Regulated Swap Entities may have increased leverage over
clients and counterparties that are Special Entities client
27
Clearing
 If a Swap is required to be cleared, it is unlawful for any person to engage in
the Swap unless it is submitted for clearing to a derivatives clearing
organization or, if a SB Swap, to a registered or exempt clearing agency.
 There are very limited exemptions and exclusions from clearing.

Exemptions for transactions entered into prior to July 21, 2010 or thereafter but before
clearing requirement becomes applicable to them.

Commercial end-user exemption for
 A commercial entity (i.e., not a financial entity);
 Entering into a transaction to hedge its own commercial risk;
 That notifies the SEC or CFTC how it meets its financial obligations associated with
entering into uncleared Swaps; and
 That obtains (if a public company) the approval of its board of directors or governing body
or committee thereof.

The CFTC has proposed regulations setting forth the manner in which
end-users provide notice to the CFTC
28
Clearing – Trade Execution
 A commercial end-user that is counterparty to a Swap or SB Swap
that is required to be cleared “has the sole right to select” the DCO or
clearing agency on which the Swap will be cleared.
 If the Swap is not required to be cleared, such a counterparty
 “may elect to require clearing” (assuming there is a DCO or clearing agency
that clears it); and
 “has the sole right to select” the DCO or clearing agency on which the Swap
will be cleared (again assuming the availability of a choice).
 Swaps that are required to be cleared must also be executed either:
 on a board of trade that is designated as a contract market or
 on a regulated Swap (or SB Swap) execution facility.
29
Clearing – Trade Execution
 Requirement not applicable if no board of trade or Swap execution
facility makes the Swap available for trading or if Swap is subject to
the commercial hedging exception.
 “Swap (and SB Swap) execution facilities” do not currently exist.
 These are newly minted terms for trading platforms that the statute specifies
must be distinct from the existing “designated contract markets.” Their
characteristics are thinly drawn under Title VII.
 A Swap execution facility is “a trading system or platform in which multiple
participants have the ability to execute or trade Swaps by accepting bids and
offers made by multiple participants in the facility or system through any
means of interstate commerce that (A) facilitates the execution of Swaps
between persons, and (B) is not a designated contract market.”
 Similar definition for SB Swaps.
30
Clearing – Trade Execution
 Only eligible contract participants (“ECPs”) may enter into
Swaps that are NOT entered into on or subject to the rules
of a designated contract market or, in the case of SB Swaps,
that are not effected on a national securities exchange.
 The CEA definition of “Eligible Contract Participant” has been slightly
narrowed by Dodd Frank.
 Commodity pools are eligible for purposes of FX transactions only if all
participants in the pool are themselves ECPs;
 Individuals must have “amounts invested on a discretionary basis”
(rather than “total assets”) in excess of $10 million or, if hedging, $5 million.
31
Clearing Process and Documentation
 Title VII does not address the mechanics of clearing.
 Likelihood is that they will be similar to those of existing markets.
 But OTC derivatives transaction volume is hugely greater than the current
volume of exchange traded futures.
 The systems needed to handle that volume may need to be somewhat
different than those currently in place.
32
Clearing Process and Documentation
 Most non-dealer customers will not be able to clear and settle trades
directly with the clearing entity.
 Trades normally will need to be intermediated by a dealer that is a clearing
member of the relevant clearing entity.
 Also, since not all dealers are likely to be members of all relevant clearing
entities, a “give-up” arrangement between a non-member and member dealer
may also be necessary.
 This means that centrally cleared trades involve additional levels, in terms of
parties, mechanics and documentation.
 In other words, central clearing seems likely to make Swap documentation
more complex – not to simplify it.
33
Clearing Process and Documentation
 Submission of derivatives trades to a clearing entity likely will take
one of two basic forms.
 An “OTC style” arrangement involving back-to-back or “mirror image”
transactions, respectively between the customer and a clearing member
and another between the clearing member and the clearing entity; or
 A “futures style” arrangement in which the clearing member acts as the
agent for and the guarantor of its customer to novate a customer-dealer
transaction into one between the customer and the clearing entity through
give-up agreements.
34
Mandatory Transaction Reporting for
Cleared Swaps and SB Swaps
 All cleared Swaps and SB Swaps must be reported to a Swap data
repository or SB Swap data repository, or to the CFTC or SEC,
respectively.
 Cleared Swaps and SB Swaps entered into prior to date of
enactment of Title VII must be reported within 180 days after
effective date, i.e., by January 12, 2012.
 Cleared Swaps and SB Swaps entered into on or after date of
enactment of Title VII must be reported within 90 days after such
effective date (October 14, 2011) or such other time as prescribed
by the CFTC or the SEC.
 SEC and CFTC have adopted interim final rules for reporting and
recordkeeping; the absence of clearing infrastructure has been a
practical impediment to a robust reporting regime.
35
Collateral and Margin Requirements
 Collateral Segregation for Cleared Swaps
 Only an FCM or (in the case of an SB Swap) a broker, dealer or SB Swap
dealer may accept margin or collateral for a cleared Swap.
 Collateral so received must be “treated as belonging to the Swaps customer”
and be segregated from the dealer’s proprietary assets.
 Unlawful for any person to “hold, dispose of or use” any such collateral assets
“as belonging to” any person other than the customer.
 Meaning of “as belonging to” unclear in this context.
36
Collateral and Margin Requirements
 Notwithstanding the general segregation requirement:
 Collateral assets can be withdrawn to meet clearing entity margin
requirements, transfer or settle trades, payment of brokerage commissions
and the like.
 Collateral assets can be commingled:
 in omnibus accounts at a bank, trust company or DCO/clearing agency with
collateral assets that the FCM/broker-dealer is holding for its other Swap
customers; and
 Subject to Commission rules, in commingled customer accounts at the
FCM/broker-dealer along with any other assets that the relevant Commission
requires to be separately accounted for and treated as belonging to the
customer.
 Segregated cash collateral can be invested in Treasuries, municipal
obligations and other liquid investments.
37
Collateral and Margin Requirements
 The CFTC has issued an advanced notice of proposed rulemaking
(“ANPR”) soliciting comment on four models for treatment of collateral
posted by customers of futures commission merchants clearing
Swaps. These are:
 Full physical segregation of collateral,
 Legal segregation with commingling,
 Provisions for use of collateral in case of default with pro rata sharing of
downward valuations adjustments and
 Transfer or return of positions and collateral.
 The baseline starting point for cleared futures consists of omnibus
collateral accounts in which participants are subject to "fellow
customer" risks. In general the clearing houses favor hewing close
to this omnibus position while end users tend to favor segregation and
bilateral contracts and margin in the context of a clearing house
environment.
38
Collateral and Margin Requirements
 Collateral Segregation for Non-Cleared Swaps
 Not mandatory, but customers do have a right to require such segregation by
contract.
 Any Swap dealer or major Swap participant must notify its Swap
counterparties of the right to require segregation of margin or other security
posted by it
 If segregation is requested, the Swap (or SB Swap) dealer or major Swap (or
SB Swap) participant must segregate the collateral in a segregated account
that is:
 Separate from its own proprietary assets; and
 Carried by an independent, third party custodian “for and on behalf of” the
customer.
39
Collateral and Margin Requirements
 The segregation-upon-request requirement applies only to initial, not variation
margin.
 It does not preclude:
 Any commercial arrangement regarding the investment in such investments
as the relevant Commission may permit by rule or regulation; or
 Any commercial arrangement regarding the allocation of gains or losses from
such investments.
 If a customer does not require segregation, the dealer or major participant
must certify quarterly that its back office procedures relating to collateral
comply with the agreement of the parties.
40
Bankruptcy Issues Relating to Derivatives
 Dodd Frank bankruptcy provisions relating to derivatives:
 Title II creates a new “orderly liquidation authority” for non-bank financial
companies.
 Generally retains the exceptions to the automatic stay for qualified financial
contracts that previously existed in the Bankruptcy Code and the Federal
Deposit Insurance Act.
 The Financial Stability Oversight Council must conduct a study of secured
creditor haircuts. This may affect pricing and margin for repurchase
agreements and other derivatives.
41
Bankruptcy Issues Relating to Derivatives
 Orderly Liquation Authority is a new hybrid FDIC receivership /
bankruptcy process for “covered financial companies.” These generally
include:
 “Bank holding companies” and nonbank financial companies subject to
supervision by the Federal Reserve.
 Companies predominantly engaged in activities that the Federal Reserve
determines are financial in nature,
 Subsidiaries of the foregoing of financial companies, other than subsidiaries
that are insured depository institutions or insurance companies and
 SEC-registered brokers and dealers that are members of the SIPC.
42
Bankruptcy Issues Relating to Derivatives
 Title II contains several provisions that afford special protections to
parties to “qualified financial contracts” with covered financial
companies (“QFCs”).
 QFCs include repurchase agreements, securities contracts, forward
contracts, commodity contracts and Swap agreements and, in each instance,
specifically defined classes of counterparties.
 The definition is similar to the corresponding term in the Federal Deposit
Insurance Act applicable to bank receiverships
43
Bankruptcy Issues Relating to Derivatives
 Certain counterparties to qualified financial contracts (“protected
parties”) may exercise contractual rights to terminate, close-out and
liquidate their positions upon the insolvency of counterparties that are
covered financial companies. However, the right is subject to some
limitations:
 Stay of termination right
 A counterparty may not terminate, liquidate or net out its position solely by
reason of the appointment of the FDIC as receiver or the financial condition of
the financial company in receivership until 5:00 p.m. Eastern Time on the
business day following the date of appointment of the FDIC.
 A protected party also is precluded from exercising any such contractual
rights after it has received notice that its qualified financial contract has been
transferred to another financial institution — including a bridge financial
company. The FDIC is required to notify a protected party of any such
transfer by 5:00 p.m. Eastern Time on the business day following the date of
appointment of the FDIC.
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Bankruptcy Issues Relating to Derivatives
 A protected party may not enforce a “walkaway clause” against a
covered financial company.
 A walkaway clause is a provision that permits a non-defaulting counterparty to
make only limited payments or no payments at all to the other on termination
even if the defaulter is a net creditor (i.e., the non-defaulting party is out of the
money.
 E.g., (“First Method” in 1992 ISDA)
 E.g., section 2(a)(iii) of 1992 and 2002 ISDA
 Walkaway clauses are not enforceable in a qualified financial contract
of a covered financial company in default.
 This limitation is similar to existing provisions in the Bankruptcy Code
and the Federal Deposit Insurance Act.
45
Bankruptcy Issues Relating to Derivatives
 Study on Secured Creditor Haircuts
 The Financial Stability Oversight Council is required to conduct a study
evaluating the importance of maximizing United States taxpayer
protections and promoting market discipline with respect to the treatment
of fully secured creditors in the utilization of the orderly liquidation
authority authorized by Dodd-Frank Title II.
 Not later than July 21, 2011 the Council must issue a report to Congress
containing all findings and conclusions made by the Council in carrying
out the study required under subsection (a). Importance to repo, may
affect margin in non-cleared OTC derivatives.
46
Strategic Issues and Compliance Challenges
 Implications of revision of Commodities Exchange Act to remove
the exception for Swaps from the definition of “commodity”
 Swaps based on commodities (including broad-based 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.
 As a result of the new legislation, registered funds and funds seeking to
register with the SEC may have to rethink their use of Swaps if they wish
to be regulated as investment companies rather than as commodity
pools.
47
Strategic Issues and Compliance Challenges
 Compliance challenges
 Multiple new regulatory frameworks of the CFTC and SEC may create
dual registration requirements
 Clearing rules may create bifurcated or trifurcated work flow with separate
documentation and compliance requirements and non-netted margin.
 Multiple clearing agencies
 Cleared and non-cleared bilateral trades.
 Statutory ambiguities
 Definitions of Swaps and SB Swaps will need to be resolved to delineate
jurisdictional boundaries between the CFTC and SEC.
 Statutory ambiguities among the definitions and overlapping regulation of
futures, options, Swaps and forwards add to legal complexity and may
affect trading decisions.
48
Strategic Issues and Compliance Challenges
 Requirements for Regulated Swap Entities.
 Registration requirements
 Business conduct standards
 Special business conduct requirements for advisors or counterparties to
“Special Entities”
 Clearing, exchange trading, margining and reporting requirements for Swaps
and SB Swaps.
 Impacts on end-users
 Scope of commercial end-user exemption from clearing
 Increased costs
 Commercial end-user direct margin??
 Impact of convergence of OTC and exchange traded markets
49
Strategic Issues and Compliance Challenges
 Regulatory implications for funds
 Registered Investment companies using Swaps may need to reconsider
regulatory status and investment strategies.
 Private investment companies using Swaps might be deemed to be dealers
or major participants and be required to register with the CFTC, the SEC or
both. Relevant considerations include:
 The “regularity” with which the fund or its adviser enters into Swaps “in the
ordinary course of business”
 The degree of leverage employed
 Managers also must carefully consider how the instruments they employ in
their investment programs might be characterized and regulated
50
Strategic Issues and Compliance Challenges
 Regulatory process and studies may provide an opportunity to impact
the process.
 SEC / CFTC rulemaking for (i) definitions of Swap, major Swap participant
etc. and (ii) regulation of mixed Swaps
 Treasury determination of whether FX trades are “swaps”
 Study on collateral haircuts
 Other studies on topics such as margin requirements, treatment of stable
value contracts etc.
 Congressional oversight and budget process is becoming more
prominent, may be key to the future of Dodd Frank
 Oversight hearings
 Budget approval
51
Thank you!
 Christopher J. DeLise
+1.312.807.4347
 Anthony R. G. Nolan
+1.212.536.4843
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