1. OTC Derivatives – Product History and Regulation
September 2009
OTC Derivatives – Product History and Regulation

2. Introduction What is a Derivative? Common Types of Swaps
History, Purposes, Types
Common Types of Swaps
Swap Documentation
OTC Derivatives Regulatory

3. History of Derivatives
Derivatives are not really “products” and they are not really “traded”
Simply views or bets on future price movements
Rice derivatives traded in Japan in 15th C
Stock options traded in the 1800’s
Corn and wheat futures traded on the CME today

4. What is a Derivative? Definition of a Derivative
a financial instrument (swap, put, call, cap, floor, collar, or similar option) for the purchase or sale of, or whose value is based on, one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind
Definition of an Over-the-Counter (OTC) Derivative
a derivative that is not traded through an exchange or other regulated market but through a bilateral negotiation between two parties and thus executed off-exchange
The Securities Exchange Act and the Commodities Exchange Act regulate exchanges

5. Purposes and uses of OTC Derivatives
Risk transfer
Hedging
Investment
Exposure to different markets
Change an asset’s balance sheet character
Speculation
Leverage

6. Common Types of Derivatives
Options
Futures
Forwards
Warrants
Swaps
Other

7. Options
Options
Holder can buy or sell a security/commodity at a set price on, or prior to, expiration of the option
calls or puts, caps or floors
European versus American Style
Exercise/Strike Price
Options on stocks; pork bellies
Options also are embedded, for example, in
Convertible Bonds
Holder can convert bond into shares of stock or other securities in the issuing company
Structured Notes
Holder can receive a return of principal greater than original investment if Note’s embedded option has adequately increased in value

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

9. Forwards
Forwards
Like a futures contract, an agreement to buy or sell an asset at a specified future time and price
Customized between parties and not exchange traded
Can be for any underlier
Can be for any settlement date
Forwards are different from futures
Forwards entail credit risk exposure to your counterparty
Market risk on the trade unless negotiated re-margining

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

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

12. Exchange Traded vs. OTC Derivatives
exchange central clearing house (CCH) acts as counterparty on both sides of the transaction
credit risk exposure to CCH
margin as required by CCH rules
limited number of standardized products
Transparent end-of-day valuation
simple liquidation
OTC
private transaction between two parties
creates counterparty credit risk to be managed
collateral negotiated between the parties
valuation based on models using various and at times differing assumptions (witness AIGFP)
negotiated liquidation and early termination thus more complex outside of bankruptcy; sometimes skewed in bankruptcy

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

14. Interest Rate Swaps
Interest rate swaps developed in 1981 to alleviate mismatch on capital rates, investment returns and improve issuer balance sheet management
European companies could raise money with fixed rate Eurobonds, but European investments paid floating rates
US companies often used commercial paper and other floating rate capital markets while investments, such as Treasury, paid fixed returns.

15. Interest Rate Swaps Use and Structure
Banks, funds and corporations use interest rate swaps to reduce mismatched interest exposure on other investments or speculate on interest rate movement
Interest rate swaps are standardized/very liquid
Notional Amount= $500 million
Fixed Interest Rate (e.g., 3%) A B
Floating Interest Rate (e.g., LIBOR + 50 bps)

16. Interest Rate Swap Payment Summary
Each payment is based on a notional amount, but the notional amount is not transferred
One party makes a stream of payments calculated like interest that would be paid on notional amount with a fixed (or floating) interest rate
Other party does the same but based on another interest index (typically a floating rate such as LIBOR, but can be based even on another fixed rate interest index)
Fixed and Floating payments
typically match on same day (otherwise credit risk)
can be made monthly, quarterly, semi-annually etc.

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

18. FX Swaps Use and Structure
Banks, funds and other financial institutions use FX swaps to reduce currency risk on other investments or to speculate on currency fluctuations
Currency swaps are standardized and very liquid
5% on $10 Million USD A B
LIBOR + 2% on $1.2 Billion JPY

19. FX Swaps Payment Summary
Parties exchange streams of payments in different currencies to reduce exposure to currency risk
Multiple currency combinations are possible and some transactions have different currencies swapped based on exchange rate or other factors
Often used in conjunction with interest rate swaps where underlying liabilities are financing transactions

20. Commodity Swaps
The Chase Manhattan Bank introduced commodity swaps in 1986
Commodity futures were common for many years, but swaps provided advantages in products and maturity
The first swaps referenced oil, but the commodity swap market has expanded
natural gas, electricity, coal, other energy products, as well as metals, agriculture and other commodities

21. Commodity Swaps Use and Structure
Commodity users use swaps to protect themselves from risk of price swings
Banks and financial institutions use commodity swaps to hedge market exposure to such commodities or to speculate on future price movement
Depreciation on Referenced Commodity A B
Appreciation on Referenced Commodity
Fixed or Floating Payment or other Commodity returns

22. Commodity Swap Payment Summary
Transaction relates to a certain amount of a particular commodity
Commodity amount may be for a one time settlement or multiple settlements at set time periods
One party pays an amount based on change in price of commodity
Other party pays a fixed/floating amount on each settlement date
These are cash settled and commodity is almost never transferred

23. Credit Default Swaps (CDS)
Developed in 1994 by JPMorgan to overcome bank capital restrictions on outstanding Exxon loans
By transferring Exxon credit risk, JPM could reduce bank capital required to be held against Exxon loans
Credit derivatives expanded to reference loans, corporate, sovereign and fixed income notes, indices, etc.
How is it different from financial guaranty insurance?
CDS buyer need not have an insurable interest

24. CDS Use and Structure
Banks, funds and other financial institutions use CDS
to hedge credit risk on investments
gain leveraged exposure to loans, debt etc.
engage in capital structure arbitrage
arbitrage credit markets
Fixed Payments
Reference
Entity
Buyer
Seller
DEFAULT
Par Value of
Reference Obligation

25. Structure of Original 1994 JPM CDS (BISTrO)
Loan portfolio ($9.7 Bn)
U.S. Treasuries
Capital market investors
Return
Par
Credit default swap Fee (X bp p.a.)
Morgan Guaranty Trust (MGT)
Special Purpose Vehicle (SPV)
Treas return + X
Par
Net losses
Par (minus net losses) at maturity
0.3 % first loss (equity)
J.P. Morgan retains ownership of loans, but sheds credit risk
Credit default swap between MGT and SPV transfers risk
Investment proceeds invested in U.S. Treasuries, which collateralize credit default swap (but not entire $9.7 Bn underlying amount)
BISTrO notes exposed to credit risk of larger reference portfolio
US $697 MM of BISTrO notes exposed to risk of $9.7 Bn portfolio

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

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

28. Equity Swaps Use and Structure
Banks, funds and corporations use equity swaps
gain exposure to equities or indices
to avoid tax or transaction costs
gain exposure to illiquid markets
hedge investments
Depreciation on Referenced Equity A B
Appreciation on Referenced Equity
Fixed or Floating Payment or other Equity returns

29. Equity Swap Payment Summary
Transaction relates to a certain number of shares of a particular equity
Equity amounts may be for a one time settlement or multiple settlements at set time periods
One party pays an amount based on change in price of an equity security
Other party pays a fixed/floating amount on each settlement date
These are cash settled and equity security is almost never transferred

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

31. TRS Use and Structure TRS Buyer TRS Seller Interest payments
Increase in Value of Asset
Interest payments from Asset
TRS
Buyer
TRS
Seller
Interest Payment (LIBOR + Spread)
Loss in Value of Asset
Interest payments
Reference Asset (e.g., bonds, indices, equities, etc.)

32. TRS Payment Summary
TRS Buyer pays a rate of interest on notional amount of Reference Asset
Interest rate typically less than TRS Buyer’s cost of funding
TRS Seller can hedge exposure to asset and receive interest payments that are typically greater than TRS Seller’s cost of funding
Allows TRS Buyer to derive the benefit of owning an asset without having the asset on balance sheet, and gives TRS Seller protection from loss in value

33. Other Swaps and Derivatives
Other common derivatives:
weather derivatives
electricity derivatives
life settlement indices
sovereign debt
There is no limit on products referenced
parties can create derivatives to precisely fit their investment needs and goals

34. Exotic Derivatives
Parties can also combine derivative instruments to create new instruments
A Swaption is an option to enter into a swap and is a common derivative instrument
Parties also modify payment structure to fit investment goals
Swaps can be drafted to be effective only under certain conditions (interest rate, exchange rate, equity price triggers) or limit parties exposure to certain percentages of loss or gain

35. Questions?
Are there any questions?

36. Swap Documentation OTC Derivatives are traded under Master Agreements
Master Agreements by their terms:
net all transactions
Master Agreement nets all transactions for one aggregate liability or asset of a party
provide for representations, covenants, and events of default
methodology for terminating all transactions and calculating a final settlement amount

37. Swap Documentation - Bankruptcy
Protected features under the Bankruptcy Code
Debtor generally has the ability to avoid
pre-petition “preferences” (S. 547)
fraudulent transfers (S. 548)
unperfected security interests (S. 547)
pre-petition set-offs (S. 553) and post-petition transfers (S. 549)
Trustee generally has the right to assume or reject executory contracts
Gives the trustee the power to “cherry-pick”
assume transactions favorable to debtor
reject transactions favorable to counterparty

38. Swap Documentation - Bankruptcy
Master Agreements are “protected contracts” under Bankruptcy Code (S. 560)
ISDA was very active in lobbying for these changes to the US Bankruptcy Code and in some 50+ other countries
Other protected contracts include
securities contracts (S. 555)
commodities contracts (S. 556)
forward contracts (S. 556)
repurchase agreements (S. 559)
master netting agreements (S. 561)
These contracts protected to maintain integrity of financial markets
In Lehman bankruptcy there were 930,000 outstanding swaps
918,000 terminated soon after the bankruptcy filings (September 2008)

39. Swap Documentation - Bankruptcy
A party with a protected contract (including Swap Agreements (S. 362(b)(17)), notwithstanding the automatic stay, trustee’s powers, or any order of the Bankruptcy Court:
may terminate, liquidate, or accelerate the agreement
offset or net termination values, payment amounts or other transfer obligations
foreclose on collateral
Under a Swap Agreement, a party may be able to suspend performance under a transaction without terminating the agreement (Section 2(a)(iii))
interest accrues

40. Swap Documentation - Termination
Under 1992 ISDA Master Agreement, parties elect either “Market Quotation” or “Loss”
Market Quotation: based on (i) average of two middle bids obtained from 4 reference market makers or (ii) the middle bid of 3 bids so obtained – poses problems in times of market turmoil
Loss: cost of unwinding hedges related to the terminated transactions under the Swap Agreement – unilateral if “reasonable” determination of non-defaulting party
2002 ISDA Agreement adopts single damages measurement defined as the “Close-out Amount”
requires a good faith determination, using commercially reasonable procedures, of the losses or gains that are or would be realized in providing for the economic equivalent of the material terms of and option rights of the parties under the terminated transactions

41. Simplified ISDA Structure
ISDA Master Agreement
Long form
Confirmation(s)
Short form
Confirmation(s)
Definitions
Definitions 41

42. ISDA Agreement Structure (2009)
Credit Support Documents: to reduce credit risk
2001 Margin Supplement (incorporating 2001 Margin Provisions)
1995 Credit Support Annex (Transfer-English law)
1994 Credit Support Annex (New York law)
Annexes
ISDA Global Physical Coal Annex
US Emissions Annex
EU Emissions Annex
North American Power Annex
North American Gas Annex
GTMA Annex (UK Power)
European Gas Annex
US Crude Oil and Refined Petroleum Products Annex
Bridges
2002 Energy Agreement Bridge
2001 Cross-Agreement Bridge
1996 FRABBA Bridge
1996 BBAIRS Bridge
Definitions: for use in documenting Transactions
2007 Property Index Derivatives Definitions
2006 Definitions
2006 Inflation Derivatives Definitions
2006 Fund Derivatives Definitions
2005 Commodity Definitions
2003 Credit Derivatives Definitions
2002 Equity Derivatives Definitions
1998 Euro Definitions
1998 FX and Currency Option Definitions
1997 Government Bond Option Definitions
1992/2002 Master Agreement
1995 Credit Support Deed (Security Interest-English law)
1995 Credit Support Annex (Japanese law)
Confirmations
Long form confirmations
2002 Master Agreement Protocol
Confirmations
Short form confirmations
Master confirmation agreements 42

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

44. Arguments for regulating OTC Derivatives
Speculative nature of the transactions cause market integrity issues
Lack of “transparency” or “opaqueness”
Precise nature of risk and scope unknown to regulators
Leads to potential increased systemic risk
Viewed as having exacerbated the Financial Crises

45. Early Derivatives Regulation
Originally regulated in US and UK by common-law “rules against difference contracts”
could wager anything you wanted, but to go to court to enforce it had to demonstrate at least one party had a real economic interest in the underlying and was using the derivative to hedge against a risk to that interest
akin to insurance law concept of insurable interest

46. Early Derivatives Regulation
Didn’t mean you couldn’t use derivatives to speculate, rather needed to come up with ways to make sure counterparts paid on their bets if they had no economic interest in the underlying
Private exchanges created with membership, margin, and netting requirements designed to make sure speculators would make good on their contracts
Control increased with imposition of government regulators
CFTC and SEC
ISDA Swap Agreements essentially created an OTC derivatives private exchange with netting benefits

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

48. 1974 Treasury Amendment
Treasury Amendment proposed over concerns of scope of CFTC’s jurisdiction
Amended CEA to exempt (so long as not conducted on a “board of trade”):
transactions in foreign currencies
government securities
mortgages
While these exemptions covered the exclusion of a number of private markets of concern to Treasury, a large number of derivative transactions would not fit into CEA/CFTC statutory exclusions or exemptions

49. 1982 Shad/Johnson Accord
1982 Shad/Johnson Accord attempted to clarify the regulatory jurisdiction over futures and options based on securities and stock indices between the CFTC and the SEC
Banned futures contracts on single stocks and narrow-based stock indices
thus viewed as a prohibition on equity derivatives

50. 1982 Shad/Johnson Accord
CFTC retained authority over futures contracts and options on future contracts on
commodities (including exempt securities (other than munis))
foreign currencies not traded on a national securities exchange
certificates of deposit
broad-based indices of securities
SEC retained authority over options on
securities (including certificates of deposit)
certain securities indices
foreign currencies traded on a national securities exchange

51. 1989 CFTC Swap Policy Statement
Reflected CFTC’s view:
“that most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the CEA” as futures or commodity options
Enacted prior to CFTC having authority to exempt futures contracts from being required to be traded on CFTC approved contract markets
Swap Policy Statement viewed by some as indication that swaps covered by the Swap Policy Statement were not futures contracts

52. 1989 CFTC Swap Policy Statement
To meet the Swap Policy Statement safe harbor, the swap agreement must:
have individually negotiated terms
be entered in conjunction with the swap parties’ line of business
not be terminable without the consent of the other party
If a high net worth individual enters into a swap agreement, what is his/her line of business?

53. 1989 CFTC Statutory Interpretation Concerning Certain Hybrid Instruments
Excluded from CEA regulation certain instruments (debt or equity) whose repayment was linked to a commodity component
Rule tested the “commodity independent yield” and “commodity dependent yield”
“commodity independent yield” of the hybrid instrument had to be between 50% to 150% of the estimated yield on a comparable non-hybrid instrument
Rule led to a number of regulatory uncertainties when it was applied

54. Futures Trading Practices Act of 1992
Granted the CFTC authority to grant exemptions from the CEA regulation
Again did not specifically address whether a swap agreement is a futures contract or an option on a futures contract

55. 1993 CFTC Swap Exemption CFTC exempted “swap agreements” that were:
entered into with eligible swap participants (ESPs)
not part of a fungible class of agreements that are standardized as to their material terms
creditworthiness of the parties is a material consideration
swap agreement is not traded through a multilateral transaction execution facility

56. 1993 CFTC Swap Exemption
Since swaps were exempt and still not held to not be futures, CFTC still retained anti-fraud and anti-manipulation authority over exempted swap agreements
Swap Exemption applied to most common interest rate, currency and commodity swaps
cast doubt on the legality of equity derivatives (which continued to rely on the Swap Policy Statement)

57. 1993 CFTC Hybrid Exemption
Eliminated a hybrid instrument’s “commodity independent yield” test for a “predominance test”
Predominance test requires
the debt and equity component of a hybrid instrument (“commodity-independent component”) must exceed the value of the option-like or futures-like commodity component of the instrument (“commodity-dependent component”)
CFTC prescribed a method by which the commodity indexation had to be decomposed by assigning premium values to be assigned to the commodity options
varying assumptions used produced considerable regulatory uncertainty

58. Post 1993
Two developments led market participants to believe that the CFTC might seek to modify the Swap Exemption
Comment letter on SEC’s “broker-dealer lite” proposal stated that the SEC proposal created potential conflict with the CEA to the extent that certain OTCs fall within the ambit of the CEA and are subject to the exclusive authority of the CFTC
CFTC 1998 Concept Release requesting comment of whether OTC derivatives regulation is appropriate and if so what form should it take raising uncertainty about the Swap Exemption
1998 Legislation enacted at request of Treasury, Fed, and SEC limited CFTC’s rule-making authority with respect to swaps and hybrid instruments until March 30, 1999
essentially froze the pre-existing legal status of swaps and hybrids entered into in reliance on prior CFTC policy statements and exemptions

59. 2000 CFMA
In need was recognized to overhaul OTC derivative regulation
1993 Swap Exemption could be revoked by CFTC at any time
CFMA declared OTC derivatives exempt from both CFTC and SEC regulation
CFMA provided legal certainty
No OTC derivative contract would be unenforceable under the CEA or any other federal or state law for failure to comply with exemptions or exclusions provided by CEA
OTC derivatives excluded from requirement to be executed on a regulated trading facility
Repealed Shad-Johnson to permits US trading of security futures
futures on individual non-exempt securities
futures on narrowly-based groups or indices of non-exempt securities

60. 2000 CFMA
Provided that swap agreements entered into with “eligible contract participants” that are not executed on a “trading facility” are excluded from the CEA
ECPs
corporations with $10 million in assets
natural persons with $5 million in assets entered into to manage risk
Much more effective than 1993 Swap Exemption
can be modified only by Congress
applies to “transactions” and not just master agreements
ECPs were broader than ESPs
Swap Exemption non-fungibility and creditworthiness requirement eliminated

61. 2000 CFMA
Also amended the securities laws to define “security-based” and “non-security based” swaps agreements.
“security-based swap agreement” is a swap agreement of which a material term is based on the price, yield, value or volatility of any security or any group or index of securities
“non-security based swap agreement” means any swap agreement that is not a security-based swap agreement.
CFMA made security-based swaps agreement subject to anti-fraud, anti-manipulation and anti-insider trading provisions of the 1933 Act and 1934 Act

62. 2000 CFMA
However, SEC had no regulatory authority over security based swap agreements
SEC could propose no “reporting or record-keeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation or insider trading with respect to any security-based swap agreement”
certainly could not require the registration of security-based swap agreements under Section 5

63. 2000 CFMA
Excluded from CEA jurisdiction “identified banking products” to deal with CFTC and banking regulators jurisdictional issues
includes certificates of deposit
bank loans
loan participations sold to qualified investors
credit swaps
equity swaps sold to qualified investors

64. 2000 CFMA
Also provided that CFMA preempts any state or local laws regulating gaming or bucket shops
eliminates concern that excluded or exempt transactions may be voided for violating these state or local laws
Contained a savings clause that no transaction between ECPs, and no hybrid instrument, shall be void, voidable or unenforceable solely because it fails to comply with the terms of an exemption or exclusion
Thus with CFMA 2000, OTC derivatives’ regulatory regime and enforceability was set in stone

65. Over-the-Counter Derivatives Markets Act of 2009 (proposed August 11, 2009)
Significant changes to the regulatory structure
Significant changes to the way OTC’s are cleared
Significant rule-making to come

66. OTC DMA of Overview
Eliminated the unregulated status of OTC derivatives and implemented a new regulatory authority
carved up regulatory authority over swaps between SEC and CFTC
Created registration requirements for swap dealers and major swap participants
Legislated mandatory clearing requirements
for standardized swaps
Legislated registration requirements for swap clearing houses

67. OTC DMA of Overview
Expansion of regulatory authority over swaps
CFTC
would have exclusive jurisdiction over all swaps except security-based swaps
swaps include options but does not include foreign exchange swaps and foreign exchange forwards
CFTC would be limited to regulating entities dealing in swaps and to enforcing anti-manipulation and anti-fraud provisions
SEC
would have exclusive jurisdiction over security-based swaps
security based swap are swaps based on a single security, loan or a narrow-based security index
SEC would maintain authority over anti-fraud, short-swing profits, and insider trading

68. OTC DMA of 2009 – Credit Default Swaps
Allocates jurisdiction over credit-default swaps to the CFTC and SEC
SEC has jurisdiction over security-based swaps
single security, loan (CDS) or narrow-based security index (including narrow-based CDS index)
CFTC has jurisdiction over all other swaps
includes broad based securities indicies (including CDS)

69. OTC DMA of 2009 – Standardized and Non-Standardized Swaps
Distinguishes between standardized swaps and non-standardized swaps
standardized swaps will be required to be cleared through a central clearing house
non-standardized swaps will be subject to higher capital and margin requirements on derivatives dealers and major swap participants
CFTC and SEC to define “standardized swaps” within 180 days of enactment
define “as broadly as possible, after taking into account”
terms of the trade
volume
extent to which a swap is similar to other centrally cleared swaps
economically similar to other centrally cleared swaps
in a manner to reduce avoidance schemes

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

71. OTC DMA of 2009 – Registration Requirements
requires “swap dealers” and “major swap participants” to register with the CFTC
requires “security-based swap dealers” and “major security-based swap participants” to register with the SEC

72. OTC DMA of 2009 – Swap Dealer Definition
Who is a swap dealer?
swap dealer is any person who is engaged in the business of buying or selling swaps for its own account, excluding persons who do not engage in this activity as part of a regular business (trader exemption)
if trader exemption interpreted consistent with Exchange Act would potentially exclude many end users such as hedge funds, insurance companies, and operating companies
No bank exemption as presently under the 1934 Act for Banks
Brokers of security-based swaps will also be required to register under the 1934 Act

73. OTC DMA of 2009 – Major Swap Participant Definition
Who is a major swap participant?
a person who is not a swap dealer but who maintains a substantial net position in outstanding swaps, excluding persons who engage in trading swaps to maintain an effective hedge under GAAP
GAAP hedges is pretty narrowly defined as an accounting matter
Many financial companies, banks, insurance companies, investment companies likely to meet this definition

74. OTC DMA of 2009 – Swap Dealer Provisions
Swap dealer and major swap participant are required to
meet minimum capital and margin requirements to be established by
Fed/OCC or FDIC for Banks
SEC and CFTC jointly (for non-banks)
capital requirements would be higher for non-standardized swaps than for swaps
Bank regulators would set a floor for SEC and CFTC requirements
initial and variation margin set by Bank regulators would also set floor for SEC and CFTC requirements
comply with various reporting and record-keeping requirements
must require daily records of swaps, cash, recorded conversations, including and IM’s
a complete audit trail
conform to certain business conduct, documentation and back office standards
comply with requirements relating to position limits, disclosure, conflicts of interest, and antitrust

75. OTC DMA of 2009 – Swap Dealer Provisions
Major security-based swap participants required to register with SEC potentially resulting in dual registration (for e.g., may be regulated by the OCC or under the Investment Company Act)
SEC and CFTC are required to jointly define major swap participant

76. OTC DMA Act of 2009 – Mandatory Clearing
requires all standardized swaps to be traded on a designated contract market or alternative swap execution facility (ASEF)
ASEF must provide that all swaps with same terms and conditions are fungible and may be offset with each other
these mandatory trading requirements would not apply to swaps if
no clearing agency accepts the swap for clearing
one of the parties to the swap is not a swap dealer or a major swap participant
swap dealer or major swap participant does not meet the eligibility requirements of any clearing organization that clears such transactions

77. OTC DMA of 2009 – Trading Facilities
ASEFs for trading of standardized swaps or standardized security-based swaps required to register with CFTC or SEC, as appropriate
As an ASEF, would be subject to
trading procedures
deterrence of trading abuses
financial integrity of transactions
ASEFs would have core regulatory principles, and subject to
enforcement,
position limits
emergency powers
recordkeeping and reporting
conflicts of interest

78. OTC DMA of 2009 – Trading Facilities
ASEFs subject to comparable comprehensive supervision/regulation by another domestic/foreign regulator could be exempted by the Agency
ASEFs would make publicly available aggregate data on swap trading volumes and positions (without disclosing business transactions or individual market positions)

79. OTC DMA of 2009 – Swap Repository
Parties who enter into non-standardized (uncleared) swaps are required to report such swaps to a registered swap repository
registered swap repositories are required to register with the appropriate Agency
would be required to accept, maintain and make available data to the Agency
would be subject to inspection and examination
deterrence of trading abuses
financial integrity of transactions
seems more like a governmental function raising private market issues

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

81. OTC DMA of 2009 – Position Reporting
CFTC given power to establish aggregate position limits for contracts listed by a DCM/ASEF and swap contracts that perform or affect a significant price discovery function, allowing for hedging exemptions
SEC has similar authority for
position limits for securities listed on a national securities exchange and security-based swaps that perform or affect a significant price discovery function with respect to regulated markets
large trader reporting requirements for security-based swaps that perform or affect a significant price discovery function with respect to regulated markets

82. OTC DMA of 2009 – Sections 13d and 16
Sections 13 and 16 would apply also to security-based swaps and any other derivative instrument the SEC may determine
Section 13 turns on beneficial ownership ‘s power to dispose or to vote which is generally not present in a cash settled security-based swap

83. OTC DMA of 2009 – ECP Definition
ECP definition would be modified
government entities that invest on a discretionary basis $50m (previously $25m)
individuals with $10m in assets invested on a discretionary basis (previous just $10m in assets)
Mandatory exchange clearing provisions would not apply to swaps entered into by ECPs

84. OTC DMA of 2009 – Retail Regulated Swaps
Unlawful for anyone other than an ECP (i.e., retail) to enter into a swap unless
a swap subject to a regulated futures exchange
a security-based swap entered into on a national securities exchange and the trade was registered under the 1933 Act

85. Questions
Are there any questions?

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

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