OTC Derivatives

OTC Derivatives Product History and Regulation

September 2009

Introduction
What is a Derivative?
History, Purposes, Types

Common Types of Swaps

Swap Documentation
OTC Derivatives Regulatory

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

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

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

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

Purposes and uses of OTC Derivatives

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

Common Types of Derivatives

Options
Futures
Forwards
Warrants
Swaps
Other

Options

Options
Holder can buy or sell a security/commodity at a set price on,
or prior to, expiration of the option

calls or puts, caps or floors

European versus American Style
Exercise/Strike Price
Options on stocks; pork bellies

Options also are embedded, for example, in

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

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

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

Futures have only market risk due to daily re-margining

through the exchange

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

Forwards are different from futures

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

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

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

Exchange Traded vs. OTC Derivatives

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

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

Common Types of Swaps

Interest Rate Swaps

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

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.

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%)

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

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.

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

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

B
LIBOR + 2% on $1.2 Billion JPY

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

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

Commodity Swaps Use and Structure

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

Appreciation on Referenced Commodity

Fixed or Floating Payment or other Commodity returns

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

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

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

Buyer

Seller
Par Value of
Reference Obligation

Reference
Entity
DEFAULT

Structure of Original 1994 JPM CDS

(BISTrO)
Loan portfolio
($9.7 Bn)

U.S.
Treasuries
Return

Morgan
Guaranty
Trust (MGT)

Credit default swap Fee

(X bp p.a.)

Net losses

Par

Special
Purpose
Vehicle (SPV)

Treas return + X
Par
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

Capital
market
investors

CDS Payment Summary

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

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

Equity Swaps Use and Structure

Banks, funds and corporations use equity
swaps

gain exposure to equities or indices

to avoid tax or transaction costs
gain exposure to illiquid markets
hedge investments
Depreciation on Referenced Equity

Appreciation on Referenced Equity

Fixed or Floating Payment or other Equity returns

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

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

TRS Use and Structure

Increase in Value of Asset
Interest payments from Asset

TRS
Buyer

Interest Payment (LIBOR + Spread)

Loss in Value of Asset

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

TRS
Seller

TRS Payment Summary

TRS Buyer pays a rate of interest on notional amount of

Reference Asset
Interest rate typically less than TRS Buyers cost of funding

TRS Seller can hedge exposure to asset and receive interest

payments that are typically greater than TRS Sellers cost of
funding

Allows TRS Buyer to derive the benefit of owning an asset

without having the asset on balance sheet, and gives TRS Seller
protection from loss in value

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

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

Questions?
Are there any questions?

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

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

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)

Swap Documentation - Bankruptcy

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

Under a Swap Agreement, a party may be able to suspend

performance under a transaction without terminating the
agreement (Section 2(a)(iii))
interest accrues

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

Simplified ISDA Structure

ISDA Master Agreement

Short form

Long form

Confirmation(
s)

Confirmation(s
)

Definitions

Definitions
41

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

1995 Credit Support Deed

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

1992/2002 Master
Agreement
Confirmations
Long form
confirmations
Confirmations
Short form confirmations
Master confirmation
agreements

42

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

OTC Derivatives Regulatory

History of OTC Derivatives Regulation

Discussion of Over-the-Counter Derivatives
Markets Act of 2009

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

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

Early Derivatives Regulation

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

ISDA Swap Agreements essentially created an OTC derivatives

private exchange with netting benefits

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

1974 Treasury Amendment

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

While these exemptions covered the exclusion of a number of

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

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

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

1989 CFTC Swap Policy Statement

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

Enacted prior to CFTC having authority to exempt futures

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

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?

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

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

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

1993 CFTC Swap Exemption

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

1993 CFTC Hybrid Exemption

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

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

1998 Legislation enacted at request of Treasury, Fed, and SEC

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

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

CFMA declared OTC derivatives exempt from both CFTC and

SEC regulation
CFMA provided legal certainty
No OTC derivative contract would be unenforceable under the CEA or
any other federal or state law for failure to comply with exemptions or
exclusions provided by CEA
OTC derivatives excluded from requirement to be executed on a
regulated trading facility
Repealed Shad-Johnson to permits US trading of security futures
futures on individual non-exempt securities
futures on narrowly-based groups or indices of non-exempt securities

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

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

CFMA made security-based swaps agreement subject

to anti-fraud, anti-manipulation and anti-insider trading
provisions of the 1933 Act and 1934 Act

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

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

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

Over-the-Counter Derivatives Markets

Act of 2009 (proposed August 11, 2009)
Significant changes to the regulatory structure
Significant changes to the way OTCs are cleared
Significant rule-making to come

OTC DMA of 2009 - Overview

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

Created registration requirements for swap dealers

and major swap participants
Legislated mandatory clearing requirements
for standardized swaps

Legislated registration requirements for swap clearing

houses

OTC DMA of 2009 - Overview

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

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

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)

OTC DMA of 2009 Standardized and

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

CFTC and SEC to define standardized swaps within 180 days

of enactment
define as broadly as possible, after taking into account

terms of the trade

volume
extent to which a swap is similar to other centrally cleared swaps
economically similar to other centrally cleared swaps
in a manner to reduce avoidance schemes

OTC DMA of 2009 - Rulemaking

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

OTC DMA of 2009 Registration Requirements

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

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

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

OTC DMA of 2009 Swap Dealer Provisions

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

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

comply with various reporting and record-keeping requirements

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

conform to certain business conduct, documentation and back

office standards
comply with requirements relating to position limits, disclosure,
conflicts of interest, and antitrust

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

OTC DMA Act of 2009 Mandatory Clearing

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

these mandatory trading requirements would not apply to

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

OTC DMA of 2009 Trading Facilities

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

ASEFs would have core regulatory principles, and subject to

enforcement,
position limits
emergency powers
recordkeeping and reporting
conflicts of interest

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)

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

OTC DMA of 2009 Final Reporting

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

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

OTC DMA of 2009 Sections 13d and 16

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

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

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

Questions
Are there any questions?

Bill Satchell, Partner

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

Demetri Xistris, Senior Counsel

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