OTC Derivatives

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OTC Derivatives OTC Derivatives – Product History and Regulation September 2009

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OTC Derivatives – Product History and Regulation. OTC Derivatives. September 2009. Introduction. What is a Derivative? History, Purposes, Types Common Types of Swaps Swap Documentation OTC Derivatives Regulatory. History of Derivatives. - PowerPoint PPT Presentation

Transcript of OTC Derivatives

Page 1: OTC Derivatives

OTC Derivatives

OTC Derivatives – Product History and Regulation September 2009

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Introduction

• What is a Derivative?– History, Purposes, Types

• Common Types of Swaps

• Swap Documentation

• OTC Derivatives Regulatory

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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

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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

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Purposes and uses of OTC Derivatives

• Risk transfer• Hedging• Investment• Exposure to different markets• Change an asset’s balance sheet character• Speculation• Leverage

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Common Types of Derivatives

• Options• Futures• Forwards• Warrants• Swaps• Other

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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

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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

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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

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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

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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

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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

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Common Types of Swaps

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

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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.

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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

A BFixed Interest Rate (e.g., 3%)

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

Notional Amount= $500 million

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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.

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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

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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

A B

5% on $10 Million USD

LIBOR + 2% on $1.2 Billion JPY

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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

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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

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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

A BAppreciation on Referenced Commodity

Fixed or Floating Payment or other Commodity returns

Depreciation on Referenced Commodity

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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

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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

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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

Buyer SellerFixed Payments

ReferenceEntity

DEFAULTPar Value of Reference Obligation

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Treas return + X

Par

Net losses

Structure of Original 1994 JPM CDS (BISTrO)

• 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

Loan portfolio($9.7 Bn)

MorganGuaranty

Trust (MGT)

SpecialPurpose

Vehicle (SPV)

U.S.Treasuries

Capitalmarket

investors

Credit default swap Fee (X bp p.a.)

Return Par

0.3 % first loss (equity)

Par (minus net losses) at maturity

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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

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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

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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

A BAppreciation on Referenced Equity

Fixed or Floating Payment or other Equity returns

Depreciation on Referenced Equity

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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

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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

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TRS Use and Structure

TRSBuyer

Interest payments from Asset

Loss in Value of Asset

TRS Seller

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

Interest payments

Increase in Value of Asset

Interest Payment (LIBOR + Spread)

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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

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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

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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

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Questions?

Are there any questions?

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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

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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

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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)

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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

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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

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Simplified ISDA Structure

ISDA Master Agreement

Long form

Confirmation(s)

Short form

Confirmation(s)

Definitions

41

Definitions

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ISDA Agreement Structure (2009)

1992/2002 Master

Agreement

1995 Credit Support Deed (Security Interest-English law)

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

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)

1995 Credit Support Annex (Japanese law)

Bridges

2002 Energy Agreement Bridge

2001 Cross-Agreement Bridge

1996 FRABBA Bridge

1996 BBAIRS Bridge

2002 Master Agreement Protocol

ConfirmationsShort form confirmations

Master confirmation agreements

ConfirmationsLong form

confirmations

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

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OTC Derivatives Regulatory

• History of OTC Derivatives Regulation

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

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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

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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

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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

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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

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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

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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

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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

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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

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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?

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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 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

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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Questions

Are there any questions?

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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.

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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.