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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
2
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
3
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
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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
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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
•
•
•
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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
7
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
8
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
10
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
11
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
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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.
14
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)
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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
5% on $10 Million USD
A
B
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
Depreciation on Referenced Commodity
A
Appreciation on Referenced Commodity
B
Fixed or Floating Payment or other Commodity returns
21
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
22
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
23
CDS Use and Structure
• Banks, funds and other financial institutions
use CDS
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–
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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
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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
Capital
market
investors
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
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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
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–
–
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gain exposure to equities or indices
to avoid tax or transaction costs
gain exposure to illiquid markets
hedge investments
Depreciation on Referenced Equity
A
Appreciation on Referenced Equity
B
Fixed or Floating Payment or other Equity returns
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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
29
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
Increase in Value of Asset
Interest payments from Asset
TRS
Buyer
Interest Payment (LIBOR + Spread)
TRS
Seller
Loss in Value of Asset
Interest payments
Reference Asset (e.g., bonds, indices, equities,
etc.)
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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:
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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?
35
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
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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
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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
Short form
Long form
Confirmation(s)
Confirmation(s)
Definitions
Definitions
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ISDA Agreement Structure (2009)
Credit Support Documents:
to reduce credit risk
 2001 Margin Supplement
(incorporating 2001 Margin
Provisions)
Annexes
 ISDA Global Physical Coal Annex
 1995 Credit Support Annex
(Transfer-English law)
 North American Gas Annex
 1994 Credit Support Annex
(New York law)
 European Gas Annex
 US Emissions Annex
 EU Emissions Annex
 North American Power Annex
 GTMA Annex (UK Power)
 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
 2006 Definitions
 2006 Inflation Derivatives
Definitions
 2006 Fund Derivatives Definitions
 2005 Commodity Definitions
Confirmations
 Long form
confirmations
Confirmations
 Short form confirmations
 Master confirmation
agreements
 2003 Credit Derivatives
Definitions
 2002 Equity Derivatives
Definitions
 1998 Euro Definitions
 1998 FX and Currency Option
Definitions
 1997 Government Bond Option
Definitions
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42
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
44
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
45
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
46
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
47
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
48
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
49
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
50
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
51
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?
52
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
53
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
54
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
55
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)
56
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 (“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
57
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
58
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
59
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
60
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
61
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
62
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
63
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
64
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
65
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
66
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
67
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)
68
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
69
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
70
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 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
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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 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
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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.
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