CFA Institute Webinar

OTC Derivatives: Pervasive Regulatory Changes and Impact on Market Participants in Asia, Europe, and Beyond

Moderators:Samuel Lum, CFA, Director, Private Wealth & Capital Markets, CFA InstitutePadma Venkat, CFA, Director, Capital Markets Policy, CFA Institute

Scott Peterman, CFA Partner, Sidley Austin, Hong Kong

Yin Toa Lee, CFAPartner & Financial Services Leader of Ernst & Young’s Financial Accounting Advisory Services in the Asia-Pacific

Kishore Kumar RamakrishnanDirector, Advisory Services, Ernst & Young

Tate BarnesVice-President, Institutional Client Group, Deutsche Bank, Singapore

20 November 2012

Agenda

1. Key Imperatives of Dodd Frank Act - Title VII & Global OTC Derivatives Reform (Lee 5min)

2. Dodd Frank Act – Extra-territoriality & Cross Border Supervision (Peterman 20min)

3. OTC Derivatives Reform – Asia Pacific & Europe Overview (Ramakrishnan 5min)

4. OTC Derivatives Ecosystem in the Post-Dodd-Frank Era –Capital, Margin, Clearing & Accounting Implications (Ramakrishnan & Lee 20min )

5. OTC Derivatives Reform – Practical Industry Issues (Barnes 15min)

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Key Imperatives of Dodd Frank Act - Title VII&

Global OTCD Reform

Yin Toa LeePartner & Financial Services Leader of Ernst & Young’s Financial Accounting

Advisory Services in the Asia-Pacific

20 November 2012

CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market

Participants in Asia, Europe, and Beyond

OTC Derivatives & Dodd Frank Act: Beauty lies in the eyes of the beholder!

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100 Years of Legislation - Size Matters ?

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Dodd Frank Reforms Process – unprecedented in scope and extent of coverage !

Regulatory

Framework /

Structure

Capital StandardsBanking /

Securities Business

Conventional

Banking

Customer

Protection

Permissible Banking

Activities

Dodd Frank Act

Dodd Frank Act: Key Imperatives of Title VII

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Of the 16 titles published under Dodd Frank Act[DFA] - Title VII in particular aims to regulate andbring transparency in OTC derivatives [OTCD]trading which will impact broker-dealers; hedge-funds; mutual funds and any end-user that tradeand clear derivatives.

Title Scope of Coverage

I Financial Stability

II Orderly Liquidation Authority

III Transfer of powers to the Comptroller of Currency

IV Regulation of Advisers to Hedge funds & others

V Insurance

VI Bank/savings/depository institution regulation

VII Wall Street transparency & accountability

VIII Payment, clearing & settlement provisions

IX Investor protection & improvements to the regulation of securities

X Bureau of consumer financial protection

XI Federal reserve system provisions

XII Improving access to mainstream financial institutions

XIII Pay it back act

XIV Mortgage reform & anti-predatory lending act

XV Miscellaneous provisions

XVI Section 1256 contracts

2. Central Clearing [DCO]

3. Reporting [SDR]

1. Capital & Margin

5. Cross Border

Implications

4. Registration

[SD/MSP]

6. Electronic Trading

[SEF/OTF]

Dodd Frank Act – Extra-territoriality & Cross Border Supervision

Scott D. Peterman, PhD, CFAPartner

Sidley Austin

20 November 2012

CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market

Participants in Asia, Europe, and Beyond

Introduction & BackgroundAt the G-20 meeting in September 2009, G-20 leaders made the following commitments to regulate standardized over-the-counter (“OTC”) derivatives markets: • All standardized OTC derivative contracts to be traded on exchanges or electronic trading platforms, and cleared through central counterparties by the end of 2012 at the latest;• OTC derivative contracts reported to trade repositories; and • Non-centrally cleared contracts subject to higher capital requirements. As a result of these commitments, multiple regulatory reform initiatives are taking place globally. Many of these initiatives have extra-territorial effect. For end users with global trading operations, it is possible that difficult compliance and choice-of-law questions will arise as the new global regulatory landscape for OTC derivatives evolves.

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Extra-territorial Applicability:CFTC-Regulated Swaps

• Section 722(d): ‘‘(i) APPLICABILITY.−The provisions of [the Commodity Exchange Act] relating to swaps that were enacted by the Wall Street Transparency and Accountability Act of 2010 (including any rule prescribed or regulation promulgated under that Act), shall not apply to activities outside the United States unless those activities −

‘‘(1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or

‘‘(2) contravene such rules or regulations as the Commission may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act....”

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Extra-territoriality Rule: SEC-Regulation Security-Based Swaps

• Section 772: “Rule of Construction. No provision of [the Securities Exchange Act of 1934] that was added by [Title VII of the Dodd-Frank Act], or any rule or regulation thereunder, shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate to prevent the evasion of any provision of this title that was added by [Title VII of the Dodd-Frank Act]. This subsection shall not be construed to limit the jurisdiction of the Commission under any provision of this title, as in effect prior to the date of enactment of [Title VII of the Dodd-Frank Act].’’

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Cross-Border Regulatory Harmonization / Sanctions

• Section 752 requires both the CFTC and SEC to seek harmonization with regulators in other countries by consulting and coordinating “with foreign regulatory authorities on the establishment of consistent international standards” for derivatives regulation.

• Section 715 gives both the CFTC and SEC leverage:

“. . . if the [relevant Commission] determines that the regulation of swaps or security-based swaps markets in a foreign country undermines the stability of the United States financial system, either Commission, in consultation with the Secretary of the Treasury, may prohibit an entity domiciled in the foreign country from participating in the United States in any swap or security-based swap activities.”

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EU OTC Derivatives Rules –Overview and Extra-territorial Reach

In the EU, the rules requiring OTC derivatives to be centrally cleared and traded on trading platforms are being addressed in two separate pieces of legislation:

1. European Market Infrastructure Regulation (“EMIR”) – EMIR governs the central clearing and OTC derivatives data reporting requirements. EMIR applies from 1 January 2013 onwards.

2. MiFID II – “MiFID II” refers to the comprehensive review of the existing Markets in Financial Instruments Directive (“MiFID”) which, among other things, requires all OTC derivatives to be traded on trading venues. MiFID II is currently going through the EU legislative process (involving the European Parliament and Council of the European Union); not expected to apply until early 2015.

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International Coordination of OTC Derivatives

• Dodd-Frank Act and EMIR/MiFID II anticipate the need for international coordination of OTC derivatives reforms and regulation. EMIR and MiFID II apply to OTC derivative contracts eligible for clearing/trading on trading venues that have a “direct, substantial and foreseeable effect within the EU” or where such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR/MiFID II.

• Dodd-Frank where activities relating to CFTC-governed swaps have a “direct and significant connection with activities in, or effect on, commerce of the United States”.

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More Work to Be Done• There is not yet clarity as to the meaning of the words “direct,

substantial and foreseeable effect within the EU.” • There is a similar lack of clarity on the analogous Dodd-Frank

Act wordings (“direct and significant connection with activities in, or effect on, commerce of the United States” and “without the jurisdiction of the United States”).

• Thus U.S. and other non-EU firms face uncertainty in relation to clearing and trading obligations under EMIR and MiFID II, respectively. Conversely, EU firms and other non-U.S. firms face uncertainty under broadly similar provisions in the Dodd-Frank Act.

• Is there a need for further rules and amendments to the Dodd-Frank Act and EMIR to close regulatory gaps and avoid arbitrage between the EU, U.S. and other major jurisdictions?

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SEC Enforcement Actions

Section 929P explicitly authorizes SEC enforcement actions (but not private actions) involving “conduct within the U.S. that constitutes significant steps in furtherance of a violation” or “conduct occurring outside the U.S. [that] has a foreseeable substantial effect within the U.S.”

Note: no comparable statutory provision for CFTC enforcement.

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CFTC Proposed Rules on Registration

CFTC indicated that a person who “engages in swap dealing activities and regularly enters into swaps with U.S. persons” would likely be required to register as a swap dealer.

Proposed CFTC Rule 1.6 would prohibit activities conducted outside the U.S., including entering into transactions and structuring entities, to willfully evade or attempt to evade any provision of the federal commodities laws (including rules) enacted under the Dodd-Frank Act and would subject these transactions or entities to the swap provisions of the commodities laws.

Proposed CFTC Rule 1.3(xxx)(6) would permit the CFTC to consider whether “willfully structured to evade” factors may also be considered in determining whether a person is a dealer or major participant. “Sham transaction” test, “lack of a legitimate business interest”, intent test.

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Open Questions

• When does swap dealing activity by a non-U.S. person with non-U.S. affiliates of U.S. persons or with other non-U.S. persons have a “direct and significant connection” with or effect on U.S. commerce?

• What about non-dealing swap transacting activity with non-U.S. affiliates of U.S. persons or with other non-U.S. persons?

• Are non-U.S. affiliates of U.S. persons (particularly dealers) treated as U.S. persons when they TRANSACT (or DEAL) with non-U.S. counterparties?

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Foreign Banks’ Perspective

• Comment letter February 17, 2011: Permit comprehensively regulated and supervised foreign banks to continue to book their global swaps using a centralized booking model out of a well-capitalized and comprehensively regulated booking center in a non-U.S. jurisdiction.

• Swap dealer registration should be through the central booking non-U.S. branch of a foreign bank.

• Apply home country regulation for capital and margin requirements for non-cleared swaps.

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Foreign Banks’ Perspective

Apply U.S. transaction requirements to foreign dealer’s swaps activities with U.S. counterparties, but not to its swaps activities with non-U.S. counterparties. Two alternative registration approaches suggested:

(1)registration and regulation of just the foreign (non-U.S.) branch or separately identified department or division; or

(2)registration of a U.S. affiliate of the foreign bank to conduct swaps activities with U.S. counterparties; the foreign branch that is the booking center for swaps with U.S. counterparties but that does not otherwise deal directly with U.S. counterparties could also register solely with respect to its acting as a booking center for swaps with U.S. counterparties.

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Dual Regulatory Regime in U.S.• Title VII of Dodd-Frank provides for comprehensive regulation

of OTC derivatives markets

─ Significant market participants will be required to register with either or both the SEC or the CFTC depending on the categories of OTC derivatives in which they transact

• Title VII generally bifurcates regulation of OTC derivatives between the CFTC and the SEC

─ CFTC having jurisdiction over swaps

─ SEC having jurisdiction over security-based swaps

─ Shared jurisdiction over mixed swaps and security-based swap agreements

Statutory Definitions

• Title VII substantially amended the CEA, the 1933 Act and the 1934 Exchange Act

─ Added detailed statutory definitions of “swap,” “security-based swap,” and “mixed swap”

─ Provided interpretation and clarification with respect to various products, including OTC derivatives, Title VII instruments, and non-Title VII instruments

─ The Final Rules clarified the characterization of certain products that would otherwise be uncertain under the statutory definition

─ Characterization is generally made at the inception of the trade, unless the instrument is materially modified

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Elimination of CFMA Regulatory Exemptions

• Eliminates almost all exemptions from the U.S. federal securities and commodities laws created by the Commodity Futures Modernization Act of 2000 for over-the-counter (“OTC”) derivatives. Permits the filing of petitions to extend Commodity Exchange Act (“CEA”) section 2(h) exemptions for 1 year for transactions in “exempt commodities,” e.g., metals and energy products, and electronic commercial markets whose participants are limited to “eligible commercial entities” and whose products are limited to exempt commodities.

• All of the following discussions of Title VII of DFA are conditioned upon ongoing rulemakings being conducted by the CFTC and SEC.

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Swaps under Title VII of the DFA: SEC/CFTC: Bifurcated Regulation

• Creates a two-regulator structure regime for OTC derivatives, OTC market participants and OTC markets based on whether the OTC derivative is a “swap” or a “security-based swap” (an “SB swap”). The CFTC is given jurisdiction over swaps that are not SB swaps. The SEC is given jurisdiction over SB swaps. (Swaps in agricultural commodities are prohibited except to the extent specifically permitted by the CFTC.) Participants in both swap and SB swap markets will therefore be subject to regulation by both the SEC and the CFTC, as in the case of a dually registered broker-dealer/futures commission merchant. The base definition of a “swap” is sufficiently broad to include virtually any OTC derivative with the important exception of options on individual securities or any group or index of securities (whether broad-based or narrow-based) and certain other limited exceptions.

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Treatment of Specific Products

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General Product Characterization

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SwapsTitle VII instruments where the underlying is:

1. “Non-security” assets (commodity, dividend, interest rates, etc.)

2. A broad index of securities or multiple underlying products

• Broad index CDS, correlation swap, dividend swap, total return swap, variance swap

• Security-based swap agreements

3. A swap itself

• Guarantee of swap, options on a swap

4. An exempt security

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Security-Based Swaps1. Title VII products where the underlying is:

─ A security or a narrow security index

• Narrow index or single security CDS, correlation swap, dividend swap, total return swap, variance swap, certain contracts for differences

• OTC option on a single non-security loan

─ A municipal security

2. Definitions of “security” under 1933 Securities Act and 1934 Securities Exchange Act have been amended to include “security-based swaps”

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Mixed Swaps

1. Title VII products where the underlying is:

─ Certain CFTC-regulated rates, indices, currencies and commodities will be treated both as swaps and security-based swap

─ Narrowly defined

─ Regulated by both the SEC and the CFTC

2. Parties may request a joint CFTC/SEC order permitting compliance with specified provisions of either the Commodity Exchange Act OR the Securities Exchange Act

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CPO Registration Required

• Commodity pool operator (“CPO”) essentially means a sponsor or promoter of commodity pool, meaning fund that trades any futures, futures options and (soon) non-securities based swaps and FX contracts.

• Applies to managers of funds of funds that invest in pools.• CFTC takes view it has jurisdiction over non-U.S. CPO of any

pool sold to U.S. persons.• CFTC has eliminated Rule 4.13(a)(4) sophisticated investor

exemption used by most non-U.S. CPOs.• Effective late April for new pools and 31 December 2012 for

existing exempt pools.

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Available Registration Exemptions

• CFTC Regulation 4.5―Regulated Persons─ an investment company registered under the U.S. Company

Act (i.e., a mutual fund)─ insurance companies subject to state regulation─ banks, trust companies and other financial depository

institutions subject to state or federal regulation─ a trustee of, a named fiduciary of or an employer

maintaining a pension plan that is subject to ERISA

• CFTC Regulation 4.13(a)(3)

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De Minimis Exemption• CPO must satisfy either one of two trading limit tests:

─ the “initial margin” test • aggregate initial margin, option premiums and required

minimum security deposit (for retail forex transactions) required to establish commodities interest positions, determined at the time the most recent position was established, does not exceed 5% of the liquidation value

─ “net notional value” test• aggregate net notional value of commodities interest

positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into

• No hedging exemption

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How to claim a 4.13 exemption

CPO eligible to claim an exemption under Regulation 4.13 must •furnish to prospective participants in the pool

─ a statement that the person is exempt from registration with the CFTC as a commodity pool operator and that therefore, unlike a registered commodity pool operator, it is not required to deliver a disclosure document and a certified annual report to participants in the pool; and

─ a description of the criteria pursuant to which it qualifies for such exemption from registration; and

•file a notice of exemption with the NFA, which sets forth basic information regarding the commodity pool operator and commodity pool, in each case, no later than the time it delivers a subscription agreement

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Limited Relief Available• CFTC Regulation 30.4(c)―Non-U.S. Futures/Options

Trading. (1) trading is limited to non-U.S. futures contract or foreign options transaction; (2) trading is for non-U.S. commodity pool whose securities are registered under the Securities Act or otherwise exempt from registration; and (3) no more than 10% of the participants in the commodity pool (determined by value) are held by or on behalf of U.S. persons.

• CFTC Regulation 30.5―Non-U.S. CPOs. (1) is located outside U.S.; (2) is otherwise required to be registered with CFTC solely because the CPO trades non-U.S. futures/options; (3) receives confirmation from NFA that Regulation 30.5 exemption applies; (4) engages in all non-U.S. futures/options transactions through registered FCM or a non-U.S. broker with a registration exemption; (5) designates an agent for service of process in U.S.; and (6) provides access to records to the CFTC or U.S. Department of Justice upon demand.

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Alternatives to Registration• Stop trading commodity interests.• Don’t accept U.S. investors -- don’t manage U.S. money.• Only manage U.S. money through true managed accounts and

have less than 15 of these.• Don’t trade “Commodity Interests.”• Don’t trade “Commodity Interests” for U.S. investors/clients.• Find a “CPO-for hire” so the non-U.S. adviser can live under the

less than 15 CTA client exemption.• Trade “Commodity Interests” only in a way that the 4.13(a)(3)

measurement is simpler math.• For pure non-U.S. pools, register and obtain certain relief under

Advisory 18-96.• Register and obtain relief under Rule 4.7 (note new annual

audit requirement).

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CTA Registration Requirement

• Applies to firms that advise others as to futures and (soon) FX and non-securities based swaps.

• Jurisdictional analysis same as for CPOs.

• CFTC has eliminated portion of 4.14(a)(8) exemption that applies to CTAs that advise 4.13(a)(4) pools and whose advice on commodity interests is solely incidental to advice on securities.

• Not as common for CTAs to rely on this exemption as it is for CPOs to use 4.13(a)(4).

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Available Alternatives• Exemption for CTAs that advise fewer than 15 clients in a 12-

month period, with a pool counting as a single client and non-U.S. clients not counting for non-U.S. CTAs, and don’t hold themselves out as CTAs in the United States.

• Exemption for SEC-registered IAs whose business does not consist primarily of acting as a CTA and do not act as a CTA to a pool that is primarily engaged in trading commodity interests

• No CTA registration requirement if advise only pools for which CTA is also the CPO (registered or exempt).

• Exemption for CTA which provides advice only to non-U.S. pools whose interests are sold only to non-U.S. persons where no person conducts marketing activities in the U.S. and the advice on commodity interests is solely incidental to advice on securities.

• Register as CTA and obtain some relief under Rule 4.7.

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CPOI / CTA Registration Process

• Requires Form 7R for firm and Form 8R for each principal and associated person (“AP”).

• Electronic filing.

• Unlike Form ADV these are not disclosure documents and can be done with limited assistance of counsel.

• Testing requirements for APs.

• Fingerprint requirement.

• Must join National Futures Association (“NFA”).

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Risk Disclosure Requirements

• NFA’s Guide for CPOs and CTAs about Disclosure Documentshttp://www.nfa.futures.org/nfa-compliance/publication-library/disclosure-document-guide.pdf

• CPOs under CFTC Rule 4.24(g)

• CTAs under CFTC Rule 4.34(g) http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&rgn=div5&view=text&node=17:1.0.1.1.4&idno=17#17:1.0.1.1.4.2.7.5

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OTC Derivatives Reform – Asia Pacific & Europe

Overview OTC Derivatives Ecosystem in the Post-Dodd-Frank Era – Capital, Margin, Clearing & Accounting Implications

Yin Toa LeePartner & Financial Services Leader of Ernst & Young’s Financial Accounting

Advisory Services in the Asia-Pacific

Kishore Kumar RamakrishnanDirector, Advisory Services, Ernst & Young

20 November 2012

CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market

Participants in Asia, Europe, and Beyond

Source: FSB Publications, EY Analysis

Key Reform Provisions – Coordination Matrix

Countries Central Clearing Reporting Execution Capital/Collateral

Hong Kong No regulations currently

Singapore No regulations currently

Japan

Korea No regulations currently

Australia No regulations currently

India No regulations currently

Taiwan No regulations currently No regulations currently

Malaysia No regulations currently No regulations currently

China No regulations currently

Maturity – OTC Reform vs. OTCD Market Depth

Market Maturity

Reform Maturity

5

4

3

2

1 2 3 4 5Indonesia

Malaysia

Taiwan

India

Korea

Australia

Singapore

Japan

Hong Kong

Source: EY APAC OTC Regulatory Regime Review1. Circle sizes represent relative OTCD market size. Currently Asia represents less than 10% of the global OTCD market, of which Japan accounts for less than half (~4% of global market size)

China

While aligned to the G20 commitments, the region’s proposed OTC reform frameworks appear to be overly regulated when compared to the maturity & depth of the OTCD markets in each location, with each market adopting a divergent approach to OTC reform

Key Observations:• Imbalance between OTC reform framework vs. immaturity of

markets in the region

• Divergent approach of regulators in APAC

• Proliferation of CCPs

• On-shore vs. Off-shore Clearing Models

• SDR: Local vs. Global Infrastructure

• Inconsistent Basel Capital Considerations

DFA vs. OTCD Reforms in AsiaPacific:This is not “United States of Asia”!

Recent Developments from the US / APAC to consider…

!

1 Substituted Compliance - DefinitionCurrent proposed guidelines under Dodd Frank regarding satisfaction of compliance with a foreign regulatory regime allows for market participants to comply with on-shore requirements on a case-by-case review and approve basis by the CFTC.

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Over the last 8 weeks, many regulatory developments have unfolded in U.S. and APAC: a.Entity and Product Definitionsb.Basel’s Margin Rules, andc.CFTC Cross Border guidance d.CFTC mandatory clearing phase-in rulee.HK – conclusion of consultation publishedf.SG – Margin framework for centrally cleared derivativesg.AUS – 2 papers published by Treasury/council of regulatorsh.AUS – consultation on CCP and Securities settlement systems in

response to CPSS-IOSCO principles of financial market infrastructure

Regulatory alignment – US versus Europe

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Central clearing► All standardised derivatives contracts for ‘products eligible for clearing’ to be cleared through regulated ‘clearing houses’► Applies for trades between US and non US counterparties

HighSome

ambiguity

► Mandatory CCP clearing for eligible products, by standardisation and liquidity► Differences in agent vs principal model and related local EU legislation► New ESMA 2012_600 focus on Indirect clearing model► Mandatory clearing of ‘eligible’ derivative contracts for trades between financial counterparts and third party entities.

Non-cleared Trades

► Stricter oversight of swap dealers and major participants, including stricter capital and margin requirements. ► Transactions between financial and non-financial counterparties not exempt

Medium ► Bilateral trading on non-cleared trades possible (providing risk management is in place). Likely to hold higher capital charges and 1-3% risk weighting.

Trade Execution ► Proposed rule: All relevant swaps must be traded on SEFs or exchanges► Best execution with regard to the broader market eg CCP CpR, functionality and im/vm rates. Medium ► MiFID II draft legislation proposes mandatory trading of sufficiently liquid derivatives using regulated venues;

unclear how execution with regard to broader market will be carried out per MTFs/OTFs/platforms.

Trade Reporting

► Mandatory Trade Reporting - Details of swaps must be reported to a swap data repository as soon as possible after trade execution and kept updated throughout the life of the swap; Reporting responsibility will depend on hierarchy of counterparties. ► All counterparties must obtain a unique identifier and must submit parent and affiliate information to the swap data repository.

HighSome

ambiguity

► Financial and non-financial counterparties must report if they exceed information threshold. Possible for counterparty to report OTC derivatives on behalf of another ► When trade depository is registered by ESMA, reporting must be done within 120 days► EMIR differences around inclusion of ETDs and dual sided reporting.

Collateral ► Collateral eligibility restricted to cash and limited securities for im/vm for both cleared and un-cleared swaps; LSOC segregation approach

Mediumambiguity

► Provision for omnibus and individual segregated collateral at CCP and DCM; ► LSOC treats all margins as operationally co-mingled but legally segregated to give credit to each customer in case of a member default, but most CCPs not geared up to handle multiple accounts.

Margin► Initial and variation margin required for all swaps transacted with swap dealers, major swap participants and financial end users►Margin requirements vary depending on type of swap counterparty.

TBC

► Clearing houses must maintain assets and positions of segregation► Acceptable forms of collateral include cash and government bonds► Where derivative contracts are not cleared through a CCP, bilateral collateral requirements will be necessary for financial counterparties.

Standardisation►Definitions of standardised OTC Derivatives/participants being updated to match evolving markets. ‘Swap dealer’ and ‘Major swap participant’ are defined terms, as will be ‘Commercial end-user’

Medium

More standardisation:► EC focus on legal terms of the contract; ► Standardisation needs to take the form of legal, commercial and operational issues; Capital

requirements set by CRD III/IV with specific references to highly-liquid assets, and standards for liquidity.

Controls and reducing risk

► All OTC derivatives dealers and all other major OTC derivatives markets participants will be constrained by regulation, supervision, a capital regime, margin requirements and business conduct rules and tightening of standards of who may participate in those derivatives markets

LowSome

ambiguity

Reduce counterparty risk by:► Proposing legislation to establish common safety, regulatory and operational standards for CCPs and

mandate CCP clearing for standardised contracts ► Improving collateralisation of bilaterally-cleared contracts► Substantially raising capital charges for bilaterally-cleared cf. CCP-cleared transactions,

Exemptions

►Commercial end users exempt from the need to post margin to meet the clearing requirement. US Treasury issued a proposed determination that would exempt FX swaps and forwards from the definition of “swap” for most Dodd-Frank Act purposes, including registration and clearing► Needs to be re-confirmed post-Aug 2012; Spot FX transactions and certain physically settled commodity transactions exempt. FX options, XCSs and NDFs not exempt.

Low

► Exemption for corporates not granted unless ‘objectively measurable as reducing risk related to commercial activity or treasury financing’ ► Two proportionality tests applied per a clearing threshold► Three-year review clause for pension funds under EMIR, but suggestion as of Apr ‘12 that PFs will need to post collateral if trades are not centrally-cleared► Spot FX transactions, commercial forward FX transactions, certain physically settled commodity transactions and inter-affiliate trading exemptions exempt.

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OverlapDodd Frank EMIR

Page 41 "The High-level Impact of Regulatory Reform on the Capital Markets”

Regulatory alignment – US versus Europe II

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Trade Confirmation

► Transactions between SDs/MSPs and other SDs/MSPs: SD/MSP must execute confirm as soon as technologically possible and by end T+1 (with financial entities) and by end T+2 (with other counterparties)► CFTC rules do not mandate use of electronic means where available.

MediumSome

ambiguity

► Transactions between SDs/MSPs and other SDs/MSPs: SD/MSP must execute confirm as soon as technologically possible and by end T+1 (with financial entities) and by end T+2 (with other counterparties) - Art 11 RTS► Draft EU rules do not address timing requirements for confirmations between an FC/NFC and non-EU entity, and do not address: the treatment of transactions executed anonymously.

Portfolio Reconciliation

► SDs/MSPs must agree in writing on terms of reconciliation with counterparties ; reconciliation can be performed by a third party► Covers exchange of trade terms and valuations and reconciliation of discrepancies in material terms and valuations.

High► FCs/NFCs must agree in writing (or other equivalent electronic means) on terms of reconciliation with counterparties for OTC derivatives not cleared by a CCP.; reconciliation can be performed by a third party► Covers reconciliation of key trade terms and valuations attributed under Article 11(2)

Portfolio Compression

► SDs/MSPs must have policies and procedures for portfolio compression, including policies and procedures for periodically terminating fully offsetting swaps and engaging in portfolio compression exercises when requested.► Record-keeping requirements apply.

Low Some ambiguity

► FCs and NFCs with portfolio of ≥500 outstanding OTC derivatives not cleared by a CCP must have procedures to analyse possibility of conducting portfolio compression exercises and engage in such exercises. ► No record-keeping requirement.

Client Documentation

► Documentation between SDs/MSPs and other MSPs or financial entities and requested SDs/and, if requested, other counterparties must include agreed process for determining the value of swaps.► Documentation must include: 1) Status disclosure on SD/MSP (e.g. whether insured depository institution); 2) Notice about effect of acceptance of a swap for clearing by a DCO. Record keeping requirements apply.

MediumSome

ambiguity

► Under Art 14 EMIR draft RTS, FCs/NFCs concluding transactions with each other must agree detailed procedures and processes covering:►1) Identification, recording and monitoring of disputes relating to recognition or valuation of contract and exchange of collateral.►2) Resolution of disputes in a timely manner, with a specific process for those disputes that are not resolved within 5 business days.

Designation of the CCO

► FCMs, SDs and MSPs must appoint a CCO reporting to its board/senior officer, who must among other things submit an annual report to the CFTC on the firm’s policies and procedures and compliance with the CEA and CFTC regulations (after review by the board/senior officer). 17 CFR §3.3.

Mediumambiguity

► Authorised firms are required to maintain a permanent and effective compliance function that operates independently, but neither the proposed EMIR measures (post-trade) nor the proposed MiFID Review measures (pre-trade) stipulate the specific need for a CCO function.

BCP

► SDs/MSPs must establish and maintain business continuity and disaster recovery plans (and specifies the components of that plan and procedures for its testing and maintenance). There are requirements to notify the CFTC of disruptions and to provide emergency contacts. Plans to be tested annually by an independent internal or external party. 17 CFR §23.603

High►Authorised firms are required to establish, implement and maintain an adequate business continuity policy aimed at ensuring the preservation of essential data and functions and maintenance of investment services and activities (or where not possible timely recovery).

Safeguarding Client Assets

► Safeguarding and verification of client assets is referred to at a high level.► Could include verification of assets by independent public accountant. ►§763 features detailed stipulations on how client assets should be treated for security-based swaps, featuring conditions where segregation is required and prohibition of co-mingling.

Mediumambiguity

► Per CP12/22, the FSA proposes to introduce ‘client money sub-pools’ into the CASS regime featuring legally and operationally separate client money sub-pools comprising the margin held in a particular net client transaction account at a CCP and the client money the clearing member holds in relation to that transaction account. ► If the clearing member became insolvent and a CCP ported the positions to a backup clearing member, the insolvency practitioner would be able to make the margin that the insolvent clearing member held as client money in relation to the transaction.

Disclosures► SDs/MSPs must give advance disclosure to counterparties of: the material risks of the transaction; the material characteristics of the particular swap; and material incentives/conflicts of interest (including price and mid-market price).

LowSome

ambiguity

► Data transfer to third countries outside the EU can only take place in compliance with the Data Protection Law, and provided the recipient state ensures an adequate level of protection.► The adequacy of a non-EU state's level of protection must be assessed in light of all circumstances surrounding the data transfer operations in force in that state and its professional rules and security measures, such as 1) the nature of the data; 2) the purpose and duration of the proposed processing operation or operations.; 3) the country of origin and country of final destination; 4) rules of law, both general and sectoral.

Extra-territoriality

►§722(d)/§772(c) - the provisions of the DFA relating to swaps shall not apply to activities outside the US unless those activities; 1) have a direct and significant connection with activities in, or effect on, commerce of the US; or 2) to prevent the evasion of any provision of the DFA. ►CFTC is proposing ‘Substituted Compliance’, based upon mutual recognition on an authority-by-authority basis and broad comparability of regimes.

LowSome

ambiguity

►Third country ‘mutual recognition’/Member State of Reference approach based on satisfying various tests, e.g.:►1) Appropriate regulatory cooperation arrangements are in place;►2) Third country where the non-EU AIFM is established is not listed as a Non-Cooperative Country and Territory by FATF requirements on money laundering and terrorist financing; ►3) Third country fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and Capital .

OverlapDodd Frank EMIR

DFA vs. OTCD Reforms in Europe*

43

* Source: ISDA

44

Global OTC derivative reforms has resulted in the creation of a completely newOTC market landscape comprising of a new infrastructure and service offering

OTC Ecosystem in the post Dodd Frank reforms era

8. Post Trade Reporting2. Major Swap Participant

[MSP]

6. Capital Requirements 4. SEF’s

1.Swap Dealers [SD]

5. SDR’s

7. Collateral / Margin

Requirements3. CCP’s

OTC Derivatives Market

Microstructure

#1; 2 : New Market Participants

#3; 4; 5 : New Market Entities

#6; 7; 8 : New Risk

Mgmt Approaches

Trade

Pre-Trade

Buy-Side

• Determine execution venue• New Legal Framework• Reconcile internal valuations with external broker / CCP’• Assess total cost of trade

[capital; clearing; electronic connectivity]

• Trade on single / multiple SEF’s• Leverage electronic trading methods viz., CLOB, RFQ, • Identify new data requirementsfor risk capture/assessment

Post-Trade

• Margin management with CCP• Intraday margin calculations• Clearing broker relationshipmanagement• Increase in collateral for OTCsnot centrally cleared

OTCD Reforms – Key Challenges to Buy Side

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Overview of buy-side response to swaps reforms

► Analysis of executing and clearing brokers and clearing houses:► Questionnaires and comparisons of services to be offered► Level of required margin (initial and variation)► Collateral eligibility ► Default waterfall model

► Operating model► Identify changes to current processes and new processes► Identify data requirements and gaps across the business► Develop IT design and estimate cost for budget provision

► Conducting readiness assessments including:► Analysis of existing positions / clearing eligibility► Analysis of future plans for OTC usage and clearing ability► Review of margin requirements► Evaluation of counterparty risk and resulting changes to business /

operating model► Assessing impact of and performing gap assessments on proposed

and final rules

1. Dodd Frank Act [DFA] sets up separate margin rules for uncleared swaps and allows CCP's to set up initial and variation margin rules approved by CFTC / SEC

2. Prudential regulators [federal reserve, federal deposit insurance corp (FDIC) and office of the comptroller of the currency(OCC)] have proposed a set of rules on margin for uncleared trades applicable for banks including bank holding companies[BHC's]. In fact, for banks and BHC's - prudential authority rules override the DFA rules.

a. For high risk counterparties - margin requirements [both initial and variation margins - IM and VM] are set out using a table or through regulator-approved formula established by the bank

b. For low risk financial counterparties such as pension funds -> no margin is required until the bank's exposure to each counterparty is less than or equal to USD 30 million or 0.2% of the bank's tier-1 capital and margin rules come into effect only to the extent the exposure exceeds the limit.

c. For low risk non-financial counterparties such as end users - no IM or VM is ever required

3. Basel capital rules related to OTC derivative transactions

a. Basel rules require that a regulated entity to hold capital to cover counterparty credit risk on a CCP both for: (a) its trade exposure to CCP (b) its default fund contribution to a CCP

b. Basel capital rules for trade exposure to CCP offer multiple risk weights: i. Qualifying CCP – 2% capital charges if collateral is segregated from client, CM and double default scenarioii. Qualifying CCP – 4% capital charges if collateral is not segregated against joint default of CM and other

clients of CMiii. Non-Qualifying CCP – 20% capital charges i.e., if non-qualifying CCP is a bankiv. Non-Qualifying CCP – 100% capital charges i.e., if non-qualifying CCP is a corporate financial institution

Additionally, CM will have to apply a risk weight of 1250% [broadly equivalent to one-to-one for deduction] to their default fund contributions (both funded and unfunded)

p g pRisk Management in the Post Dodd-Frank Era –Capital & Margin Framework for Cleared vs. Un-cleared Swaps

46

Dangerous Intersection of Basel, Dodd Frank and Prudential Regulatory regimes

Proposed RuleType of Counterparty

Swap Entity [SD/MSP] Financial End-User Non-Financial End-user

Initial Margin Threshold

Zero: Swap entity is not allowed to establish an initial margin threshold amount for other swap entities and IM must be collected at or before the execution of any un-cleared swap subject to MTA $100,000.

a. High Risk – Zerob. Low-Risk – Lesser of

between $15-$45 million and 0.1% - 0.3% of Tier-1 regulatory capital

a. CFTC – no specific requirement; threshold per credit support arrangement

b. Prudential Regulator –credit exposure limit set by swap entity

Variation Margin Threshold

Zero Same as above Same as above

Frequency of collection of variation margin

At least once per business day At least once per business day Same as above

Segregation of IM Independent [non-affiliated] third party custodian

Not mandatory but can request Not mandatory but can request

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Risk Management in Post Dodd-Frank Era –CFTC Margin Requirements for Un-cleared Swap Trades

Proposed Rule Proposed Rule Summary

Scope of coverage – Products covered / scope of applicability

► Cash / Gold► High quality government and central bank securities► High quality corporate bonds► High quality covered bonds► Equities included in major stock indices► IM – to be collected on a gross basis; cash and non-cash collateral collected as IM should not be

re-hypothecated or re-used► Full variation margin should be collected b/w a firm and its affiliates

Eligible Collateral / Treatment of collected margin

► Overseas branch treated as equivalent to legal entity as the headquarter and hence margin requirements of headquarter jurisdiction is applicable to its branches

► US bank vs. UK bank -> respective home country margin rule applicable► US bank vs. UK subsidiary of Swiss bank -> respective home country margin rule applicable► UK subsidiary of US bank vs. UK bank -> UK margin rules applicable► UK subsidiary of US bank vs. UK subsidiary of Swiss bank -> UK margin rules applicable

Cross border implications

► All derivatives not centrally cleared covered under this proposal► Exempt FX swaps and forwards with maturity less than 1 month to 1 year?► Full – two way margining with zero thresholds► Two way margining with single threshold► Two way margining with higher threshold for transactions b/w prudentially regulated entities► Two way margining with three threshold covering system

Risk Management in Post Dodd-Frank Era –International Working Group on Margin Requirements Proposal – July 2012 [Basel; IOSCO; CPSS]

48

Cleared vs. Bilateral Trade - A Case in PointAsset Class

Initial Margin Requirement (% of notional exposure)

Credit: 0-2 year duration

2

Credit: 2-5 year duration

5

Credit 5+ year duration

10

Commodity 15

Equity 15

Foreign Exchange\Currency

6

Interest Rate: 0-2 year duration

1

Interest Rate: 2-5 year duration

2

Interest Rate: 5+ year duration

4

Other 15

Product TypeMargin Implication for a

sample un-cleared transaction

Margin Implication for a sample Cleared Transaction Remarks

IRS [2-year swap] 1% – 2% in Initial MarginSwap clear requires only 1.8% of the notional exposure for a swap of the same tenor

However, the proposed margin grid from BCBS does not recognize netting, so the margin schedule for uncleared swaps on active accounts will end up becoming relatively more expensive

5 year CDS

A buy-side firm looking to trade an uncleared CDS product would require to post 10% of the notional upfront towards Initial Margin for buy side

e.g., 5 year $10 million notional CDS would cost $1 million towards initial margin

A buy-side firm looking to trade CDS that is centrally cleared at ICE would indicatively need:a. 2.8% of the notional for the protection buyer [i.e., $280,000] b.while it charges 4.5% towards initial margin for the protection seller [i.e., $450,000]

a. Basel proposal on margin requirements for uncleared swaps does not distinguish between index-linked vs. single name CDS

b. Also it does not differentiate on the margin requirements between the protection buyer vs. protection seller

Implications of differential treatment of margin requirements between cleared and un-cleared swap trades:

a.Not differentiating between seller and buyer of credit protection could be a major oversight. For e.g., if one buys a protection on using 5 year CDS at 200 bps – the “MOST” the counterparty loses would be 2% * 5% = 10% of the trade notional while the protection seller of the CDS transaction defaults – I could be down under by more than 90% of the notional – hence, its important to differentiate between the margin requirements for protection seller vs. protection buyerb.Low risk counterparties have a definite advantage while entering into an uncleared swap trade with banking counterparty [as opposed to a non-banking counterparty]– as banking regulations have a much lower IM and VM requirements than DFA does.

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Accounting offsetting criteria

50

General Criteria

IFRS U.S. GAAPTwo condition must exists to offset a financial assets and a financial liability:A legally enforceable right of set‐off exists in all circumstances; andThere is an intent to settle net or simultaneous settlement

A right of offset exists when all of the following conditions are met:Each of two parties owes the other determinable amountsThe reporting party has the right to offset the amount owed by the other partyThe reporting party intends to offset (exception  provided when  there is a  MNA)The right of offset is enforceable by law

Accounting Policy Offsetting is not optional; therefore it is not an accounting policy option. Offsetting is required when the conditions are met

A debtor having a legal right of offset has the option to offset the related asset and liability and report the net amount. The accounting policy must be applied consistently to the same class of transactions.

Number of Counterparties Two or more Only two

Rights to set‐off Unconditional  Conditional

Focus Gross fair values Net  fair values

Key accounting differences

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The key differences between the models relate to:• Conditional right to set-off (under a master

netting agreement) criterion under U.S. GAAP• Existing US GAAP ‘exception’ for derivatives in

relation to the intent criterion between the two models

Industry Response to OTCD Reforms: Picking the right battles

Dodd Frank [DF] Response Dimensions

TextRe-evaluate business strategy and seize new revenue opportunities

Optimal capital allocation & capital management coupled with aggressive cost management – key to navigating regulatory tsunami

► Assess the impact of DF legislation across the balance sheet covering each business line; region and customer segment

► Revise the business approach by refining the revenue model including pricing and value proposition to the client e.g., client clearing, collateral transformation, asset securitization

Effective areas of engagement in harnessing and delivering valuable and sustainable business transformation

► Reallocate capital to businesses by aligning to risk-adjusted profitability and in the process effectively manage economic and regulatory capital allocation

► Incorporate economic and regulatory capital allocation into business processes as one of the proxies for performance measurement

► Reduce the trapped liquidity pools by reconfiguring the funding approach and thereby enabling the businesses in meeting the new requirements – i.e. LCR etc.,

► Rationalize costs by either “eliminating,” “streamlining,” or “re-distributing” costs along the business-line; corporate center and support functions

Enhance risk and regulatory compliance capabilities by ensuring “customer-first” theme is embedded in the risk & compliance dimension

► Streamline and simplify the legal structure in the context of Dodd-Frank where feasible

► Automate manual risk management and regulatory compliance processes where possible by integrating data from different sources and eventually develop a comprehensive view of risk as an enabler of effective response

► Fortify dynamic risk reporting capabilities with appropriate detail within specific lines of business

► Enhance the capability to access “data” swiftly and accurately that will eventually pay off in the form of improved risk transparency

52

Industry Response to OTCD Reforms – getting ready for the new normal

53

OTC Derivatives Market Reform: Practical Industry Issues

Tate BarnesVice-President, OTC Derivatives Clearing, Institutional Client Group

Deutsch Bank, AG (Singapore)

20 November 2012

CFA Institute WebinarOTC Derivatives: Pervasive Regulatory Changes and Impact on Market

Participants in Asia, Europe, and Beyond

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The Business of Clearing (1)• Major Investment required for a global OTC clearing

provider: Connectivity to CCPs, n x Guarantee Fund contributions.

• Profitability of clearing houses: CCPs are not government owned utilities, they have a profit motive. Fragmentation of CCPs across Asia-Pac and limited demand from non-members (i.e. end clients) could mean that not all CCPs offer ‘client clearing’.

• Profitability of client clearing for direct clearing members: Estimates of the fee pool vary wildly, however the experience of market participants is that clients are very price sensitive and that the fee pool will be relatively small.

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The Business of Clearing (2)• Return on investment: The investment that direct members are making

in people and infrastructure suggest that it will take many years for OTC clearing businesses to be profitable after costs.

• Barriers to entry to offering OTC clearing services will likely be high for a number of reasons:

─ Utility like pricing is a natural barrier to new entrants entering the market.

─ The long term return on investment profile of being a global OTC clearing provider is a disincentive to new entrants.

─ Client demand for experienced in-country support across the Asia-Pacific region means that unless a clearing broker has critical mass in a particular country, providing local support will not be cost effective (most dealers are off-shoring support functions to low cost regional hubs).

• For the reasons noted above, only a limited number of global OTC clearing providers will be eventually exist.

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Competitive Environment: Controlling risks or creating them? (1)

• Whilst OTC clearing creates some standardisation (e.g. zero thresholds for mark to market payments), the key commercial and risk terms are still negotiated between clearing members and their clients.

• As with other business lines, clients negotiate heavily with clearing members on commercial and legal terms. Unlike other business lines, however, where an appropriate balance of risk between client and dealer has emerged in the market over time (through experience of defaults, etc), no such balance has been found for OTC clearing. Clients are taking advantage of this to extract favourable terms from their clearers.

58

Competitive Environment: Controlling risks or creating them? (2)

• Is there a land grab going on amongst OTC clearing providers, or are market participants simply reacting to a massive amount of client demand for the service? Either way, clients' ability to negotiate heavily with clearing providers has the potential to expose clearing members to liquidity and other risks.

• Clearing providers' willingness to provide 'guaranteed portability' to clients has the potential to destabilise non-defaulting clearing members in a default scenario.

59

Legal Resources (1)

• There is a massive demand for professional legal serviceswith experience in negotiating OTC clearing related documentation.

• As some elements of the legal documentation and the regulations are completely new to clients (e.g. LSOC), the legal negotiation process often involves a lot of education which extends the time required to negotiate the documentation.

• The phasing of mandatory clearing has not resulted in a phasing of demand for legal services. No one wants to clear first, no one wants to clear last… everyone wants to be ‘in the middle’.

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Legal Resources (2)

• Across the market, there is active legal negotiation taking place with over a hundred clients globally, with several hundred more to begin formal legal negotiation during 2013.

• Whilst the number of clients which are ultimately expected to implement client clearing runs into the hundreds, the number of individual funds runs into the thousands.

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Small OTC Derivative Market Participants (1)

• There are a large number of clients who trade clearable OTC derivatives in very small volumes which makes finding a clearer difficult (clearing brokers will often have a minimum overall clearing fee which would be uneconomic for occasional users of OTC products).

• Where infrequent users of OTC derivatives can find a clearer, they will usually only appoint one (because it wouldn’t be economic to pay two clearers’ minimum fees).

• With no ‘guaranteed portability’ in the event of the default of their clearing member, clients with only a single clearer face the prospect of their positions being unwound by the CCPs, potentially exposing them to losses.

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Small OTC Derivative Market Participants (2)

• Some clients may stop using OTC derivatives and hedge using exchange traded instruments instead. Gap risk from hedging with imprecise instruments may expose clients to increased risks.

• Will some clients cease to hedge altogether, resulting in greater volatility of earnings?