Futurization Or Swapification: Developments, Trends and Predictions

2nd National Advanced Summit on Reform, Regulation, and Enforcement of Derivative Transactions January 14-15, 2014

Futurization or Swapification: Developments, Trends and Predictions

Ronald S. Oppenheimer Daniel Waldman Mark D. Young Senior Vice President and Partner Partner General Counsel Arnold & Porter L.L.P. Skadden, Arps, Slate, Vitol Inc. Meagher & Flom L.L.P.

Tweeting about this conference? #ACIDerivatives Futurization or Swapification:

• Is the Dodd-Frank Act’s derivatives reform and so-called “futurization” simply a return to the basic principles that governed derivatives regulation before the development of the swaps market? • Does it make sense to establish two, not- quite-parallel trading regimes for identical instruments that are simply labeled differently? 2

#ACIDerivatives The Early History of Derivatives

• Derivatives first emerged in the late 19th century on commodity exchanges as an outgrowth of forward contracting. • The earliest futures exchanges, the Chicago Board of Trade, the Kansas City Board of Trade, the New York Cotton Exchange, the Minneapolis Grain Exchange and others offered standardized and fungible forward contracts that could be easily offset and proved well-suited to hedging or speculating on commodity price risk. 3

#ACIDerivatives Early History cont.

• The trading of these forward contracts among Exchange members grew enormously both at CBOT and other commodities exchanges. • The introduction of exchange clearing to reduce counterparty risk further fueled this growth. • From 1884-88, 23.6 million bushels of grain were traded on the CBOT alone, many times more that the total amount of grain produced in the US during this period. 4

#ACIDerivatives Early History cont.

• Small businesses, called bucket shops, also arose that allowed the public to bet on commodity prices. • These bucket shops would use prices from the exchanges or come up with their own prices, i.e. bucket the trade with the customer directly. (Like a bookie). • If the bucket shop’s trades were not well balanced on the long and short side, the bucket shop could lose big and go out of business, leaving the customers with profitable trades out of luck. 5

#ACIDerivatives Early History cont.

• At the time, most state laws did not explicitly recognize futures trading. • A contract for future delivery was only enforceable when the parties intended to make delivery of the underlying. See Irwin v. Willar, 110 U.S. 499 (1884) • As the Harvard Law Review wrote in the 1920s: “A contract to sell for future delivery is invalid at common law if the parties intend instead of actual delivery a settlement of differences at the time the transaction is closed.” Note, “Dealings in Futures”, Harvard Law Review, vol. 40 (1926-27), p. 638. 6

#ACIDerivatives Early History cont.

• Despite the legal uncertainty, commodities exchanges offering standardized futures contracts and centralized clearing grew and flourished in the late 19th and early 20th centuries. • Pressure on Congress from agrarian interests to deal with the perceived ills of commodities speculation however also grew—especially with the sharp decline in commodity prices after the end of WWI. 7

#ACIDerivatives Grain Futures Act of 1922

• In 1922, Congress passed the Grain Futures Act, the predecessor to the Commodity Exchange Act. • The Act authorized the Secretary of Agriculture to designate exchanges that meet certain regulatory conditions as “contract markets”. • The Act also banned futures trading that was not conducted on these designated

contract markets. 8

#ACIDerivatives Contract Market Monopoly

• This contract market monopoly became the central principle of derivatives regulation for over 60 years. • Federal law required that all futures contracts must be traded on designated contract markets. • These markets would be fully regulated to ensure their financial integrity and the integrity of the price discovery process. • All persons who deal with futures customers (either who solicit them to trade, advise them about trading and/or 9 who hold their money for trading) would also be regulated.

#ACIDerivatives Contract Market Monopoly cont.

• Section 4(a) of the CEA states: “It shall be unlawful for any person . . . to enter into . . . a contract for the purchase or sale of a commodity for future delivery . . . unless- • (1) such transaction is conducted on or subject to the rules of a board of trade which has been designated by the Commission as a ‘contract market’. 7 USC Section 6(a).

#ACIDerivatives Contract Market Monopoly cont.

• The contract market monopoly--the notion that derivatives can only be safely and legally traded on a centralized futures exchange-- is not the only, or even the most obvious, regulatory model. • See securities. • Was the contract market monopoly the product of anti-competitive exchange lobbying? • A reaction to the weaknesses of the bucket shop business model? 11

#ACIDerivatives Contract Market Monopoly cont.

• The CFTC justified the requirement that all derivatives trading must occur on regulated exchanges as follows: • “Such markets provide safeguards to participants in futures and commodity option transactions, including open competitive trading, public price dissemination and protection against counterparty credit risk, that are not generally available other than on exchange markets.” 52 Fed. Reg. 47022 (December 11, 1987) • In other words, futures exchanges provide centralized clearing, price transparency and open and competitive execution not typically available with off-exchange products. 12

#ACIDerivatives Contract Market Monopoly Erodes

• By the late 1980s, the principle that derivatives should only trade on regulated exchanges comes under attack. • Trade Options (17 CFR Part 32) • Purchaser must be a commercial user. • Hybrid transactions (17 CFR Part 34) • Debt, preferred equity or depository instrument with a commodity dependent payment.

• Swaps (17 CFR Part 35) 13

#ACIDerivatives Swap Policy Statement

• 1989 Swap Policy Statement (54 Fed. Reg. 30694 (July 21, 1989) • Swaps although possessing elements of futures and options are not appropriately regulated as such. • Safe Harbor if: • 1. Individually tailored terms individualized credit determinations, privately negotiated as to material terms (intending to preclude fungible, readily transferred and traded instruments). • 2. Absence of exchange style offset (close out or assignment only with consent of counterparty). • 3. Absence of clearinghouse or margin system. • Additional requirements: • Transaction undertaken in conjunction with line of business (precludes public involvement). • Not marketed to the public. 14

#ACIDerivatives Futures Trading Practice Act of 1992

• Congress grants the CFTC authority to exempt OTC derivatives and other transactions from CFTC regulation. • Section 4(c) provides: “In order to promote responsible economic or financial innovation and fair competition, the Commission . . . may . . . exempt any agreement, contract or transaction . . . from any . . . provision of the [CEA].” • The CFTC’s authority to grant exemptions extends to on exchange transactions. 15

#ACIDerivatives 1993 Swaps Exemption (17 CFR Part 35)

• CFTC grants swap exemption (without determining whether swaps are futures or options). • Exemption criteria • Participation limited to eligible swap participants (institutions and wealthy individuals). • Non-fungible contracts, i.e., cannot be standardized as to their material economic terms. • Creditworthiness must be a material consideration in determining the terms of the swap (no clearinghouse). • May not be executed on a transaction facility. 16

#ACIDerivatives Commodity Futures Modernization Act of 2000

• In the late 90s, the CFTC questions the Swap Exemption and Swap Policy Statement. See OTC Derivatives Concept Release, 63 Fed. Reg. 26114 (May 12, 1998) • Congress responds to the perceived legal uncertainty by passing the Commodity Futures Modernization Act (CFMA). • The CFMA creates a statutory exemption for most off-exchange derivative instruments. 17 #ACIDerivatives “Back to the Future” for Derivatives Regulation • The recent financial crisis caused Congress to return to the original principles of futures regulation. • Key assumption: derivatives can most safely and efficiently be traded when offered on regulated exchanges with centralized clearing. • Dodd-Frank Act eliminates the exemption from regulation for OTC derivatives and seeks to force off exchange swaps back on to multilateral exchanges with regulated clearinghouses. See CEA, Sect. 2(h) 18

#ACIDerivatives The Dodd-Frank Act

• Clearing, pre and post trade transparency, open and competitive execution—all hallmarks of futures trading—are required for most swaps, particularly the most liquid, standardized products. • Comprehensive regulation of all intermediaries who deal with derivatives customers—another key element of futures regulation- has also been introduced. 19

#ACIDerivatives The Business Evolution - Energy

• NYMEX had a monopoly on energy contracts through the 1980s and 1990s. • OTC transactions began to proliferate, serving three principal purposes: • Allowing parties to hedge non-standardized risks; • Allowing for bespoke financial terms – credit and margin; and • “Securitizing” commodity returns. • ICE began to gain prominence in the very late 1990s and beginning of 2000s, principally in matching OTC transactions. • CFMA and Enron collapse create a perfect storm: • Less regulation; and • A need for clearing. 20

#ACIDerivatives The Business Evolution - Energy

• ICE begins to “clear swaps” through LCH. • NYMEX develops ClearPort, an avenue to clear lesser liquid contracts (that are executed as swaps), using the EFS. • Both systems enjoyed enormous success. 21

#ACIDerivatives The Dodd-Frank Act

• The Dodd-Frank Act injected (again) substantial uncertainty into the energy markets • What constituted “market making” or “facilitating or accommodating” in ICE or ClearPort contracts? • Would margin requirements differ? • How would swaps be brokered? • How would SEF regulation differ from DCM regulation?

#ACIDerivatives Swaps to Futures

• On July 30, 2012, ICE announced that it would transition all of its OTC products to futures, to be cleared at ICE Clear Europe. Execution was ultimately divided between ICE Futures US (natural gas, power and environmental products) and ICE Futures Europe (petroleum products, NGLs, freight and coal). • On September 4, 2012, ICE announced that it was accelerating the transition to the weekend of October 13-14, 2012. (The definition of swap was scheduled to take effect on October 12, 23 2012).

#ACIDerivatives Swaps to Futures (cont’d)

• On September 24, 2012, CME announced that it was introducing three new features to its energy markets: • Adding more contracts for execution on GLOBEX; • Establishing new (generally, lower) block thresholds; and • Submitting a rule filing to permit “9(B)(iii) trades.”

#ACIDerivatives Swaps to Futures (cont’d) • The transitions over the weekend of October 13-14, 2012 were virtually seamless. • The most difficult issues were: • Explaining to brokers/traders the differences between ICE and ClearPort models and between “cleared swaps” and EFSs; • Understanding the limitations on permissible voice broker communications and limitations on the use of block trade information; and • Monitoring speculative position limits for futures contracts that were formerly cleared swaps and were not previously subject to speculative position limits. 25

#ACIDerivatives The Death of the Contingent EFS/Futures Block Sizes • The contingent EFS was quickly replaced by the futures block transactions. • Concern over documentation, swap reporting/recordkeeping, and ultimately, the legitimacy of the EFS. • Favorable block sizes.

#ACIDerivatives The Result

• The best contract to exemplify the result is the ICE Henry Hub LD1 Natural Gas Futures Contract: • There were no changes to the terms and conditions of the contract when it went from being considered an OTC swap on Friday, October 12, 2012 to being considered a futures contract on Monday, October 15, 2012. • There were no changes to the clearing process, either, yet hundreds of thousands of contracts in open interest were moved. • In addition, significant volumes of open interest moved from a US market (ICE OTC) to a non-US market (ICE Futures Europe). 27

#ACIDerivatives So . . . Did Swaps Become Futures? • Before proceeding to an examination of where we’re heading, ask yourself: • Did swaps become futures, or were they futures all along, traded off of a DCM because the CFMA allowed it? • Are SEFs really necessary, or is trading a standardized, cleared instrument on a SEF actually “swapifying” a futures contract? • What are the consequences of trading standardized, cleared instruments under both the SEF and DCM regimes? • From a competition standpoint? • From a regulatory standpoint?

#ACIDerivatives A Few Things to Consider

• Execution Methodologies • CLOB and RFQ plus blocks. • CLOB plus blocks. • Margin requirements • And, the potential bifurcation of a user’s margin deposits. • Ongoing reporting obligations • ECP requirements

• Tax 29

#ACIDerivatives Where Are We Headed?

• An examination of present and potential future issues.

#ACIDerivatives Block Trading – Swaps vs. Futures • Swap blocks are exempt from real- time swap reporting; delay in reporting is allowed. Post-trade transparency considerations. • Futures blocks are executed off the CLOB and price reporting is delayed. Pre-trade and post-trade transparency considerations. 31

#ACIDerivatives Where’s Transparency?

• The word appears once in the CEA. • Only in the context of SEFs. • “The goal of this section is to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency in the swap market.” CEA Section 5h(e)(Rule of Construction) 32 #ACIDerivatives Block Trading for Swaps

• CFTC has promulgated rules prescribing block levels for swaps as Congress required. CEA Section 2(a)(13)(E). SEFs also must have block trade rules. CEA Section 5h(f)(2)(C). (Only statutory use of “block trades.”) • The CFTC’s rules address: • Appropriate block sizes (phased approach) • Real-time reporting time delays • Anonymity protections (cap size disseminated only) 33

#ACIDerivatives

Block Trading for Futures

• DCMs set block levels and other restrictions for futures. CFTC reviews (allows or approves) DCM rules. • Prices must be “fair and reasonable” • Parties must be ECPs • ICE Futures U.S. Rule 4.07; CME Rule 526 34

#ACIDerivatives CFTC Considering Proposals for Futures Blocks • Proposals had been expected in 2013. • Timing now uncertain. • What is the problem (if any) the CFTC is trying to solve with its proposal?

#ACIDerivatives The Death of the Contingent EFS?

#ACIDerivatives Contingent EFS Have Historically Been Widely Traded • Exchanges have historically permitted contingent or transitory exchanges of futures for swap transactions (“EFS”) in certain asset classes. • These transactions originate over-the-counter (typically through a voice broker) and result in each party obtaining a cleared futures position. • As a result of providing clearing for OTC transactions, contingent or transitory EFS have been an important mechanism for reducing counterparty credit risk in the derivatives markets for a decade. • The CFTC questioned these transactions because they lack comfort with an OTC execution resulting in a cleared 37 futures position. #ACIDerivatives CFTC Proposed Bans

• In 2004, the CFTC proposed rules that called into question the validity of some contingent or transitory EFS (and other exchange of futures for a related position transactions “EFRPs”). 69 Fed. Reg. 39880 (Jul. 1, 2004). • In 2008, the CFTC again proposed rules, this time explicitly restricting transitory EFRPs. 73 Fed. Reg. 54097 (Sep. 18, 2008). • In 2010, the CFTC again proposed rules, restricting transitory EFRPs and banning contingent EFRPs outright. 75 Fed. Reg. 80572 (Dec. 22, 2010). 38

#ACIDerivatives Schrodinger’s Cat: EFRP?

• The CFTC never finalized any rule banning contingent EFS. • Nevertheless, the Division of Enforcement has been investigating transitory or contingent EFS trading practices. • In response to the CFTC’s failure to clarify its swap rules and the investigations, CME has proposed eliminating contingent EFRPs for some commodities. • On November 1, 2013, CME filed a request for the CFTC to approve an amended CME Rule 538, which addresses exchange of futures for a related position transactions (“EFRPs”) generally. • Under proposed CME Rule 538, the exchange would eliminate the use of contingent EFRPs for metals and energy. 39

#ACIDerivatives Core Principle 9 Developments

#ACIDerivatives Commodity Exchange Act §5(d)(9) (9) EXECUTION OF TRANSACTIONS.— (A) IN GENERAL.—The board of trade shall provide a competitive, open, and efficient market and mechanism for executing transactions that protects the price discovery process of trading in the centralized market of the board of trade. (B) RULES.—The rules of the board of trade may authorize, for bona fide business purposes— (i) transfer trades or office trades; (ii) an exchange of— (I) futures in connection with a cash commodity transaction (II) futures for cash commodities; or (III) futures for swaps; or (iii) a futures commission merchant, acting as principal or agent, to enter into or confirm the execution of a contract for the purchase or sale of a commodity for future delivery if the contract is reported, recorded, or cleared in accordance with the rules of the contract market or 41 a derivatives clearing organization.

#ACIDerivatives CFTC’s Proposed Core Principle 9 Rules • Most trades in each contract type listed on a DCM must be traded on a CLOB. Proposed Rule 38.502(a). • Contracts not meeting an 85% CLOB threshold would have to be delisted, but could be traded as swaps on SEFs. Proposed Rule 38.502(c). • New requirements for futures block trades, including appropriate size, price, and reporting. Proposed Rule 38.503. • Requirements for EFRPs, including bona fide requirements and ban of contingent EFRPs. 42 Proposed Rule 38.505.

#ACIDerivatives

Remaining Core Principle 9 Issues • The CFTC’s Core Principle 9 rulemaking is not finalized. • Application of Core Principle 9 or similar requirements to SEFs appears unlikely:

The Commission notes that a DCM must operate as a trading facility and in conjunction with that trading facility is also permitted to utilize additional execution methods; however, those additional execution methods are limited by the requirements set forth in DCM Core Principle 9, for which there is no identical core principle for SEFs. 77 Fed. Reg. 33476, 33484 43 (Jun. 4, 2013).

#ACIDerivatives Conclusions?

• Are two, differently regulated trading paradigms for standardized, cleared derivatives really necessary or appropriate? • If not, how do we fix the problem? • What is the appropriate role for swaps in the new, post Dodd-Frank world? 44

#ACIDerivatives