Derivatives Before and After Dodd-Frank March 23, 2011

Leigh R. Fraser Ropes & Gray LLP (617) 951-7485 [email protected]

ROPES & GRAY LLP Overview

1. How derivatives work now 2. Current risks of derivatives trading 3. How Dodd-Frank will affect how derivatives work 4. How Dodd-Frank will affect risks of derivatives trading

2 ROPES & GRAY How Derivatives Work Now: General

Total Return Swap:

Short-term rate (together with any decrease in value of 100 shares of Google) ------> Fund Dealer <------(Any increase in value of 100 shares of Google)

• Fund pays short-term floating rate to Dealer (say, LIBOR + 0.25%). • Dealer pays Fund any increase in the value of 100 shares of Google. • Fund pays Dealer the amount of any decrease in the value of 100 shares of Google. • Payments are made on a periodic basis (typically monthly).

3 ROPES & GRAY How Derivatives Work Now: Documentation

• Over-the-counter arrangement between two parties; trades typically entered into by phone. • Typically governed by ISDA Master Agreement, which treats all OTC derivatives between the parties as one arrangement, allowing netting and setoff. • Both parties have the right to terminate all trades between them upon an insolvency or default of the other party and calculate an overall net amount owed by one party to the other based on the then current value of the derivatives under the agreement. • In an insolvency, Fund treated as a general unsecured creditor of the dealer for any amounts owed by the dealer that cannot be satisfied by collateral posted by the dealer.

4 ROPES & GRAY How Derivatives Work Now: Collateral Calculation

ISDA Credit Support Annex provides for two types of collateral: – Mark-to-market collateral – Independent Amounts

5 ROPES & GRAY How Derivatives Work Now: Mark-to-Market Collateral

• General rule: on any business day, either party can ask the other party to transfer to it the amount that would be payable to such party if all transactions under the ISDA Master Agreement were terminated on that day. • In our example above, if the value of Google stock increases, the dealer owes the fund collateral. If the value of Google stock decreases, the fund owes the dealer collateral. • Mark-to-market collateral calculated on an overall net basis, not transaction-by-transaction.

6 ROPES & GRAY How Derivatives Work Now: Independent Amounts

• Independent amounts are similar to initial margin. • Additional cushion of collateral demanded by dealer to cover for time between margin transfers. • Typically determined on a transaction by transaction basis and established on trade date. • Funds typically provide Independent Amounts to dealers; dealers do not provide them to funds.

7 ROPES & GRAY How Derivatives Work Now: Where Collateral is Held

• Section 17(f) of the 1940 Act provides that the investments of a registered investment company must be held by a bank, subject to certain exceptions. • Generally, this means that collateral posted by a mutual fund to a counterparty under the Credit Support Annex cannot be transferred to the counterparty. • Instead, collateral is placed in a segregated account at the fund’s custodian and the counterparty is given a security interest in the account. • Collateral is therefore segregated from other assets.

8 ROPES & GRAY Current Risks of Derivatives Trading: Credit Risk

• Credit risk is greatly reduced by: – Receiving mark-to-market collateral from dealers – Collateral being held in triparty account • Credit risk arises from: – Failure to call for collateral from dealers; – Thresholds and Minimum Transfer Amounts that limit ability to call for full mark-to-market collateral; – Large movements in value of transactions before insolvency; and – Inability to direct custodian to release assets from triparty account

9 ROPES & GRAY Current Risks of Derivatives Trading: Other Risks

• Leverage Risk: – Derivatives are often economically similar to borrowings • Liquidity Risk: – Typically, derivatives can only be terminated or assigned with the consent of the dealer • Valuation Risk: – Derivatives are typically valued based on broker quotations

10 ROPES & GRAY Current Risks of Derivatives Trading: Other Risks

• Termination Risk: – Dealer can typically terminate all of the fund’s transactions with that dealer if the fund’s NAV declines by a certain amount over a certain time period – While trades are terminated at then current market value, pricing can be punitive • Documentation Risk: – Dealer, as Calculation Agent, typically has broad discretion to calculate payments and make adjustments – Terms of trade can be complicated and subject to dispute between the parties

11 ROPES & GRAY Dodd-Frank: Timing

DATE MILESTONE

July 21, 2010 Enactment of Dodd-Frank Act

July 16, 2011 General effective date for derivatives provisions of Act September 13, 2011 Effective date for most regulations

• We expect a gradual phase-in of requirements starting in September, not a “big bang.”

12 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

• CFTC/SEC will review each swap or category of swap on an ongoing basis to determine what should be cleared • Derivatives clearing organizations (DCOs) must submit to the CFTC/SEC each swap they intend to clear, for determination whether they should be cleared • Lists may be inconsistent

13 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

• Limited exemption for end users who are using swaps to hedge or mitigate commercial risk (does not include financial entities) • Swaps entered into prior to effective date of clearing requirement (July 16, 2011) do not need to be cleared, as long as they are reported • Credit default index swaps (CDX), highly liquid single name credit default swaps, and plain vanilla interest rate swaps are likely to be required to be cleared first

14 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: How Clearing Works

15 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

Segregation of Collateral for Cleared Swaps • Under futures contracts, customers are currently subject to “fellow customer risk” – If a customer of a futures commission merchant (“FCM”) defaults, and the FCM does not make the clearinghouse whole, margin provided by other customers of the FCM can be used to meet the FCM’s obligations to the clearinghouse • Has been substantial buy-side resistance to having this same model apply to cleared swaps because: – This model provides less protection of initial margin than under triparty custodial accounts, the method currently used by registered investment companies for over-the-counter derivatives; – It is impossible to hedge against (or manage) fellow customer risk, since you do not know the identity of the other customers of your FCM.

16 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

• CFTC has issued an advance notice of proposed rulemaking asking for comments on four possible approaches for segregation of collateral for cleared derivatives: - Current futures model; - Current futures model, but fellow customer margin at risk only after the guaranty fund of the clearinghouse has been used and exhausted; - Collateral still commingled in omnibus account, but attributed to individual clients; or - Full segregation of collateral at all levels.

17 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

• Clearing is likely to lead to higher margin requirements and higher costs • Use of clearinghouse spreads credit risk (however, creates fellow customer risk) • If the dealer defaults, clearinghouse will either (i) transfer positions to another dealer; or (ii) liquidate positions – Ability of Funds to exercise remedies will be limited

18 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Clearing

• A substantial portion of derivatives are likely to remain uncleared (although more and more are likely to be cleared over time) • Uncleared derivatives will continue to work as they do currently, except: – Higher costs – Higher margin requirements – Will be subject to reporting requirements – Will be subject to recordkeeping requirements

19 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Trading

• Swaps subject to the clearing requirement must be executed on an exchange or a swap execution facility, unless no exchange or swap execution facility trades the swap • A “swap execution facility” is a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system: – Order book system. – Request for quote system: CFTC proposed rule requires that the request be submitted to at least 5 dealers.

20 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Margin

• At a minimum, will need to comply with the margin requirements of the clearinghouse for cleared swaps • CFTC/SEC/Fed will establish minimum capital requirements, and minimum initial and variation margin requirements for uncleared swaps (for swap dealers and major swap participants) • Potential impact of high margin requirements for uncleared swaps: clearing of swaps that are not required to be cleared • Applicability of margin requirements to swaps entered into prior to effective date remains unclear

21 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Reporting

• Uncleared swaps need to be reported to a swap repository or the CFTC/SEC • If one party to the swap is a dealer, the dealer reports (however, if only one party is a US person, that party reports) • Swap repository makes information available to the regulators on a confidential basis • Swap data (without identifying parties) will be made available to the public on a real time basis.

22 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Registration as Major Swap Participant

• Impact of Being a Major Swap Participant: – Required to register with CFTC/SEC – Must comply with minimum capital and initial and variation margin requirements (not yet defined) – Must file reports regarding transactions and financial position – Must maintain daily trading records of swaps and related communications – Must comply with business conduct standards The thresholds for registration have been set quite high. We expect that few, if any, funds will be required to register.

23 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Effect on Derivatives Counterparties

• Dodd-Frank contains other provisions that are expected to impact the derivatives business of funds’ typical counterparties: – Swaps Push Out Rule: • Deposit-taking banks can continue to house swap desks that engage in hedging transactions, swaps involving interest rates or currencies, swaps involving certain hard commodities (gold, silver, other forms of bullion) and cleared CDS. • Other swap activities (such as equity swaps, commodity swaps, and non- cleared CDS) must move to a non-bank affiliate. – Volcker Rule: Limits proprietary trading of swaps by banks and affiliates. Exceptions for: • Risk-mitigating hedging activities; and • Trading activity in connection with underwriting and market-making reasonably expected to meet the near term demands of clients, customers, or counterparties.

24 ROPES & GRAY How Dodd-Frank Will Affect How Derivatives Work: Effect on Derivatives Counterparties

– FDIC Special Resolution Authority • Could apply to any financial institution • Required to wait one business day before closing out contracts • During that day, FDIC can transfer positions to another entity, including a bridge financial institution

• What this means for funds: – Counterparties could be less creditworthy – Could have trades with a several affiliates, with no ability to net or set off exposures

25 ROPES & GRAY How Dodd-Frank Will Affect Risks of Derivatives Trading: Credit Risk

• Use of clearinghouse generally seen to mitigate credit risk • However: – Fellow customer risk (as opposed to segregated account at custodian) – Credit risk focused in clearing member(s) – Funds will have less control if a dealer becomes insolvent; clearinghouse exercises remedies – Counterparties could be less creditworthy – May not be able to net and set off exposures among dealer affiliates

26 ROPES & GRAY How Dodd-Frank Will Affect Risks of Derivatives Trading: Leverage Risk and Liquidity Risk

• Leverage risk – May be reduced due to higher margin requirements • Liquidity risk – May be reduced for cleared trades: • Fund is likely to have the right to transfer position to another clearing member or close out trade

27 ROPES & GRAY How Dodd-Frank Will Affect Risks of Derivatives Trading: Valuation Risk and Termination Risk

• Valuation Risk – Likely to be reduced due to public reporting of derivatives trades and use of swap execution facilities • Termination Risk – Likely to be increased: • Dealer will typically have the right to close out cleared trades at any time • Documentation for cleared derivatives generally gives dealer broader rights to call event of default than under current ISDA documentation

28 ROPES & GRAY How Dodd-Frank Will Affect Risks of Derivatives Trading: Documentation Risk

• Documentation Risk – Documents governing trades are likely to be less favorable to funds than current ISDA documents: • For example, default remedies – Trading documents may become more standardized, which could minimize risk of disputes

29 ROPES & GRAY How Dodd-Frank will Affect Risks of Derivatives Trading: New Risks

• Regulatory Risks – Reporting requirements if counterparty is a non-US entity – Recordkeeping requirements • Increased costs and margin requirements • Certain types of derivatives may no longer be cost effective or available

30 ROPES & GRAY