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Presentation Focuses on Swaps and the CEA Derivatives Regulatory Framework

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Presentation Focuses on Swaps and the CEA Derivatives Regulatory Framework Agenda Overview of Regulatory Framework for Derivatives Overview of Trade Execution & On-Boarding Overview of Clearing and Protection of Customer Funds Clearing: When is it Required, What are the Choices and Who Gets to Make Them? Basic Credit Considerations for Swaps Potential Business Implications Counterparty Considerations 2 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 1 Chicago, IL 60654 • 312.832.4500 Part I Overview of Regulatory Framework for Derivatives: – Statutes & Regulators – Derivatives Products – Market Facilities – Market Participants 3 Statutes & Regulators Statute: Commodity Exchange Act (CEA): – Derivatives covered: futures / options on futures, commodity options,** security futures /options on security futures,* swaps, mixed swaps,* retail forex, retail commodity, leverage, hybrid securities* / banking products (unless covered by exemption). – *Regulated jointly with SEC. **Commodity options now regulated as swaps. Regulators: – Primary Federal Agency: Commodity Futures Trading Commission (CFTC) – Prudential Regulators: Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration and Federal Housing Finance Agency. Regulate banks and other entities under their prudential regulation that are swap dealers, security- based swap dealers, major swap participants and major security-based swap participants in certain areas, e.g., margin for uncleared swaps and capital requirements. – Self-Regulatory Organizations (SROs): National Futures Association (NFA) Futures exchanges Clearinghouses 4 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 2 Chicago, IL 60654 • 312.832.4500 Statutes & Regulators Statutes: Securities Exchange Act of 1934 (Exchange Act) & other federal securities laws: – Derivatives covered: options on securities and securities indices, security futures and options on security futures,* security-based swaps, mixed swaps,* hybrid securities.** – * Regulated jointly with CFTC. ** Regulated jointly with CFTC unless covered by exemption from CEA, in which case regulated by SEC only. Regulators: – Primary Federal Agency: Securities and Exchange Commission (SEC) – Prudential Regulators: Same as under CEA. Regulate banks and other entities under their prudential regulation that are swap dealers, security- based swap dealers, major swap participants and major security-based swap participants in certain areas, e.g., margin for uncleared swaps and capital requirements. – Self-Regulatory Organizations (SROs): Financial Industry Regulatory Authority (FINRA) National securities exchanges Clearing agencies 5 The Wall Street Transparency and Accountability Act Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Amended CEA and Exchange Act to provide for comprehensive regulation of over-the- counter (OTC) derivatives, i.e., swaps and security-based swaps. CFTC regulates swaps, such as: – Interest rates, foreign currencies and swaps on a broad-based index of securities, including credit default swaps (CDS) on a broad-based index of reference obligations or issuers (> 9 plus other conditions); and – Swaps on physical commodities. SEC regulates security-based swaps, i.e., swaps on an individual security or narrow- based index of securities, such as: – Single-name CDS and CDS on a narrow-index of reference obligations or issuers (≤ 9 plus other conditions). CFTC and SEC jointly regulate mixed swaps, i.e., security-based swaps with a “commodity” component. This presentation focuses on swaps and the CEA derivatives regulatory framework. 6 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 3 Chicago, IL 60654 • 312.832.4500 CEA Derivatives Classifications Corresponding to Differences in Regulation Futures on commodities and options on futures (collectively, futures) – Futures are “contracts of sale of a commodity for future delivery,” but deferred delivery commercial merchandizing contracts are excluded. – Commodity is broadly defined. – Exchange-trading requirement; trades must be cleared. Swaps and mixed swaps – Broad definition of swap. – Shorthand for derivatives commonly traded on a bi-lateral, OTC basis. Options on commodities – Subject to CFTC plenary authority to regulate. – Covered by swap definition; CFTC will regulate as swaps, but exempts trade options from almost all swaps regulation. Other: Retail forex (e.g., rolling spot), retail commodity, leverage contracts, hybrid securities, security futures and options on security futures. 7 Market Facilities: Trading Futures exchanges, called designated contract markets (DCMs) – Centralized, competitive auction markets; limited trading off facility pursuant to trade rules. – May list futures and swaps; all trades must be cleared. – Examples: Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange, ICE Futures U.S. – No requirement that participants be eligible contract participants. Swap execution facilities (SEFs) – May only list swaps. – Platforms for displaying trading interest; function is to provide price transparency. – No centralized competitive market requirements. – Participants must be eligible contract participants. OTC trading of swaps will also still continue; futures must be traded on or pursuant to the rules of a futures exchange. 8 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 4 Chicago, IL 60654 • 312.832.4500 Market Facilities: Clearing and Swaps Trade Reporting Clearing: – Clearinghouses, called derivatives clearing organizations (DCOs) May clear futures and swaps. General regulatory requirements the same for futures and swaps, but with some important differences. – A clearinghouse may also clear swaps pursuant to CFTC exemption from DCO registration. – Examples: Chicago Mercantile Exchange (CME), London Clearing House (LCH), ICE Clear U.S. and ICE Clear Credit. Swap Trade Reporting: – Swap Data Repositories (SDRs). – CFTC, if no SDR exists to accept reports of trades for a type of swap. 9 Market Professionals CEA Baseline Registration Categories Futures Commission Merchant (FCM) – – Executes and/or clears transactions in futures and/or swaps. – May carry customer accounts; may receive and hold customer funds. – Carrying v. non-carrying; clearing v. non-clearing. Introducing Broker (IB) – – May solicit customers/orders for futures and/or swaps but may not carry customer accounts or hold customer funds. – Introduces customers to one or more FCMs. Commodity Trading Advisor (CTA) – – Trading advisor for futures and/or swaps. Commodity Pool Operator (CPO) – – Operator of a pooled investment vehicle that trades futures and/or swaps. 10 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 5 Chicago, IL 60654 • 312.832.4500 Market Professionals New CEA Registration Categories - Swap Dealers CEA and CFTC Rule 1.3(ggg) baseline definition includes 4 separate subjective tests. A Swap Dealer is a person that: – holds itself out as a dealer in swaps; or – makes a market in swaps; or – regularly enters into swaps for its own account in the ordinary course of business; or – engages in activities causing the person to be commonly known as a dealer or market maker in swaps. Definition excludes a person that enters into swaps but not as part of a regular business. CFTC adopting release provides interpretive guidance. CFTC definition includes bright line exclusions of certain transactions from analysis, e.g., transactions between majority-owned affiliates and physical hedge transactions. – Trade options also excluded from the analysis by operation of the trade option exemption. 11 Market Professionals New CEA Registration Categories - Swap Dealers De minimis exclusion is available if: – Over the prior 12 months (rolling basis),* – The person’s transactions constituting swap dealing and/or those of its control affiliates, – Do not exceed $8B ($25M in trades with special entities) in aggregate gross notional amount (calculated taking into account any leverage features under the terms of a trade). *De minimis exclusion provides a reset opportunity because counting of positions starts on the effective date of the swap definition rule (once adopted). – Effective date of swap definition rule is expected to be 60 days after publication in the Federal Register. – Exclusion effectively postpones the deadline for filing a swap dealer registration application since that deadline is the effective date of the swap definition rule. But a swap counterparty should assess its status using historical data to identify if it could, absent prospective changes to its swaps trading, be deemed a dealer and outside the de minimis exclusion. If initially not a swap dealer, a counterparty has an ongoing obligation to monitor swap trading activities to determine if it has moved into the definition. 12 ©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • 321 N. Clark Street, Suite 2800, 6 Chicago, IL 60654 • 312.832.4500 Market Professionals New CEA Registration Categories – Major Swap Participants Swap Dealers are excluded from the definition.
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