Regulatory Practice Letter

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1 Financial Services Regulatory Practice Regulatory Practice Letter RPL Number ADVISORY Dodd-Frank Act: Regulation of Over-the-Counter Derivatives (Title VII) Executive Summary On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) was signed into law by U.S. President Barack Obama. The law touches on nearly every facet of the financial sector. Title VII of the Dodd-Frank Act, entitled the Wall Street Transparency and Accountability Act of 2010, establishes a new framework for regulatory and supervisory oversight of the over-the-counter ( OTC ) derivatives market, which is estimated at more than $600 trillion. In general, the new regulatory framework requires: The Commodity Futures Trading Commission ( CFTC ) and the Securities and Exchange Commission ( SEC ) to share regulatory and supervisory authority for OTC derivatives (i.e., swaps and security-based swaps, respectively hereinafter swaps ) and to participate jointly in the rule-making process. Mandatory clearing for swaps accepted by a clearing entity and designated by the CFTC and SEC as clearable. Mandatory execution of cleared swaps on a regulated exchange or swap execution facility ( SEF ). Mandatory reporting of cleared and uncleared swaps to a trade repository or the CFTC or SEC. Capital and margin requirements with higher requirements to be imposed on uncleared swaps. Prohibitions on certain swap activities for insured depository institutions. Public access to swap transaction volume and pricing data. The CFTC and SEC are required to promulgate final rules implementing the provisions of Title VII within 360 days of enactment. Background Historically, the OTC derivatives market has been largely unregulated, which critics say permitted significant risks to build within the financial services industry virtually unchecked. In the wake of the financial crisis in 2008, regulation of derivatives became a primary focus of financial regulatory reform. The areas of debate have centered on exclusions for certain Subject: Regulation of the Over-the-Counter Derivatives Market by the CFTC and SEC As Issued By: Title VII of the Dodd-Frank Act the Wall Street Transparency and Accountability Act Date: August 10, 2010 professionals, including more than 7,900 partners, in 146 countries. All rights reserved. Printed in the U.S.A.

2 2 Financial Services Regulatory Practice Letter #10-13 commercial end users, prohibitions on certain swap activities conducted by insured depository institutions and the inclusion of foreign exchange swaps. Description Highlights of the major provisions of Title VII are discussed below. Scope Virtually all derivatives market participants are impacted by the legislation, though the degree of impact depends on how an individual firm is classified. Different rules apply to different market participants: swap dealers, major swap participants and commercial end-users. A swap dealer is defined as any person who 1 Holds itself out as a dealer in swaps; 2 Makes a market in swaps; 3 Regularly engages in the purchase or sale of swaps in the ordinary course of business; or 4 Engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. A person may be designated as a swap dealer for a single type or single class or category of swap but not for other types, classes, or categories of swaps. A major swap participant ( MSP ) is defined as anyone that maintains a substantial net position in swaps (excluding positions held for hedging or mitigating commercial risk) or whose positions create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets. As with swap dealers, a person may be designated as an MSP for one or more categories of swaps without being classified as an MSP for all classes of swaps. Businesses that use derivatives to hedge commercial risk, generally risk from producing or consuming commodities, are deemed commercial end-users. As discussed below, commercial end-users would be exempt from the clearing requirement. The regulators have significant authority to determine if an end-user is an MSP. Entities that have a significant swap book and are not commercial hedgers, such as hedge funds, would likely be deemed MSPs. In addition, some large commercial producers, such as major oil producers, would likely be deemed MSPs. Role of Supervisors Under the new law, the Federal regulatory supervisors have expanded powers over the derivatives business. The law provides the CFTC and SEC with extensive new authority and imposes significant requirements on these agencies to regulate the OTC derivatives market, products and market participants. The regulatory agencies determine which market participants are subject to the legislation. Under Title VII, the CFTC has authority over swaps, swap dealers and major swap participants, swap data repositories, derivative clearing organizations with regard to swaps, persons associated with a swap dealer or major swap participant, eligible contract participants, and swap execution facilities. The SEC has authority over securitybased swaps, security-based swap dealers and major security-based swap participants, security-based swap data repositories, clearing agencies with regard to security-based swaps, persons associated with a securitybased swap dealer or major securitybased swap participant, eligible contract participants with regard to securitybased swaps, and security-based swap execution facilities. Title VII further requires the CFTC and SEC to engage in multiple rulemakings and other regulatory actions related to derivatives. In advance of rulemakings, the agencies are required to consult with one another and the Federal prudential regulators (the Federal Reserve Board ( Fed ), Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation ( FDIC ), Farm Credit Administration, and Federal Housing Finance Agency, as appropriate) to ensure consistency and comparability to the extent possible. Functionally or economically similar products or entities must be treated in a similar manner by each of the agencies. Where one agency believes the rules of the other may pose conflicts, they are permitted to challenge the rule in the U.S. Court of Appeals for the District of Columbia. The CFTC and SEC are required to jointly write rules, in consultation with the Fed, to address: Definitions for swap, securitybased swap, swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, eligible contract participant, and security-based swap agreement.

3 3 Financial Services Regulatory Practice Letter #10-13 Books and records to be maintained for security-based swap agreement by persons recognized as swap data repositories. Within 180 days of enactment, the CFTC and SEC are to adopt rules to mitigate conflicts of interest at clearinghouses, clearing agencies, exchanges, and swap execution facilities in regards to bank holding companies with total consolidated assets in excess of $50 billion, nonbank financial companies supervised by the Fed, and their affiliates. The rules adopted may include numerical limits on the control of, or the voting rights of, these entities. Title VII gives regulators the ability to limit swap positions held by a derivatives trader or class of traders. The CFTC imposes aggregate position limits for contracts traded on exchanges, swap execution facilities, non-u.s. boards of trades and swaps that are not centrally executed. The SEC would be given authority to impose position limits on security-based swaps, including aggregate position limits on security-based swaps and any underlying security or loan that the security-based swap references. The CFTC and the SEC have further authority to prohibit participation in swaps activity in a foreign country that undermines the stability of the US financial market system. In general, the rules required under Title VII must be promulgated in final form no more than 360 days after the date of enactment unless otherwise specified. (See CFTC/SEC Rulemaking Process ). Derivatives Market Structure Under the new law, banks can continue to trade most OTC derivatives in-house. Permissible swap and security-based swap transactions include interest rates, foreign exchange, cleared credit default swaps ( CDS ) on investment grade entities, gold and silver swap transactions, and swaps transactions that hedge a bank s own risk. However, under Section 716 the push-out provision swap dealers and MSPs are prohibited from receiving Federal assistance (including access to the Fed discount window and FDIC deposit insurance) if they conduct other types of swaps transactions within a depository banking institution. This effectively prohibits insured depository institutions from conducting certain derivatives activities and requires them to push-out the non-permissible swaps activities into a separately capitalized bank holding company affiliate. These non-permissible swaps activities include: all commodity, energy and metals, agriculture, CDS on non-investment grade entities, equities, and uncleared CDS. A transition period of up to 24 months is available to banks that are required to cease non-permissible swaps activities or divest themselves of their swaps activity in order to avoid the prohibition against Federal assistance. The appropriate Federal banking regulator shall consider the potential impact of divestiture or cessation of activities when establishing the transition period. An extension of up to one year may be added to the transition period following consultation with the CFTC and SEC. The prohibition against Federal assistance applies only to swaps entered into by an insured institution after the end of the transition period and the prohibition will be effective two years following the effective date of the legislation. Derivatives clearing organization, clearing agencies and swap execution facilities must register with the CFTC or SEC or both and meet certain requirements including, among other things, designating a chief compliance officer, adhering to core principals; and reporting requirements. The CFTC and SEC must issue rules no later than 1 year after enactment requiring swap dealers and MSPs to register with the CFTC or SEC or both. Registered swap dealers and MSPs are required to meet certain minimum capital and minimum initial and variation margin requirements as well as business conduct standards and reporting requirements. Clearing The legislation mandates clearing of standardized OTC derivatives. The law explicitly requires that swap dealers and MSPs use a clearinghouse for standardized or clearable derivatives transactions. Under the law, the CFTC and SEC are required to promulgate rules and regulations to provide for the mandatory clearing of such swaps. A swap that is accepted by a derivatives clearing organization ( DCO ) or clearing agency for clearing and that the CFTC or SEC has designated as clearable must be cleared. All swaps subject to the clearing requirement must be executed on a designated contract market, an swap execution facility or an exchange.

4 4 Financial Services Regulatory Practice Letter #10-13 Central clearing is initially limited to a few plain vanilla swap products. On an ongoing basis, regulators will review each swap, or any group, category, type, or class of swaps to make a determination as to whether the swap or group, category, type, or class of swaps should be required to be cleared. Foreign exchange swaps and forwards are treated as swaps under the law and therefore are subject to the clearing requirement, unless the U.S. Secretary of the Treasury determines otherwise. Note: Foreign exchange swaps and forwards were exempt from the clearing requirement in prior drafts of legislation. Exceptions to the clearing requirements are provided for: Commercial end-users, such as farmers, airlines and manufacturers, provided they explain to regulators how they are meeting their financial obligations with entering into uncleared swaps. Affiliates of commercial end users if the affiliate uses swaps to mitigate the commercial risk of the commercial entity or other affiliate that is not a financial entity. Except for affiliates that are swap dealers, MSPs, investment companies, commodity pools or bank holding companies with more than $50 billion in consolidated assets. A two-year transition applies. Swaps entered into before the date of enactment and swaps entered into before the application date of the clearing requirement, provided they are reported to a swap data repository or the CFTC or SEC, as appropriate. Certain depository institutions, farm credit institutions and credit unions with total assets of $10 billion or less (except for those whose primary business is to provide financing related to the activities of its parent or holding company affiliate) if determined by the CFTC and SEC to be exempt through a rulemaking. All uncleared swaps must be reported to the CFTC, SEC or a trade repository. DCO and clearing agency rules must prescribe that all swaps with the same terms and conditions are economically equivalent and may be offset with each other within the DCO or clearing agency. Clearinghouses cannot be forced to accept credit risk from other clearinghouses. Trading All swaps subject to the clearing requirement must be executed on a regulated exchange or a swap execution facility. A swap execution facility is defined as 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 It is unclear at this time exactly what constitutes, and what types of trading platforms may qualify as a swap execution facility. Section 619 under Title VI of the Dodd- Frank Act prohibits and limits the ability of banking entities from engaging in certain activities (the Volcker Rule ). These provisions include prohibitions on proprietary trading and investing more than 3 percent of the bank s Tier 1 capital in private equity and hedge funds, and from owning more than a 3 percent stake in any one private equity or hedge fund. The prohibitions on proprietary trading extend to certain derivatives trading activity. Systemically significant nonbank financial companies are not prohibited from engaging in proprietary trading. However, these companies are subject to additional capital requirements and quantitative limits determined by the regulators. Capital & Margining Requirements Under Title VII, swap dealers and MSPs are subject to capital and margin requirements. The law requires initial and variation margin (also referred to as collateral posting) for all OTC derivatives that are not cleared. Existing swaps are not specifically exempt from the margin requirement. Regulators are also likely to set minimum margin requirements for clearinghouses. Early versions of the legislation specifically exempted commercial endusers from margin requirements. This exemption is not in the enacted law, though the sponsoring legislators have indicated that their intent was to provide such an exemption. Section 171 under Title I of the Dodd- Frank Act (the Collins Amendment ) requires Federal banking agencies to set leverage and risk-based capital requirements for insured depositories, depository holding companies and systemically significant non-banks. Such requirements must at a minimum address such risks as significant volumes of derivatives activity or activity in securitized products, financial guarantees and certain other financial instruments, as well concentrations in assets or market share. Presumably, capital requirements developed by

5 5 Financial Services Regulatory Practice Letter #10-13 supervisors for depositary institutions will be consistent with the soon-to-berevised Basel Capital guidelines. Reporting & Recordkeeping Under Title VII, all swap dealers and MSPs are required to maintain daily trading records of swaps. These daily records include recorded communications, such as electronic mail, instant messages and recordings of telephone calls; daily trading records for each customer or counterparty; and a complete audit trail for conducting comprehensive and accurate trade reconstructions. The law also requires data collection and publication through clearing houses or trade repositories. For example, each DCO is specifically required to publicly disclose: The terms and conditions of each contract, agreement or transaction cleared and settled; Clearing and other fees charged members; Its margin setting methodology; and Daily settlement prices, volume and open interest for each contract settled or cleared. Repositories have already been launched for credit and interest rate products and the industry is in the process of building a repository for equity derivatives. All trades that are cleared and uncleared will be recorded in these repositories. Transition rules provide that swaps entered into prior to the enactment date that are still outstanding as of the enactment date must be reported to a swap data repository or the CFTC or SEC, as appropriate. Similarly, swaps entered into after the enactment date and prior to the effective date will also be required to be reported. The CFTC and the SEC are required to issue an interim final rule regarding these reporting requirements within 90 days after enactment. CFTC/SEC Rulemaking Process While the Dodd-Frank Act establishes the broad outline of OTC derivatives market regulation, many questions about its impact and scope remain unanswered and are left to the CFTC and SEC to determine. These agencies are required to promulgate final rules no later than 360 days following enactment. In advance of the official rule-writing process, the CFTC has identified 30 topics where rule-writing is necessary to regulate the swaps markets. The rule-writing areas have been divided into eight groups: Comprehensive Regulation of Swap Dealers & Major Swap Participants; Clearing; Trading; Data; Particular Products; Enforcement; Position Limits; and Other Titles. The CFTC indicates that teams of staff within the agency have been assigned to each rule-writing area and will be involved with the process from analyzing the statute s requirements, to broad consultation, to recommending proposed rulemakings to publishing final rules. The CFTC is currently soliciting public input on each of the areas. Comments may be submitted through the CFTC web site and will not be considered official responses to a specific rulemaking. Similarly, the SEC has also identified broad areas for which it is seeking public input in advance of rule-writing. With regard to Title VII, these areas include: Definitions (e.g., swap, securitybased swap and mixed swap ); Security-based swap dealers and major security-based swap participants; Mandatory clearing of securitybased swaps, end-user exception and security-based swap clearing agencies; Mandatory exchange trading and swap execution facilities; Governance and conflict of interest controls for clearing agencies, swap execution facilities and exchanges; Swap data repositories; Real-time reporting; and Anti-manipulation protections. KPMG Commentary Key provisions of Title VII including clearing, trading, capital, margining, reporting and recordkeeping requirements -- are likely to fundamentally alter the OTC derivatives market. As stated earlier, virtually all derivatives market participants are impacted by the legislation, though the degree of impact will depend on how an individual firm is classified: swap dealer, major swap participant or commercial end-user. Some potential key strategic impacts to consider for each of these classifications include: Dealers Increased transparency from the exchange trading/swap execution facility requirement could reduce dealer profits but could also impact

6 6 Financial Services Regulatory Practice Letter #10-13 availability and liquidity for certain bespoke and non-standardized contracts. New entrants may try to capture a piece of the derivatives business that becomes more standardized and exchange traded. Increased regulation, potentially decreased profits and the prospects of increased competition from new market entrants may further alter the dealer landscape. Margining and other requirements could raise the cost of certain swap transactions. Swap dealers will almost certainly need more capital to support their derivatives businesses. The structure of major dealers swaps businesses may change. Dealers may look to optimize where they book derivatives within their organizational structures and global office networks. New corporate governance structures will be required to oversee the derivatives businesses in the new entities created for activity pushed out of the banking entity. MSPs MSPs face many of the same requirements as dealers. Some MSPs may decide to shrink their businesses to avoid dealing with MSP requirements. Others will see opportunities to expand into an area previously dominated by a handful of dealers. In either event, MSPs will need to review their derivatives governance, activities, operational support and related areas to ensure they are structured and functioning within appropriate guidelines. Commercial End-Users As dealers pass on increased costs to end-users, and as end-users grapple with a more complicated regulatory environment, the appetite for using OTC derivatives may decrease. On the other side of the coin: greater transparency may narrow spreads and reduce costs, leading to increased volume and usage for certain products (which is generally what occurred after US futures exchanges went electronic). While the intent of Congress is to exclude commercial end-users from capital and margining requirements, regulatory rulemaking to that effect may need to be promulgated. More Clearing Ahead For the past several years, derivatives dealers have made substantial investments of time and resources to increase their ability to centrally clear derivatives transactions. Today, for example: Approximately $10 trillion of CDS trades and over $210 trillion of IRS (interest rate swaps) have been cleared through CCPs (central counterparties). Most of the cleared CDS volume is index transactions. These are the most commoditized, standardized types of trades. (Sources: ICE Trust, LCH.Clearnet) Portfolio compression has enabled firms to significantly reduce the level of notional outstanding by approximately $100 trillion, of which $68 trillion is CDS. (Source: TriOptima) As the new law requires standardized swaps to be cleared, industry participants will look to further increase their commitment to and investment in clearing: If current trends continue, some market participants believe the volume of cleared OTC derivatives transactions could double in the next two or three years. Progress will be faster in some areas the most liquid, standard products than in others. (Source: ISDA) Although estimates vary, the chief executive of one of the largest financial institutions and swap dealers in the U.S. has publicly testified that as much as 75 to 80 percent of the OTC derivatives marketplace is standard enough to be centrally cleared. (Source: Time Magazine, July 1, 2010) In March 2010, the International Swaps and Derivatives Association ( ISDA ) submitted a letter with market participants and industry associations to global supervisors stating that more than 90 percent of new dealer-to-dealer volume of clearing-eligible IRS is now cleared and more than 90 percent of total dealer-to-dealer volume of clearingeligible CDS is now cleared. (Source: ISDA) Regulatory Rulemaking The regulatory rulemaking process is likely to be a lengthy affair that reflects the need for a significant increase in regulatory resources, as well as the number and complexity of the issues to be addressed. Some key questions yet to be answered are: Clearing: How will the CFTC and the SEC determine which swaps must be cleared? Margining requirements: How will margining requirements be set for cleared and uncleared trades? Will end-users be exempt from margin

7 7 Financial Services Regulatory Practice Letter #10-13 requirements? If not, what will be the impact? Capital requirements: How will capital requirements for dealers and major swap participants be determined? What is the process for achieving consistency amongst US Federal supervisors (and the Basel Committee) on capital requirements? Trading practices: How will the process for developing and launching new swap products change under the new law? How will the supervisors determine aggregate position limits? Reporting and recordkeeping: How will the trade reporting process work for cleared and uncleared trades? What additional information will be required to be disclosed? For additional information, please contact Howard Margolin, Partner: (Financial Services Advisory); or Doug Henderson, Managing Director: (Securities Regulation).

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