Derivatives Clearing: What Does It Mean for Buy-Side Participants?

Transcription

1 Derivatives Clearing: What Does It Mean for Buy-Side Participants? January 16, 2013 Copyright 2013 Shearman & Sterling LLP. Shearman & Sterling LLP is a limited liability partnership organized under the laws of the State of Delaware, with an affiliated limited liability partnership organized for the practice of law in the United Kingdom and Italy and an affiliated partnership organized for the practice of law in Hong Kong.

2 Welcome and Introduction Donna M. Parisi Barnabas W.B. Reynolds

3 Our objectives for this conference session To give a brief overview of the key aspects of derivatives clearing for buy-side participants Assist buy-side participants in evaluating their various options for the new regulatory regime: Clearing houses, segregation options Regional issues and models Documentation Collateral structuring Interplay with AIFMD 3

4 What is Clearing? Source: ICE 4

5 Derivatives Regulation in the United States and Europe Dodd-Frank overhauls the regulation of derivative products and market participants Based upon 2009 G-20 Pittsburgh summit commitments Similar reforms being enacted by all G-20 nations US and EU regulators have made the most progress Key Features of Dodd-Frank Title VII: Regulation of derivatives by the CFTC and/or SEC Clearing and exchange trading of many derivatives Margin requirements for cleared and uncleared swaps Registration required for Swap Dealers and Major Swap Participants 5

6 Derivatives Regulation in the United States and Europe EU-based dealers already regulated; no harmonised perimeter. Overseas persons exclusion. MiFID2: entity doing retail business will have to establish separately capitalised EU branch. Not required for wholesale business in latest drafts Principal place of business test 6

7 US Clearing Basics: Mandatory Clearing Requirement Clearing Requirements CFTC / SEC will require certain types of swaps to be cleared and will have procedures to make such determinations If regulator requires clearing, a party to a swap must submit it for clearing to a clearing house End-User exception Limited to non-financial entities, meaning that most funds will not qualify for clearing exception Limited use of derivatives to hedge or mitigate commercial risk Requires entity claiming exception to notify CFTC how it will meet obligations associated with noncleared swaps For public companies, board of directors must approve use of exception 7

8 Clearing Basics: Elements of Central Clearing Elements of Central Clearing Central clearing involves submission of trades to a central counterparty ( CCP ) CCP will require that clearing members collect initial and variation margin from the parties Clearing members may set house margin requirements above CCP requirements Parties have credit exposure to CCP, not each other Margin collected by CCP from clearing members on a gross basis; clearing members will make margin calls on clients Initial margin used to establish position is retained by CCP Variation margin is passed through based on trade valuation Clearing members required to contribute to guaranty fund and are subject to certain financial resources requirements Portability of trades (both pre- and post-default) 8

9 Clearing Basics: Different Models for Client Clearing AGENCY MODEL Client faces CH with FCM A as its agent and guarantor & Dealer faces CH with FCM B as its agent and guarantor CH PRINCIPAL MODEL Client and Dealer enter into trade Trade replaced by two trades with CH; one between Client and CH and one between Dealer and CH CH FCM A FCM B Client Dealer Client Dealer 9

10 Clearing Basics: Indirect Clearing Indirect Clearing: Clearing Members could onboard Clients who offer clearing services to indirect clients Clearing House Clearing House EU Clearing Member FCM Clearing Member Client (may be an affiliate) Client (may be an affiliate, e.g. European affiliate) Indirect Client Indirect Client (note: no privity) 10

11 US Clearing Basics: Futures Commission Merchants Clearing Requirements Role of Futures Commission Merchants (FCMs) An entity that accepts a swap customer s margin for cleared swaps must be a registered FCM for a CFTC-regulated swap, or a registered broker-dealer or security-based swap dealer for a security-based swap In practice, clearing broker is likely to be joint broker-dealer/fcm to permit coverage of all products Requirement may cause additional complexities in cross-border context US customers clearing through a non-us clearinghouse Non-US customers clearing through a US clearinghouse Cross-border recognition of clearinghouses contemplated Lack of specific provisions for cross-border recognition of clearing intermediaries 11

12 US Mandatory Clearing Determination CFTC released its first Mandatory Clearing Determination on November 28, 2012, requiring mandatory clearing for certain classes of interest rate swaps and credit default swaps. IRS classes Fixed-to-floating swaps Basis swaps Forward rate agreements Overnight index swaps CDS classes USD-denominated untranched CDX.NA indices referencing North American corporate credits Euro-denominated untranched itraxx Europe indices referencing European corporate credits Implementation of the determination will be phased in by counterparty type, beginning on March 11, Temporary inter-affiliate no-action relief pending finalized rule on inter-affiliate exemption: Either one counterparty is the majority owner of the other counterparty, or a third party is the majority owner of both counterparties; The parties (and third-party majority owner, if applicable) report their financial statements for accounting purposes on a consolidated basis; and Both counterparties agree not to clear the swap. 12

13 Dodd-Frank Clearing Implementation Timeline Proposed Initial List of Swaps for Clearing Requirement Determination published on August 7 CFTC finalizes the initial list of swaps for mandatory clearing Category 1 entities to comply with mandatory clearing T* + 90 days Category 2 entities to comply with mandatory clearing T days Category 3 entities to comply with mandatory clearing T days 30 day public comment period closed on September August 7 Sept 6 Nov 28 Mar 11 Jun 10 Sep 9 Swap Dealers Commodity Pools 3 rd Party Sub-accounts Final Rule detailing implementation timelines for clearing mandate Major Swap Participants Active Funds Private Funds Entities predominantly engaged in banking or financial in nature Pension Funds All other end users (other than exempt non-financials) (Not 3 rd Party Sub- Accounts) 13

14 Clearing Obligation - EU EU Clearing Obligation Financial counterparties - Investment firms, banks, insurers, UCITs and their managers and funds managed by AIFMs Non-financial counterparties others; end user/hedging exemption (for transactions objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or its group) Derivatives designated for mandatory clearing, as declared by ESMA Pension funds delay until August 2015 Intragroup transactions exemption subject to notification 14

15 EMIR Clearing Implementation Timeline Date Requirement 16 August 2012 EMIR enters into force (NB various provisions will take effect upon publication of technical standards). All derivatives contracts entered into or outstanding as at this date will have to be reported once the reporting obligation takes effect 27 September 2012 ESMA publishes final report on draft technical standards 19 December 2012 European Commission endorses ESMA technical standards February-September 2013 Existing CCPs to apply for authorisation within 6 months of the entry into force of the relevant technical standards 19 July 2013 All derivatives contracts entered into or outstanding as at 16 August 2012 will have to be reported from this date if a trade repository is registered for that derivative type by 19 April 2013 From Summer 2013 First CCP authorisations likely to be granted and first clearing obligations likely to take effect 15

16 Summary: Clearing Broker Regulation US: US customers (definition uncertain) required to use US-registered (and effectively domiciled) FCMs for cleared swaps (both for mandatory and voluntary clearing) Certain collateral must be maintained in US (out of apparent mistrust of foreign insolvency regimes) SEC position on clearing of security-based swaps not final, although it is expected that clearing for US customers will be through registered broker-dealers EU: must clear platform-traded and OTC derivatives with a CCP authorised or recognised under EMIR as or through (EU or non-eu) clearing member or by indirect clearing (but no type of entity requirement); MiFID2 territorial scope provisions 16

17 EU Clearing Houses Must clear on a CCP authorised or recognised under EMIR, although may also clear through non-eu clearing member of such CCP For recognition of third country CCPs under EMIR, there must be equivalent regime, effective supervision and enforced and effective equivalent system for recognition of EU clearing houses 17

18 Non-cleared Derivatives Trading US: rules on margin requirements not finalised Some exemption for non-financial end users Extraterritorial application uncertain EU: national approval of collateral models No presumption that similar approval elsewhere Affiliate trades potentially exempt from IM requirements at national discretion 18

19 Critical Issues To Be Resolved Extraterritorial Scope of Dodd-Frank Cross-border application of U.S. regulations creates potential for inconsistent or conflicting standards Regulation of dealers and intermediaries Clearing and trading requirements Margin and business conduct requirements Guidance still not final although US has entered implementation phase 19

20 Extra-territoriality EU If managed by AIFM but deal with non-eu counterparty, or not managed by AIFM, where enter into eligible derivative Must clear if both are either EU FCs or non-fcs which have exceeded the clearing threshold Must clear if one counterparty is EU and transaction would be subject to clearing obligation were both parties EU-established Must clear where both counterparties are non-eu and would be caught if were in EU and trade has direct, substantial, foreseeable effect in EU or necessary/ appropriate to prevent evasion 20

21 Other Issues Regulatory Capital Exposure to qualifying CCP low risk weighting under EU/US capital rules CCP Default Fund Contributions: separate capital charge imposed Exposure to non-financial counterparty: subject to risk weighting but collateral mitigates requirement 21

22 Other Issues Reporting Obligation Obligation to report all cleared and uncleared swaps to trade repository All new derivatives contracts and certain pre-existing contracts will have to be reported once the reporting obligation takes effect EU obligation takes effect following authorisation of trade repository for class of derivative (or, if no trade repository established by 1 July 2015, to ESMA) US obligations DCOs now required to report cleared interest rate and credit derivatives (extending to all swaps in January 2013) Swap dealers expected to start reporting all credit and interest rate derivatives beginning January 2013 (or upon registration) and other swaps by end February 2013 Reporting requirements will be in effect for all products and market participants in April

23 Risk Mitigation EU Account Segregation: Clearing Members and CCPs to offer Clients option of: keeping separate records and accounts enabling each clearing member to distinguish in accounts with the CCP the assets and positions of that clearing member from those held for the accounts of its clients ( omnibus client segregation ) or keep separate records and accounts enabling each clearing member to distinguish in accounts with the CCP the assets and positions held for the account of a client from those held for the account of other clients ( individual client segregation ) US Account Segregation: New LSOC segregation requirements for swap customer positions and margin Margin: Margin levels must be sufficient to cover the losses that result from at least 99.5% of exposure movements for OTC derivatives. The change in confidence levels could potentially increase initial margin requirements 23

24 Evolving Issues International coordination and final CFTC guidance on extraterritorial applicability Which transactions will have to be cleared? Where does a transaction have to be cleared? Multiple different clearing requirements (e.g. transaction between US bank and EU bank)? How can market participants access clearinghouses in different jurisdictions? US customers clearing through a non-us clearinghouse Non-US customers clearing through a US clearinghouse Cross-border recognition of clearinghouses contemplated Different requirements for intermediaries Lack of specific provisions in Dodd-Frank for cross-border recognition of clearing intermediaries FCM requirement may force a different model for US customers Background commercial law and insolvency law considerations and market conventions (e.g., pledge vs. title transfer) may also affect clearing access model Customer Protection LSOC Individual account segregation Portability 24

25 Customer Account Segregation and Porting Thomas Donegan Donald N. Lamson

26 Default Outcomes 1. Close-out Clearing House 2. Porting Clearing House Margin Contract Margin Contract Margin Contract Clearing Member A Clearing Member A Clearing Member B Margin Contract Margin Contract Margin Contract Client Client - Value of positions lost: must be reestablished - Assets returned and caught in insolvency process - Value of positions rolled in to Clearing Member B - Margin available much quicker - (Contracts easier to move usually) 26

27 Customer Protection: the Circumstantial Background Lehman: Many customer assets not segregated: massive disputes over asset status Close-out value disputes Uncertainty over exposures generally Still no distributions to many creditors MF Global Shortfall in assets borne by customers. Some limited porting (positions and some margin in US; largely positions in UK) 27

28 LSOC Implementation Dodd-Frank requires: FCMs must segregate collateral deposited for cleared swaps FCM must separately account for and maintain such collateral and not commingle with its own property and cannot use collateral as margin for other purposes (subject to certain exceptions) Limits on reinvestment of collateral by FCM/DCO CFTC has adopted rules to implement Dodd-Frank provisions on collateral segregation LSOC rules apply to both US-regulated clearing houses (Derivative Clearing Organizations / DCOs) and Futures Commission Merchants (FCMs) Rules prohibit DCO from using collateral allocated to one swap customer for positions of another customer (or the FCM itself) Rules came into effect in November

29 LSOC Implementation FCM maintains two types of cleared swap customer accounts: FCM customer account (maintained at a bank) to hold assets not on deposit with a DCO ( FCM Customer Account ) Account maintained by the DCO for FCM o/b/o FCM s cleared swap customers ( DCO Customer account ) Three types of risk arise from these accounts: Fellow customer risk: DCO may need more collateral from a failing cleared swap customer and FCM when they both fail simultaneously (double default) Operational risk: shortfall in segregated funds that arises due to negligence, theft or other mishap Investment risk: losses resulting from an FCM s investment of customer funds LSOC addresses fellow customer risk, but not loss from operational or investment risk 29

30 LSOC Implementation LSOC Collateral is segregated on FCM/DCO books and allocated to positions of particular customers In a double default situation, the DCO may not use collateral of non-defaulting cleared swap customers to satisfy the deficiency of a defaulting customer But, Bankruptcy Code section 766(h) requires pro rata distribution of customer property So, operational and investment losses can affect a non-defaulting customer s collateral 30

31 LSOC Implementation Other questions to be resolved over time Excess margin. Operational infrastructure for holding at DCOs not yet in place. Expected 2013 implementation How will customers react to changes in FCM condition and move from one FCM to another? Does LSOC facilitate porting and avoid dumping of collateral on market at reduced prices? Does LSOC reduce incentive of customer to evaluate FCM? If so, is that concern counter-balanced by corresponding increased incentive of DCO to conduct evaluation? Can a complete individual segregation model be developed? Should it? 31

32 LSOC Implementation Other concerns with Final Rule Possible disadvantage to customer vis-a-vis bilateral OTC contract practice Doesn t solve for operational or investment risk Fellow customer risk is rare Are there additional risks for excess collateral deposited outside the DCO Is it correct to base portability on increased record-keeping requirements when distressed FCM may not prioritize this requirement? 32

33 EMIR Segregation: Key Requirements for Clearing Members Segregation: EMIR, article 39(4): A clearing member shall keep separate records and accounts that enable it to distinguish both in accounts held with the CCP and in its own accounts its assets and positions from the assets and positions held for the account of its clients at the CCP. Choice of accounts: EMIR, article 39(5): A clearing member shall offer its clients, at least, the choice between omnibus client segregation and individual client segregation and inform them of the costs and level of protection associated with each option. The client shall confirm its choice in writing. Pass-through of margin to CCP: EMIR article 39(6): When a client opts for individual client segregation, any margin in excess of the client s requirement shall also be posted to the CCP and distinguished from the margins of other clients or clearing members and shall not be exposed to losses connected to positions recorded in another account. 33

34 EMIR Segregation: Key Requirements for Clearing Houses I Option of individual segregation: EMIR, article 39(3): A CCP shall offer to keep separate records and accounts enabling each clearing member to distinguish in accounts with the CCP the assets and positions held for the account of a client from those held for the account of other clients ( individual client segregation ). Upon request, the CCP shall offer clearing members the possibility to open more accounts in their own name or for the account of their clients. Risk disclosures: EMIR article 39(7): CCPs [and clearing members] shall publicly disclose the levels of protection and the costs associated with the different levels of segregation that they provide and shall offer those services on reasonable commercial terms. Details of the different levels of segregation shall include a description of the main legal implications of the respective levels of segregation offered including information on the insolvency law applicable in the relevant jurisdictions. 34

35 EMIR Segregation: Key Requirements for Clearing Houses II What is actually segregated: EMIR (article 39(9)): The requirement to distinguish assets and positions with the CCP in accounts is satisfied where: the assets and positions are recorded in separate accounts; the netting of positions recorded on different accounts is prevented; the assets covering the positions recorded in an account are not exposed to losses connected to positions recorded in another account. Similar use restrictions to LSOC: EMIR article 48(7): Clients collateral shall be used exclusively to cover the positions held for their account. Note account language genuine separate cleared account and cf. LSOC 35

36 Porting under EMIR Omnibus accounts - EMIR, article 48(5): CCP shall contractually commit itself to trigger the procedures for the transfer of the assets and positions held by the defaulting clearing member for the account of its clients to another clearing member designated by all of those clients, on their request and without the consent of the defaulting clearing member. That other clearing member shall be obliged to accept those assets and positions only where it has previously entered into a contractual relationship with the clients... Individual segregated accounts - EMIR, article 48(6): CCP shall contractually commit itself to trigger the procedures for the transfer of the assets and positions held by the defaulting clearing member for the account of the client to another clearing member designated by the client, on the client s request and without the consent of the defaulting clearing member. That other clearing member shall be obliged to accept these assets and positions only where it has previously entered into a contractual relationship with the client. Return of assets post-default - EMIR, article 48(7): readily returned to those clients when they are known to the CCP or, if they are not, to the clearing member for the account of its clients 36

37 Implications of New Companies Act 1989 and Client Money Changes Insolvency regime protections for CCPs who port margin and contracts Default rule actions by clearing houses in respect client-cm contracts protected Ability of CCP to divest the customer account of assets Multiple client money pools, including CCP/product line specific pools Assets at a CCP customer account not subject to pooling Ability of CCP to make transfers direct to clients and transferee clearing members 37

38 Comparison of LSOC versus EMIR Individual Segregation LSOC Facilitates porting of Yes Yes positions Facilitates porting of Yes Yes margin Fellow customer risk No No Member operational risk Yes Yes CCP risk Yes Yes Nature of clearing house account / net sum Omnibus Individual Segregation Single per client Collateral model Only pledge Pledge or title transfer 38

39 The FIA-ISDA Addendum Donna M. Parisi

40 Documentation: Cleared vs. Uncleared Swaps Cleared Swaps Futures Agreement OTC cleared addendum (FIA/ISDA form (product/clearinghouse neutral) or clearinghouse specific form) Give-up agreement (FIA/ISDA execution agreement). Potential master netting arrangement to net futures, cleared and uncleared swaps Collateral transformation documentation Principal model clearing docs (if desired for EU clearinghouses) Both DF Protocol Swap Dealer must comply with Business Conduct rules when they face a customer for a swap, whether it is to be cleared or not. Uncleared Swaps ISDA Master Agreement Schedule Credit Support Annex If segregation of IA is elected, then Account Control Agreement with third party custodian and CSA amendments 40

41 Documentation Suite for US Cleared Derivatives Futures Agreement FIA/ISDA Cleared Derivatives Addendum FIA/ISDA Execution Agreement 41

42 Futures Customer Account Agreement Overview Designed for exchange-traded futures and options Typically not negotiated Not standardized Each FCM has its own version, often with nuanced differences. Relevant because the provisions of the futures agreement will apply to the extent they are not addressed by the OTC Addendum 42

43 Futures Customer Account Agreement Key Provisions Typical Futures Agreement addresses: Parties to the futures agreement Agreement to act as broker Representations and warranties; FCM financial information. Margin Payment Obligations and Timing The FCM may set and increase margin requirements over and above clearing house requirements Events of Default and Liquidation of Positions Objective vs. Subjective Events of Default Cure periods for events of default 43

44 Futures Customer Account Agreement Key Provisions Typical Futures Agreement (cont.): Acceptance of Orders and Position Limits Security Interests Cross-collateralization Termination Rights Portability/Transfer of Positions and Collateral 44

45 FIA/ISDA Cleared Derivatives Addendum Overview Purpose To supplement the terms of a futures agreement between an FCM and its customer to allow for the clearing of swaps. Necessary because futures clearing agreements typically do not expressly cover cleared swaps. Clearing of swaps can present unique issues. FIA Addendum is generic in nature and is expected to replace any DCOspecific addenda Scope All swaps, forwards, options or similar transactions (whether executed in the OTC market or traded on a SEF or a DCM) that are submitted to and accepted for clearing by a clearing organization. 45

46 FIA/ISDA Cleared Derivatives Addendum Key Provisions Typical OTC Cleared Derivatives Addendum: Definitions Covered Transactions: cleared swaps executed OTC or on execution facility. Representations and Covenants of Clearing Member and Customer Applicable Law (including DCO/SEF rules) Transactions Not Accepted for Clearing Limitation of Liability Transfer of Positions (i.e., portability ) NFA Rule 2-27 Events of Default/Liquidation Section 7 Tax Provisions Schedule Parties can customize to make additional representations or other modifications to the OTC Addendum. 46

47 Section 7 Cleared Derivatives Addendum Liquidation Upon Close-out Event Liquidation Standard: Clearing Member must act in good faith, in accordance with applicable law and using commercially reasonable procedures in order to produce a commercially reasonable result. Transactions in the Customer s Cleared Derivatives Account: Offsetting Transaction A transaction that exactly offsets another position in the account; Risk-reducing Transaction A transaction which does not exactly offset another position in the account; designed to reduce the net risk of customer s positions, but will not reduce the number or size of the outstanding trades; and Sale/Novation Transaction A transaction in which a position is sold, novated or otherwise removed from the account. 47

48 Section 7 Cleared Derivatives Addendum Liquidation Upon Close-out Event (cont.) Transactions Outside of the Customer s Cleared Derivatives Account: Mitigation Transaction Done directly by the Clearing Member as principal to reduce net risk of the Customer s positions Valuation of Customer Positions vs. Close-out: Under limited circumstances the Clearing Member is entitled to value positions in the absence of liquidation. Upon any such valuation, the associated position(s) would be deemed liquidated and would no longer be treated as Customer positions. Tax Liquidation Event Same consequences, but 30-day grace period. 48

49 Execution Agreement Overview Purpose FIA/ISDA developed the standardized Execution Agreement to address issues related to the execution of OTC derivatives that are intended to be cleared. Potential Issues Process: What will be the process for submitting and affirming trades? Acceptance: What will happen when a trade is accepted for clearing? Fallback: What will happen when a trade is not accepted for clearing? 49

50 Execution Agreement Structure Bilateral agreement The parties represent to each other that each has a clearing agreement with a clearing member. Sets forth steps the parties will take if the trade does not clear. Breakage Waterfall: Sets forth how breakage payments will be calculated and paid if the transaction is terminated. Presumption that provision will override any conflicting applicable law, unless application of the provision itself would violate applicable law. Optional annexes Require the clearing member to clear transactions within specified limits. Set forth the payment obligations of the parties if the clearing member fails to accept the transaction within the set limits. 50

51 Execution Agreement: Bilateral Execution 51

52 The ISDA-FOA Addendum Ian Harvey-Samuel Thomas Donegan

53 Industry Preferred Landscape for Post-clearing Documentation CCP 1 CCP 2 CCP 3 Clearing Member ISDA Addendum* Client FOA Other documentation (eg prime brokerage) Source: ISDA * Protections to client on insolvency of clearing member provided by each CCP/applicable law 53

54 Overview of Documentation Structure Client trades subject to CCP Rules and Procedures (particularly designated Core Provisions) Master Agreement Addendum Collateral Arrangement Clearing House specific Standard Terms Annex 54

55 The Addendum Key Terms I Terms related to role of clearing member as intermediary Automatic pass through of terms of cleared contract Automatic pass through of CCP performance Ability to pass through effect of actions under cleared contract by CCP Clearing member termination right? Limitation of Liability Of clearing member to client in relation to performance or non-performance of CCP or related system Indemnity From client to clearing member for losses incurred with client transactions at CCP 55

56 The Addendum Key Terms II Pre-default portability Right of client to transfer positions pre default of clearing member to back-up clearing member(s) Pre-default porting right subject to certain conditions relating to collateral, conditions of relevant CCP, applicable law and any other condition parties agree Set-off/netting Restricts set-off by client following a clearing member default Collateral (discussed in next session) Tax 56

57 o o o o The Addendum Default Scenarios CCP default Clearing Member default Customer default Only relevant to cleared transactions For cleared transactions, definition aligned with o declaration of default under CCP rules Generally, pass-through by clearing member of what it receives Termination of back-to-back transactions for the relevant CCP service, at the same time as the CCP transactions terminate Valuation of transactions should match CCP valuations under its CCP insolvency and default rules Any porting to another CCP under CCP resolution rules or law should therefore be available Limited recourse payments, depending on extent of clearing member s claim o o o Termination of back-to-back transactions for the relevant CCP service, at the same time as the CCP transactions terminate Valuation of transactions should match CCP valuations under its CCP insolvency and default rules Porting to a solvent clearing member under CCP rules available May be some additional defaults but query remedy For uncleared transactions, same as under existing agreement Generally, as under existing OTC master agreements Clearing member needs to manage close-out of corresponding transactions at CCP Valuation of trades requires close-out values of back-toback cleared trades and any related hedging to be taken into account 57

58 The Addendum Collateral Arrangements for Europe FOA Futures style agreement Existing collateral arrangement maintained Presumption collateral for cleared transactions provided on title transfer basis Any other amendments agreed in Annex Value of collateral transferred taken into account on early termination of transactions Collateral protection at CCP for client positions ISDA Existing credit support document disapplied for cleared transactions Collateral provided on title transfer basis pursuant to English law CSA Separate CSA with form of Paragraph 11 for cleared transactions with each relevant CCP service Any amendments to form of Paragraph 11 agreed in Annex Value of collateral transferred taken into account on early termination of transactions Collateral protection at CCP for client positions Source: ISDA 58

59 Clearing House Standard Terms Role of Clearing House specific Standard Terms Binds customer to Clearing House rules/procedures Relevant porting and customer margin protection structure if clearing member defaults Facilitates information provision from customer and use of repositories Undertaking not to cause breach of rules by clearing member Liability provisions Customer acknowledges that clearing member may deal with collateral provided by Customer as if belonged solely to Clearing Member 59

60 Open or Discussion Issues Modification/termination rights/increased cost of clearing Pre-default porting conditions Collateral transformation options Changes in position limits/margin requirements; how margin is dealt with Close out process; events of default relating to client and clearing member Commitment to clear/take on porting positions held through other clearing members Indemnification Modifications to confidentiality provisions in underlying documents Tax risk allocation 60

61 Comparison of Collateral under US and EU Documentation Geoff Goldman James Duncan Ian Harvey-Samuel

62 Gross vs. Net Margin Clearing House Clearing House Margin on 1 long Margin on 1 long and 1 short retained Margin on 2 long and 1 short No margin retained Clearing Member Clearing Member Margin on 1 long Margin on 1 long Margin on 1 short Margin on 1 long Margin on 1 long Margin on 1 short Client A Client B Client C Client A Client B Client C 62

63 Collateral under US and EU Documents, Collateral Transformation, Cross-margining US Collateral Arrangements FCMs typically contract on standardised futures account customer documentation that includes US law security arrangements over margin delivered by client FCMs required to segregate customer margin and treat customer as owner and so do not use title transfer collateral 63

64 Collateral under US and EU Documents, Collateral Transformation, Cross-margining EU Collateral Arrangements Assumption that will primarily be title transfer based Implications of CFTC rules when acting as executing broker for a US person Implications of revised UK Client money regime 64

65 Collateral under US and EU Documents, Collateral Transformation, Cross-margining Collateral Transformation Many customers may need collateral transformation in order to obtain CCP eligible collateral Should collateral transformation be part of the client clearing documentation? Implications of EMIR Article 39(6) on what is excess that must be posted to a CCP Issues arising from pre-funding by clearing members 65

66 Collateral under US and EU Documents, Collateral Transformation, Cross-margining Cross-margining Differences between US and EU clearing model on portfolio margining between cleared and non-cleared transactions Restrictions on cross-margining differently regulated products Obtaining cross-margining across CCPs/cleared products 66

67 AIFMD Issues John Adams

68 Depositary Liability under AIFMD How has this got anything to do with derivatives clearing? Depositary liable for assets held in custody Question mark over whether assets provided to third party by way of collateral are treated as held in custody ESMA suggested assets provided as collateral where control or possession of collateral transferred to collateral taker are not held in custody Recital in Level 2 suggested collateral not held in custody only where collateral is no longer owned by the fund How is collateral provided? Title transfer = no longer owned = not held in custody = out of depositary liability? Pledge/other security = owned by fund (?) = held in custody = depositary liability? Confusion of legal concepts Appears that assets held with CCPs will not be subject to depositary liability 68

69 Disclosures related to Clearing Risk factors in Offering Documents General changes to law/regulation If likely cost increases, consider specific reference to clearing developments And while you re at it AIFMD disclosures Pre-investment disclosures Description of preferential treatment given under side letters, and types of investors that benefit Description of any restrictions on the use of leverage and any collateral and asset reuse arrangements Details of existence (or otherwise) of legal instruments providing for recognition/enforcement of judgments in fund s domicile Annual Report Made available to regulators and provided to investors on request (NB: remuneration ) 69

70 AIFMD Structuring Time to focus on some key questions Who would be the AIFM in each fund structure? There can be only one Appointed by or on behalf of the Fund Delegation arrangements (NB: Commission s Level 2 measures ) Who do we want to be the AIFM in each fund structure? EU or non-eu Limitation of activities Externally or internally managed? Cost/benefit analysis 70

71 Fund Industry Perspective on Derivatives Clearing Jiří Krόl AIMA

72 Application to fund industry EMIR - Financial counterparty UCITS and its management company AIF managed by AIFM authorised and registered under AIFMD not a UCITS or AIF? Management of assets likely to constitute MiFID activity, hence MiFID investment firm Dodd-Frank Is fund US person *? entity organised/incorporated in US effective as of April 1, 2013 any entity other than a fund or collective investment vehicle having its principal place of business in the US The definition of US person may be broader when the CFTC s proposed cross-border guidance is finalized (*CFTC temporary definition, SEC yet to propose a definition) Enhancing Understanding, Sound Practices and Industry Growth 72

73 Segregation Full Physical Segregation Clients should have the option of real and full segregation of collateral (as is currently negotiated in the bilateral market) AIMA is helping push the agenda for full physical segregation models including guaranteed clearing participant model ( GCP model ) Other CCP models on the horizon Arguments that costs outweigh benefits not supported by evidence in the bilateral market IT CAN BE DONE AFFORDABLY! Enforceability Ensure full physical segregation creates effective legal segregation i.e., effective against national insolvency law and out of reach of administrators/trustees in bankruptcy Enhancing Understanding, Sound Practices and Industry Growth 73

74 Risk Committee/Board Membership Client representation - Clients should have a strong voice on the CCP risk committee/board EMIR - welcome inclusion of requirement for client representation on risk committee. Disappointed clients not entitled to be permanently represented on CCP Board (i.e., shall be invited to board meetings related to transparency, segregation, and portability.) - disappointed calls for stronger buyside representation on the risk committee and board of the CCP not included in Level 2 measures DFA - welcome inclusion of requirement that governing board or risk management committee be composed of at least 10% representatives of customers, though this does not go far enough Enhancing Understanding, Sound Practices and Industry Growth 74

75 Third Country Issues Third country CCPs/TRs - Critical that counterparties can use CCPs/report to TRs outside their own jurisdiction EMIR - recognition of non-eu CCPs possible under EMIR - recognition of non-eu TRs possible under EMIR (Note: this requires an international agreement) DFA - recognition of non-us CCPs possible under DFA - recognition of non-us TRs possible under DFA (Note: issues with indemnification) BUT recognition of third country CCPs should not be required where those CCPs clear other products Enhancing Understanding, Sound Practices and Industry Growth 75

76 Cross-Border Swaps/Extraterritoriality US person - Broad definition of US person not desired outcome welcome recent narrowing of US person in CFTC interim rule Consistent global framework - Regulators should adopt harmonised international regime to avoid regulatory conflict and/or arbitrage more dialogue needed, particularly between EU and US regulators welcome recent meetings of Global regulators in the US (late 2012) and awaiting outcome of renewed attempt to harmonise Market uncertainty - Imperative formal rules on extraterritorial scope adopted as soon as possible absence of SEC rules recent CFTC rules temporary only (until 12 July 2013) ESMA yet to propose draft RTS on extraterritoriality Enhancing Understanding, Sound Practices and Industry Growth 76

77 Other Key Industry Concerns Scope - Only suitable contracts should be subject to clearing. As many parties as possible should be subject to clearing obligations (little/no exemptions pension funds, FX, intra-group, etc.) Vertical silos - Clients should continue to be able trade on a wide variety of execution venues and still access CCPs Clearing members Criteria for membership of CCPs should be wide enough to encourage participation, choice and competition Interoperability - Access to CCPs not unnecessarily unimpeded BUT scrutiny of interoperability arrangements should be sufficient welcome ESMA CP on interoperability arrangements (AIMA response in progress - deadline 31 January 2013) Indirect clearing - Buyside firms should have access to indirect clearing through broker welcome extension of portability and segregation benefits to indirect clients under EMIR Level 2 Enhancing Understanding, Sound Practices and Industry Growth 77

78 Key considerations for AIMA members Cleared Have you established a clearing relationship? Do you have documentation in place (either as clearing member/direct/indirect client)? What level of segregation do you benefit from/what is offered? Non-cleared Do you satisfy risk mitigation requirements? (Further developments expected re BCBS-IOSCO CP on margin for non cleared trades) Do you fall within certain end user exemptions? All derivatives Have you established connectivity with TRs? Will you satisfy the reporting requirement yourself or will you delegate this to the counterparty or a third party? If the latter, have you arranged this? Enhancing Understanding, Sound Practices and Industry Growth 78

79 Speakers Barnabas W.B. Reynolds London T +44.(0) [email protected] Donna M. Parisi New York T [email protected] Donald N. Lamson Washington, DC T [email protected] Thomas Donegan London T +44.(0) [email protected] Ian Harvey-Samuel London T +44.(0) [email protected] Geoffrey Goldman New York T [email protected] James Duncan London T +44.(0) [email protected] John Adams London T +44.(0) [email protected] Jiří Krόl AIMA T +44.(0) [email protected] 79

80 Worldwide Office Locations Globally Connected Approximately 900 lawyers in 20 offices worldwide, practicing US, English, French, German, Italian, EU and Hong Kong law and fluent in over 50 languages Leading global law firm Established 1873 Clients include Leading corporations, financial institutions, hedge funds and sovereign entities 80