Energy Risk Professional ERP Exam Course Pack

Transcription

1 2014 Energy Risk Professional ERP Exam Course Pack READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE In addition to the published readings listed, the Financially Traded Energy Products and Structured Transactions section of the 2014 ERP Study Guide includes several additional readings from online sources that are freely available on the GARP website (link to 2014 Online Readings). These readings include learning objectives that cover specialized topics or current trends dealing with financial transactions that are unavailable in traditional text books. The 2014 ERP Examination will include questions drawn from the following AIMs for each reading: Readings for Financially Traded Energy Products and Structured Transactions Energy Derivatives: Overview of Products, Market Mechanics and Applications 1. IEA, The Mechanics of the Derivatives Markets: What They Are and How They Function. (Special Supplement to the Oil Market Report, April 2011). Understand the role of hedgers, speculators, and arbitrageurs in a derivatives market. Compare and contrast forward and futures contracts and understand how they are applied. Understand the mechanics of a futures position and calculate the margin requirements and profit on an open futures contract. Explain the circumstances under which you would be required to post additional margin (a margin call ). Differentiate and apply market, limit and stop-loss orders. Construct a hedge for a commodity position or an obligation to buy or sell a commodity by using long or short positions in futures contracts. Explain how basis risk can arise in a hedging transaction. Describe the mechanics of swaps and explain the function of the swap counterparty, including swap dealers. Calculate a periodic swap settlement payment for a multiyear energy commodity swap given forward prices and interest rates. Explain how the market value of a swap changes over time and describe factors affecting a swap's market value. Explain how an implicit lending agreement is contained in a swap and describe how the interest rate is derived from an interest rate forward curve. Understand the differences between American, European and Bermudan options. Define plain vanilla options; understand the mechanics and payoff profiles of call and put options. Understand what it means for an option contract to be in, at, or out of the money Global Association of Risk Professionals. All rights reserved.

2 2014 Energy Risk Professional ERP Exam Course Pack Energy Commodity Exchanges and OTC Derivative Trade Process 2. OTC Commodity Derivatives Trade Processing Lifecycle Events. (ISDA Working Paper, April 2012). Understand the key features of the OTC commodity derivatives market. Summarize the steps involved in processing an OTC trade and understand the action required in each step (Trade Capture, Controls Processing, etc.). Identify the market pricing services used to settle OTC energy contracts (i.e. PlattsGas Daily) and understand how physical delivery may impact the settlement value. Explain the importance of automation (i.e. "straight-through-processing") in clearing OTC energy trades; describe the benefits and weaknesses of a settlement matching process. Describe how OTC clearing affects market transparency. Global Regulatory Developments 3. Rajarshi Aroskar. OTC Derivatives: A Comparative Analysis of Regulation in the United States, European Union, and Singapore. Describe the function and benefits of a trade repository as it relates to OTC market participants. Compare the regulatory requirements and regulatory authority in the United States, European Union, and Singapore with respect to: the central clearing of OTC derivatives, requirements of central counterparties, margin requirements for uncleared OTC derivatives, trading, and back-loading of existing OTC contracts. Describe the requirements for reporting derivative transactions to trade repositories in the United States, European Union and Singapore. 4. Cleary and Gottlieb. Navigating Key Dodd-Frank Rules Related to the Use of Swaps by End Users. (April 9, 2013). Define the terms: swap dealers, major swap participants, and end users; understand how entities are assigned to these categories under Dodd-Frank. Understand the role of a derivatives clearing organization and describe the process for clearing a swap. Understand the requirements for clearing a swap transaction, including swap reporting requirements. Explain the circumstances under which an end-user exemption may be granted to a swap participant Global Association of Risk Professionals. All rights reserved.

3 2014 Energy Risk Professional ERP Exam Course Pack 5. Gordon Goodman. Swaps: Dodd-Frank Memories. (July 2, 2013) Understand the financial limits a party must meet to qualify for the end-user exemption. Explain the use of swaps for hedging purposes and how this is affected under Dodd-Frank. Understand the de minimis and major swap participant (MSP) tests, along with other financial obligations a party must meet to be considered an end-user. Understand the reporting process under Dodd-Frank, including which party is obligated to report a transaction to a swap data repository (SDR). 6. Gordon Goodman. Dodd-Frank s Impact on Financial Entities, Financial Activities and Treasury Affiliates. (October 23, 2013) Explain how a financial entity is defined under the Dodd-Frank Act and how this designation affects mandatory clearing requirements. Understand how the end-user exemption may apply to organizations deemed financial entities Global Association of Risk Professionals. All rights reserved.

4 SPECIAL SUPPLEMENT to the April 2011 Oil Market Report The Mechanics of the Derivatives Markets What They Are and How They Function April 2011

5 PREFACE This supplement to the April 2011 OMR is designed as a reference document for member governments and subscribers. It forms part of an ongoing work programme examining the mechanics of oil price formation and the interactions between the physical and paper markets. Further research will be forthcoming in the OMR, the MTOGM and in the form of stand alone papers in months to come. The work programme is being supported by contributions from member governments, most notably those from Japan and Germany. We are grateful for that support. Further impetus for this work comes from the joint work programme the IEA is undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers. The work is overseen by David Fyfe, and the supplement s main author is Bahattin Buyuksahin, to whom all enquiries should be addressed.

6 TABLE OF CONTENTS 1. INTRODUCTION TO DERIVATIVES Basics of Derivatives Types of Derivatives History of Derivatives Markets The Markets Types of Market Participants in Derivatives Markets Hedgers Speculators Swap Dealers and Commodity Index Traders FORWARDS AND FUTURES Forward Contracts Futures Contract Specifications Box 1: Grade and Quality Specifications of WTI Contract The Clearinghouse Margins Settlement Price, Volume and Open Interest in Futures Markets Types of Orders Hedging Using Futures Contracts Basis Risk SWAPS Mechanics of Swaps OPTIONS Call Option Put Option Moneyness of Options Hedging Using Options REFERENCES GLOSSARY OF THE DERIVATIVES MARKET TERMS... 36

7 1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES In the last thirty years, the world of finance and capital markets has experienced a quite spectacular transformation in the derivatives markets. Futures, options and swaps, as well as other structured financial products, are now actively traded on many exchanges and over the counter (OTC) markets throughout the world, not only by professional traders but also by retail investors, whose interest in these derivatives has increased. Derivatives are financial instruments whose returns are derived from those of another financial instrument. As opposed to spot (cash) markets, where the sale is made, the payment is remitted, and the good or security is delivered immediately or shortly thereafter, derivatives are markets for contractual instruments whose performance depends on the performance of another instrument, the so called underlying instrument. For example, a crude oil futures is a derivative whose value depends on the price of crude oil. Derivatives contracts play a very important role in managing the risk of underlying securities such as commodities, bonds, equities and equity indices, currencies, interest rates or liability positions. Commodity derivatives are traded in agricultural products (corn, wheat, soybeans, soybean oil), livestock (live cattle, pork bellies, lean hogs); precious metals (gold, silver, platinum, palladium); industrial metals (copper, zinc, aluminum, tin, nickel); soft commodities (cotton, sugar, coffee, cocoa); forest products (lumber and pulp); and energy products (crude oil, natural gas, gasoline, heating oil, electricity). Financial derivatives, where in many cases no delivery of the physical security is involved, are traded on stocks and stock indices (single stocks, S&P 500, Dow Jones Industrials); government bonds (US Treasury bonds, US Treasury notes); interest rates (EuroDollars) and foreign exchanges (Euro, Japanese Yen, Canadian Dollar). In recent years, new derivatives instruments have been devised, which are different from the more traditional instruments, as the underlying asset of these derivatives is no longer necessarily a liquid, marketable good. For example, derivatives trading has begun on weather and credit risk. The derivatives market as a whole, and over the counter markets in particular, has recently attracted more attention after the onset of the financial crisis in In this report, we will look at the main building blocks of derivatives markets, including forwards, futures, swaps and options markets. 4 APRIL 2011

8 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES 1.1 Basics of Derivatives Derivatives contracts get their name from the fact that they are derived from some other underlying claim, contract, or asset. For instance, a crude oil forward contract is derived from the underlying physical asset crude oil. Derivatives are also called contingent claims. This term reflects the fact that their payoff the cash flow is contingent upon the price of something else. Going back to the crude oil forward contract example, the payoff to a crude oil forward contract is contingent upon the price of crude oil at the expiration of the contract. Hedgers, speculators and arbitrageurs use derivatives instruments for different purposes. Hedgers use derivatives to eliminate uncertainty by transferring the risk they face from potential future movement in prices of the underlying asset. In this regard, derivatives serve as an insurance or risk management tool against unforeseen price movements. Speculators, on the other hand, use these instruments to make profits by betting on the future direction of market prices of the underlying asset. Therefore, derivatives can be used as an alternative to investing directly in the asset without buying and holding the asset itself. Arbitrageurs use derivatives to take offsetting positions in two or more instruments to lock in a profit. In addition to risk management, derivatives markets play a very useful economic role in price discovery. Price discovery is the process of which market participants (buyers and sellers) uncover an asset s full information or permanent value, and then disseminate those prices as information throughout the market and the economy as a whole. Thus, market prices are important not only for those buying and selling the asset or commodity but also for the rest of the global market s participants (consumers or producers) who are affected by the price level. In summary, two of the most important functions of derivatives markets are the transfer of risk and price discovery. In a well functioning futures market, hedgers, who are trying to reduce their exposure to price risk, will trade with someone, generally a speculator, who is willing to accept that risk by taking opposing positions. By taking the opposing positions, these traders facilitate the needs of hedgers to mitigate their price risk, while also adding to overall trading volume, which contributes to the formation of liquid and well functioning markets. APRIL

9 1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1.2 Types of Derivatives There are four major types of derivatives instruments. In some respects, these may be regarded as building blocks and can be categorised as follows: Forwards Futures Swaps Options Each instrument has its own characteristics, which offers advantages in using them, but also brings disadvantages, which are discussed later in the text. 1.3 History of Derivatives Markets Although derivatives are frequently considered to be something new and exotic, they have been around for millennia. There are examples of derivative contracts in Aristotle s works and the Bible. It is true, however, that the use of financial derivatives has been growing since 1980s. The origins of derivatives trading dates back to 2000 B.C. when merchants, in what is now called Bahrain in the Middle East, made consignment transactions for goods to be sold in India. Derivatives contracts, dating back to the same era, have also been found written on clay tablets from Mesopotamia, when farmers borrowed barley from the King s daughter by promising to return it at harvest time. This trade can either be considered as a commodity loan or as a short selling operation. It is a commodity loan because farmers borrowed barley in order to use it for planting the crop and they promised to return it after harvesting. Of course, it is a short selling trade since farmers do not have any barley at the time of contract agreement. 1 A more literary reference comes some years ago from Aristotle, who discussed a case of manipulation call option style investment on olive oil presses. In Politics, Aristotle told the story of a trader, who buys exclusive right to use olive oil presses in the upcoming harvest from the owners of this equipment. The trader paid some down payment for this right. During the harvesting season, the demand for olive oil presses rose as predicted by the trader and he sold his right to use this equipment to other parties. In the meantime, the trader made a profit without actually being in the olive oil production business. The trader s trade carried only his down payment (option premium) as a risk; on the other hand, owners of olive oil presses transferred some of the risks associated with the possibility of a bad crop season to the trader. 1 See Weber (2008) for a detailed excellent review of the history of derivatives markets. 6 APRIL 2011

10 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES Derivatives trading in an exchange environment and with trading rules can be traced back to Venice in the 12th century. Forward and options contracts were traded on commodities, shipments and securities in Amsterdam after The first standardised futures contract can be traced to the Yodoya rice market in Osoka, Japan around In the US, forward and futures contracts of agricultural products such as wheat and corn have been formally traded on the Chicago Board of Trade 2 (CBOT) since The CBOT initially offered forward contracts on agricultural commodities. In 1865, the first standardised futures contracts were introduced on the CBOT floor. The Chicago Mercantile Exchange (CME) was established in 1919 to offer futures contracts on livestocks and agricultural products. The CME has increased the number of contracts listings over time and is now best known worldwide for its financial products, including its flagship Eurodollar contract. 1.4 The Markets There are basically two types of markets in which derivatives contracts trade. These are exchange traded markets and over the counter (OTC) markets. Regulated exchanges, since their inception in the mid 1800s until recently, have been the main venue on which producers and large scale consumers of commodities hedge their risk against fluctuations in market prices, while allowing speculators to make profits by anticipating these fluctuations. Exchange traded derivatives are fully standardised and their contract terms are designed by derivatives exchanges. However, due to standardisation and fixed contract specifications in exchange traded contracts, financial institutions began to develop non exchange traded (or over the counter, OTC) derivatives contracts. Instruments in the OTC markets are generally privately negotiated between market makers (or so called swap dealers) and their clients. Unlike exchange traded products, OTC instruments can be customised to fit clients needs. These instruments, like standardised futures contracts, can be used by hedgers to hedge their exposure to the physical asset itself, or by speculators to make speculative profits if prices of the underlying asset move in an expected direction. According to the latest Bank of International Settlements (BIS) survey, the total notional value of all OTC derivatives reached $583 trillion at end June 2010, of which $2.85 trillion (0.5%) was in commodityrelated derivatives. At their peak in end June 2008, the total notional value of commodity related derivatives had reached $13 trillion, or 2% of the total market. The total notional value of all exchangetraded derivatives contracts exceeded $90 trillion at that time. 2 CBOT merged with CME in APRIL

11 1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Figure 1: Size of Over the Counter and Exchange Traded Derivatives Markets Size of Markets ($ trillion) OTC Exchange 1.5 Types of Market Participants in Derivatives Markets Trading participants in derivatives markets can be placed into three basic categories as we mentioned earlier: (1) hedgers (2) speculators and (3) arbitrageurs. In addition to these three broad categories, swap dealers and commodity index traders are important types of market participants and have been centre stage during the recent debate on financial regulations. We discuss swap dealers and their business in details in Section Hedgers Hedgers use derivatives markets to offset the risk of prices moving unfavourably for their ongoing business activities. Hedgers, including both producers (oil producers, farmers, refiners, etc) and consumers (airlines, refiners, etc), hold positions in both the underlying commodity and in the futures (or options) contracts on that commodity. A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price. A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price. By hedging away risks that you do not want to take, you can take on more risks that you want to take while maintaining desired/target aggregate risk levels. For example, an oil producer can hedge against declines in oil price by selling an oil futures contract (taking a short position) on the exchange in light of its oil position, which is naturally long, in the physical market. If the price of oil increases over time, the profits from the actual sale of oil are offset by losses from holding the futures contract. On the other hand, if prices decline over time, oil producers can offset their losses from the actual sale of oil from selling their short position in the futures market. Basically, whatever happens to prices, hedgers are guaranteed to have constant profit. 8 APRIL 2011

12 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES Hedgers, who hold short positions in the physical market, take long positions in the paper market to limit the risk associated with fluctuations in underlying asset prices. For example, an airline company can hedge against a rise in oil prices by buying oil futures contracts (taking a long position) on the exchange for the oil required to operate its business activities (the airline company position is short in the physical market). Some hedgers might be both producers and consumers in some related commodities. For example, refiners use crude oil to produce petroleum products. Crude oil is refined to make petroleum products, in particular heating oil and gasoline. The split of oil into its different components is frequently achieved by a process known as cracking, hence the difference in price between crude oil and equivalent amounts of heating oil and gasoline is called a crack spread. Therefore, refiners can take positions in crack spreads Speculators Speculators, on the other hand, use derivatives to seek profits by betting on the future direction of market prices of the underlying asset. Hedge funds, financial institutions, commodity trading advisors, commodity pool operators, associate brokers, introducing brokers, floor brokers and traders are all considered to be speculators. In the CFTC s Commitment of Traders report, hedge funds, commodity pool operators, commodity trading advisors and associate persons constitute managed money traders. Speculators use derivatives instruments to make profits by betting on the future direction of market prices of the underlying asset. Traditional speculators can be differentiated based upon the time horizons during which they operate. Scalpers, or market makers, operate at the shortest time horizon sometimes trading within a single second. These traders typically do not trade with a view as to where prices are going, but rather make markets by standing ready to buy or sell at a moment s notice. The goal of a market maker is to buy contracts at a slightly lower price than the current market price and sell 3 The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries. Refiners profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock in a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures ( barrels) with the sale a month later of two unleaded gasoline futures ( barrels) and one heating oil future ( barrels). The ratio approximates the real world ratio of refinery output 2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades. An average ratio based on sweet crude is not appropriate for all refiners, however, and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils, while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader s portfolio is close to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients situations and the exchange standards. APRIL

13 1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS them at a slightly higher price, perhaps at only a fraction of a cent profit on each contract. Skilled market makers can profit by trading hundreds or even thousands of contracts a day. Market makers provide immediacy to the market. Without a market maker, another market participant would likely have to wait longer until the arrival of a counterparty with an opposite trading interest. Other types of speculators take longer term positions based on their view of where prices may be headed. Day traders establish positions based on their views of where prices might be moving within minutes or hours, while trend followers take positions based on price expectations over a period of days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets. Through their efforts to gather information on underlying commodities, the activity of these traders serves to bring information to the markets and aid in price discovery Swap Dealers and Commodity Index Traders Instruments in the OTC markets are generally privately negotiated between market makers (or so called swap dealers) and their client. The party offering the swap, or swap dealer, takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. The counterparties to swap dealers are generally hedgers, speculators or commodity index traders. Investor interest in commodities, including oil, has risen quite dramatically over the last decade and commodities have become a new asset class in institutional investors portfolio. Partly, this development is due to diversification benefits. In addition, the development of new investment vehicles, such as exchange traded funds, has allowed individual investors to get exposure to movements in commodity prices. Due to the storage and trading costs associated with direct physical investment in commodities, the main vehicle used by investors to gain exposure to commodities is via commodity indices (baskets of short maturity commodity futures contracts that are periodically rolled as they approach expiry), exchange traded funds or other structured products. These instruments provide generally long only exposure to commodities. The vast majority of commodity index trading by principals is conducted offexchange using swap contracts. The main goal of commodity index funds is to track the movement of commodity prices. There exist several major commodity indices as well as sub indices. Standard and Poors GSCI (formerly the Goldman Sachs Commodity Index) is the oldest and most widely tracked index in the market. The S&P GCSI, first 10 APRIL 2011

14 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES created in 1991, covers 24 commodities but is heavily tilted toward energy because its weights reflect world production figures. For example, in 2010, energy markets received almost 72% weight. Investors are exposed to three sources of returns in total return commodity index investments. The first type is the yield on the underlying commodity futures. The second type is the roll return, which is generated from the rolling of nearby futures into first deferred contracts. Depending on whether the forward curve is in contango (when longer dated futures prices are higher than nearby contracts) or, conversely, in backwardation (when nearby prices are higher than longer dated futures prices), the roll yield is either negative (in contango) or positive (in backwardation). The third type is the T bill return, which is the return on collateral. Historically, the roll return has constituted the largest contributor in total return. However, the roll return component has been negative since 2005 for the S&P GSCI Total Return Index due to the contango market we observe in crude oil futures markets. Institutional investors generally gain exposure to commodity prices through their investment in a fund that tracks a popular commodity index. The fund managers themselves either directly offset their resulting short positions by going long in futures markets or by entering swap agreements with a swap dealer. In turn, swap dealers in the OTC market generally go long or short in the futures market to offset their net long (or short) position. Of course, the client base of swap dealers also includes traditional hedgers. APRIL

15 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES 2.1 Forward Contracts A forward contract is an OTC agreement between two parties to exchange an underlying asset: for an agreed upon price (the forward price or the delivery price) at a given point in time in the future (the expiry date or maturity date) Since it is traded between two parties in the over the counter market, there is a small possibility that either side can default on the contract. Therefore, forward contracts are mainly between big institutions or between a financial institution and one of their clients. Forward contracts are most popular in currency and interest rates markets. The party that has agreed to buy the underlying asset has a long position. The party that has agreed to sell the underlying asset has a short position. By signing a forward contract, one can lock in a price ex ante for buying or selling a security. Ex post, whether one gains or loses from signing the contract depends on the spot price at expiry. If the price of the underlying asset rises, then the party who has a long position in the contract gains while the party who has a short position loses. Example 1: A commodity contract Trader A agrees to sell to Trader B one million barrels of WTI crude oil at the price of $100/bbl with delivery in six months. In this forward contract, WTI crude oil is the underlying asset. Trader A is said to be short the contract, since he must deliver oil in six months. Trader B is said to be long the contract, since he receives the delivery of oil in six months. If at the end of six months the price of oil is at $110, then the trader with a long position has a profit of $ and the trader with a short position loses $ On the other hand, if the price of oil is $95 at the end of six months, then the trader with a long position loses $ and the one with a short position has a profit of $ Example 2: A foreign exchange contract On 18 February 2011, Party A signs a forward contract with Party B to sell one million British pounds (GBP) at $ per GBP six months later. Today (18 February 2011), sign a contract, shake hands. No money changes hands. Party A entered a short position and Party B entered a long position on GBP. 12 APRIL 2011

16 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES But since it is on exchange rates, we can also say: Party A entered a long position and Party B entered a short position on USD. 18 August 2011 (the expiry date), Party A pays one million GBP to Party B, and receives million USD from Party B in return. Currently (18 February, the spot price for the pound (the spot exchange rate) is Six months later (18 August 2011), the exchange rate can be anything (unknown). $ per GBP is the forward price. The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today. It is the delivery price that would make the contract worth exactly zero. In the previous example, Party A agrees to sell one million pounds at $ per GBP at expiry. If the spot price is $1.61 at expiry, what is the profit and loss (P&L) for party A? On 18 August 2011, Party A can buy one million GBP from the market at the spot price of $1.61 and sell it to Party B per forward contract agreement at $ The net P&L at expiry is the difference between the strike price (K = ) and the spot price (S T = 1.61), multiplied by the notional value (one million). Hence, the profit is $ The primary use of a forward contract is to lock in the price at which one buys or sells a particular good in the future. This implies that the contract can be utilised to manage price risk. Forward contracts can be used to hedge against unforeseen movement in market prices. Consider an airline company which is going to buy barrels of oil one year from today. Suppose that forward price for delivery in one year is $100/bbl. Suppose that the yield on a oneyear and zero coupon bond is 5%. The airline company can use a forward contract to guarantee the cost of buying oil for the next year. The present value of this cost will be 100/1.05= The airline company could invest this amount to buy oil in one year or it could pay an oil supplier $100 at the delivery of the oil. If the spot price at the end of one year is above the agreed forward price, the airline company gains from this hedging. If the spot price at maturity is below the forward price, it would lead to the airline company to pay more than the market price of oil. Regardless of the spot price at the delivery, the airline company protects itself from potential loss and eliminates uncertainty regarding price movements. APRIL

17 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2.2 Futures Like a forward contract, a futures contract is a binding agreement between a seller and a buyer to make (seller) and to take (buyer) delivery of the underlying commodity (or financial instrument) at a specified future date with agreed upon payment terms. Unlike forward contracts: Futures contracts are standardised and exchange traded. Default risk is borne by the exchange clearinghouse. Traders are allowed to reverse ( offset ) their positions, so that physical delivery is rare (futures can be used to trade in the risk, not the commodity). This is true because most hedgers are not dealing in the commodity deliverable against the futures contract. For instance, an airline company is not going to use WTI crude oil in Cushing, Oklohama, for its operation, but may use the WTI futures contract as a hedge. That is, most hedgers are cross hedgers. Similarly, speculators are just betting on price movement, and have no interest in owning the physical oil. Therefore, most hedgers and speculators reverse their position prior to delivery. Value is marked to market daily. Different execution details also lead to pricing differences, e.g., effect of marking to market on interest calculation. Table 2.1 : Comparison Between Forward and Futures Contracts FORWARDS Private contracts between two parties Non standard contract Usually one specified delivery date Settled at the end of the contract Delivery or final cash settlement usually occurs Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Delivery is rare, usually parties offset their position before maturity Virtually no credit risk The fact that futures contracts terms are standardised is important because it enables traders to focus their attention on one variable, namely price. Standardisation also makes it possible for traders anywhere in the world to trade in these markets and know exactly what they are trading. This is in sharp contrast to the cash forward contract market, in which changes in specifications from one contract to another might cause price changes from one transaction to another. 14 APRIL 2011

18 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES Contract Specifications One of the main differences between forward contracts and futures contracts is the fact that futures contracts are standardised. When an exchange introduces a new contract, it has to specify in some detail the exact nature of the asset, the contract size, delivery point, delivery time, and settlement type (physical delivery or cash settlement). The underlying asset in the futures contract can be anything, ranging from commodities to stock indices, equities, bond, foreign exchange, interest rate, and so on. However, the exchange has to specify the exact terms in identifying the contract. The financial assets in futures contracts are well defined and there is no ambiguity. However, in the case of commodities, there may be quite a variation in the quality of what is available in the marketplace. When the asset is specified, the exchange has to specify in detail grade or grades of commodity that are acceptable for delivery. For example, the Chicago Mercantile Exchange (CME) deliverable grade specification of the WTI futures contract is presented in Box 1. Standardisation of futures contracts also requires the specification of the delivery point and the contract size (amount of asset that has to be delivered under one contract). For example, under the WTI futures contracts traded on the CME, delivery can be made F.O.B. at any pipeline or storage facility in Cushing, Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing storage. The contract size, on the other hand, is US barrels ( US gallons) of WTI crude oil. Futures contracts are also standardised with respect to the delivery month. The exchange must specify the precise period during the month when delivery can be made. The exchange also specifies when trading in a particular month s contract will begin, the last day on which trading can take place for a given contract as well as the delivery months. For example, CME WTI crude oil futures are listed nine years forward using the following listing schedule: consecutive months are listed for the current year and the next five years; in addition, the June and December contract months are listed beyond the sixth year. Additional months will be added on an annual basis after the December contract expires, so that an additional June and December contract would be added nine years forward, and the consecutive months in the sixth calendar year would be filled in. Even though physical delivery does not occur on most contracts, delivery is important nonetheless. Delivery ties the price of the expiring futures to the price of the physical commodity at delivery. Nonetheless, cash settlement can be considered another way to tie the futures and cash markets together. In a cash settled contract, at expiration the buyer pays the seller the difference between the fixed price established in the contract and the reference price prevailing on payment. APRIL

19 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Box 1: Grade and Quality Specifications of WTI Contract (Source CME) Light sweet crude oil meeting all of the following specifications and designations shall be deliverable in satisfaction of futures contract delivery obligations under this rule: (A) Domestic Crudes, (Deliverable at Par) Deliverable Crude Streams West Texas Intermediate Low Sweet Mix (Scurry Snyder) New Mexican Sweet North Texas Sweet Oklahoma Sweet South Texas Sweet Blends of these crude streams are only deliverable if such blends constitute a pipeline's designated common stream shipment which meets the grade and quality specifications for domestic crude. TEPPCO Crude Pipeline, L.P.'s and Equilon Pipeline Company LLC's Common Domestic Sweet Streams that meet quality specifications in Rule (A)(2 7) are deliverable as Domestic Crude. Sulfur: 0.42% or less by weight as determined by A.S.T.M. Standard D 4294, or its latest revision; (3) Gravity: Not less than 37 degrees API, nor more than 42 degrees API as determined by A.S.T.M. Standard D 287, or its latest revision; Viscosity: Maximum 60 Saybolt Universal Seconds at 100 degrees Fahrenheit as measured by A.S.T.M. Standard D 445 and as calculated for Saybolt Seconds by A.S.T.M. Standard D 2161; Reid vapor pressure: Less than 9.5 pounds per square inch at 100 degrees Fahrenheit, as determined by A.S.T.M. Standard D , or its latest revision; Basic Sediment, water and other impurities: Less than 1% as determined by A.S.T.M. D or D 4007, or their latest revisions; Pour Point: Not to exceed 50 degrees Fahrenheit as determined by A.S.T.M. Standard D 97. (B) Foreign Crudes Deliverable Crude Streams U.K.: Brent Blend (for which seller shall be paid a 30 cent per barrel discount below the last settlement price) Nigeria: Bonny Light (for which seller shall be paid a 15 cent per barrel premium above the last settlement price) Nigeria: Qua Iboe (for which seller shall be paid a 15 cent per barrel premium above the last settlement price) Norway: Oseberg Blend (for which seller shall be paid a 55 cent per barrel discount below the last settlement price) Colombia: Cusiana (for which seller shall be paid 15 cent per barrel premium above the last settlement price) Each foreign crude stream must meet the following requirements for gravity and sulfur, as determined by A.S.T.M. Standards referenced in Rule (A)(2 3): Foreign Crude Stream Minimum Gravity Maximum Sulfur Brent Blend 36.4 API 0.46% Bonny Light 33.8 API 0.30% Qua Iboe 34.5 API 0.30% Oseberg Blend 35.4 API 0.30% Cusiana 34.9 API 0.40% 16 APRIL 2011

20 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES The Clearinghouse Margins Clearing is the process by which trades in futures and options are processed, guaranteed, and settled by an entity known as a clearing house. A complete clearing house acts as the central counterparty to and guarantor of all trades that it has accepted for clearing from its clearing members. The clearing house becomes the buyer to every seller and the seller to every buyer through a process known as novation. The exchange clearing house intermediates all futures transactions. The credit status of the counterparty becomes irrelevant and contracts become fungible. A transactor needs only to worry about the credit status of the clearing house. Clearing houses have a legal relationship only with entities that they have been admitted as clearing members. That is to say, clearing houses have no legal relationship with the customers of their clearing members. Clearing members are generally institutions such as futures commission merchants and broker/dealers that have the financial, risk management, and operational capabilities to function as clearing members. Clearing houses perform the following duties: Match, guarantee, and settle all trades and register positions resulting from such trades. Perform mark to market calculations of all open positions at least once a day and oversee the resulting cash flows between clearing member firms. Manage the risk exposure that clearing firms present to the clearing house. Perform the exercise and assignment of options contracts. Facilitate, but not guarantee, the delivery of physical commodities. Permit multilateral netting of positions and settlement payments. Assuming contracts are fungible (interchangeable), clearing houses offset positions. Enable clearing members to substitute the credit and risk exposure of the clearing house for the credit and risk exposure of each other. Maintain a package of financial safeguards that are designed to mitigate losses in the event a clearing member defaults on its obligations to the clearing house. In the event of such a default, meet the obligations of the defaulter by first utilising the collateral pledged to it by the defaulter. If such collateral is insufficient to cover the entire amount of the defaulted amount, then utilise the components of its financial safeguards package to take care of the remaining defaulted amount. APRIL

21 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS One of the key safeguards in the risk management systems of futures clearing organisations is the requirement that market participants post collateral, known as margin, to guarantee their performance on contract obligations. In contrast to the operation of credit margins in the stock market, a futures margin is not a partial payment for the position being undertaken. Instead, the futures margin is a performance bond which serves as collateral or as a good faith deposit given by the trader to the broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures commission merchants (FCM) have the right to demand higher margins from their customers. In a traditional futures market, contracts are margined under a risk based margining system, which is called SPAN. Portfolio margining systems evaluate positions as a group and determine margin requirements based on the estimates of changes in the value of the portfolio that would occur under assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss generated by a simulation exercise that includes a range of potential market conditions. Marking to market ensures that futures contracts always have zero value; hence the clearing house does not face any risk. Marking to market takes place through margin payments. At the inception of the contract, each party pays an initial margin (typically 10% of the value contracted) to a margin account held by its broker. Initial margin may be paid in interest bearing securities (T bills) so there is no interest cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss (profit). The broker pays losses from and receives any profits into the parties margin accounts on the morning following trading. Loss making parties are required to restore their margin accounts to the required level during the course of the same day by payment of variation margins in cash; margin in excess of the required level may be withdrawn by profit making parties. For example, the initial margin for one WTI futures contract is $5 000 and the maintenance margin requirement is $3 750 per contract. Consider the following example. Trader X bought a 10 September 2011 delivery NYMEX crude oil futures contract. Suppose that the current price is $100 (18 February 2011). The broker will require the investor to deposit an initial margin of $ in the margin account. At the end of each day, the margin account is adjusted to reflect the investor s gain or loss. This practice is known as marking to market the account. Whenever the margin account exceeds or falls below the maintenance margin ($3 750 in our example), then the customer receives a margin call from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of 18 APRIL 2011

22 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES the initial margin and whenever it is below the maintenance level, the customer has to deposit to bring the margin account to its initial margin level. The extra funds deposited are known as a variation margin. Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so called variation margin, to bring the margin account to the initial level. On the other hand, the seller of the contract account will be credited. In practice, there is actually a chain of margins. Traders post margins with brokers. Non clearing brokers post margins with clearing brokers. Clearing brokers post margins with the clearinghouses. The margin posted by clearinghouse members with the clearinghouse is known as a clearing margin. However, in the case of clearinghouse member, there is an original margin but no maintenance margin. Table 2.2 : The following table summarises price changes and margin account. Daily Gain or Cumulative Margin Account Day Futures Prices of WTI Crude Oil ($/bbl) Margin Call (loss) Gain (Loss) Balance 18 Feb Feb Feb Feb Feb Feb Feb Mar Mar Mar Mar Settlement Price, Volume and Open Interest in Futures Markets The settlement price is the average of the prices at which the contract traded immediately before the end of trading for the day. The settlement price is very important since it is used to determine margin requirements and the following day's price limits. Volume in futures market represents the total amount of trading activity or contracts that have changed hands in a given commodity market for a single trading day. On the other hand, open interest is the total APRIL

23 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS number of contracts outstanding that are held by market participants at the end of each day. A contract is created by a seller and buyer of contract, therefore open interest can be calculated as the sum of all the long positions (or equivalently it is the sum of all the short positions). Open interest will increase by one contract if both parties to the trade are initiating a new position (one new buyer and one new seller) and open interest will decrease by one contract if both traders are closing an existing or old position (one old buyer and one old seller). However, if one old trader is passing off his position to a new trader (one old buyer sells to one new buyer), open interest will not change Types of Orders The simplest type of order placed with a broker is a market order. A market order is an order to buy or sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other trading platform. However, there are many other types of orders. Most commonly used orders are the limit order, and the stop order or stop loss order. A limit order is an order in which the customer specifies a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. Thus, if the limit price is $95/bbl for one April WTI contract for an investor wanting to sell, the order will be executed only at a price of $95/bbl or more. As opposed to a market order, a limit order will not be executed unless the price reaches $95/bbl. A stop order or stop loss order is an order that becomes a market order when a particular price level is reached. A sell stop is placed below the market; a buy stop is placed above the market. The purpose of a stop order is to close out a position if unfavorable price movements take place. 2.3 Hedging Using Futures Contracts 4 Traditionally, many of the market participants in futures markets were hedgers. Hedgers use futures markets to reduce particular risks arising from fluctuations in the price of the underlying asset. Of course, it might not be possible to eliminate the risks completely due to basis risk, which we discuss later in the text. For the time being, we assume the possibility of a perfect hedge, which completely eliminates the risk. A hedge might involve taking a long position (long hedge) or a short position (short hedge) in the futures contract. 4 Futures contracts can be used in similar fashion for speculation purposes as well. 20 APRIL 2011

24 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. For example, an airline company knows that it will require barrel of crude oil on 1 July 2011 for its flight operations. The spot price of oil is $95/bbl, and the future price for July delivery (July is the delivery month for June contract) is $99/bbl. In order to avoid any risk associated with price change between now and July, the airline company can buy crude oil now at $95/bbl and store it until July. In this case, the airline company has to pay storage costs as well as interest costs. Alternatively, it can hedge its position by taking a long position in one hundred CME WTI June futures contracts (each contract is for delivery of barrels of crude oil) and closing its position before the expiration by selling one hundred such contracts. Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the future price. The airline gains from futures contracts approximately ($102 $99)=$ In July, the airline pays $ =$ for the crude oil, making the net cost approximately $ On the other hand, if the spot price in July turned out to be $90/bbl, then the airline company loses from its futures contract approximately ($99 $90)=$ and pays $ =$ for the crude oil in the spot market. Again here, the total net cost of the oil for the airline company would be $ No matter what happens to the spot price in July, entering into a futures contract allows the airline company to fix its net cost to the number of oil barrels times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the cost of funding. A short hedge works in a similar way. Consider an oil producer, who wants to sell again barrels of crude oil in July. Assume that all the above information still holds. Since the oil producer wants to sell its oil, it can hedge its cash position by taking a short position in one hundred CME WTI June contracts, which will be delivered in July. The producer again offsets its short position by going long before the expiration of contract. Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the futures price. The producer loses from a futures contract approximately ($102 $99)=$ APRIL

25 2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS In July, the producer gets $ =$ for the crude oil, making a net revenue from its sales of approximately $ On the other hand, if the spot price in July turned out to be $90/bbl, then the producer company gains from its futures contract approximately ($99 $90)=$ and gets $ =$ for the crude oil in spot market. Again here, the total net revenue for the oil for the producer would be $ No matter what happens to the spot price in July, entering into the futures contract allows the producer to fix its net revenue to the barrel of oil times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the revenue. 2.4 Basis Risk Up until now, we assumed that hedgers can completely eliminate risks by taking futures positions opposite to their cash positions. However, in reality it is difficult to eliminate all risks. In order to eliminate all risks associated with cash positions, the hedger must know the precise date in the future when an asset would be bought or sold. Even if the hedger knows the exact date of purchase or sale, he might have to close his/her futures position before its delivery month, i.e. there might be a mismatch between the hedge period and available delivery date. Even then, the hedger would need to find the same asset underlying the futures contract as the asset s/he is planning to buy or sell. For all these reasons, the hedger will face basis risk, which can be defined as the difference between the spot price of the asset to be hedged and the futures price of the contract used. If the asset to be hedged and the asset underlying the futures contract are the same, then we should expect the basis risk to be zero at the expiration of the futures contract. Prior to expiration, the basis can be negative or positive. If the basis is positive, i.e. the spot price is greater than the futures price, the situation is known as backwardation. If, on the other hand, the basis is negative, i.e. spot price is less than the futures price, the situation is known as contango. If, on the other hand, the asset to be hedged and the asset underlying the futures contract are different a situation known as cross hedging then we should expect the basis risk to be different from zero even at expiration. Sometimes, it is not possible to find futures contracts for some commodities. Consider an airline company, which is concerned about the future price of jet fuel oil, rather than crude oil. Since there is no futures contract on jet fuel oil, the airline company tries to find an asset underlying the futures contract which is highly correlated with the asset to be hedged. High correlation results in low basis risk and high hedge effectiveness. 22 APRIL 2011

26 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS 3. SWAPS Forward or futures contracts settle on a single date. However, many transactions occur repeatedly For example, an airline company buys jet fuel oil on an ongoing basis. If a manager seeking to reduce risk confronts a risky payment stream, what is the easiest way to hedge this risk? You can enter into a separate forward contract for each payment you wish to hedge. However, it could be more convenient and entail lower transaction costs, if there were a single transaction that we could use to hedge a stream of payments. Swaps serve exactly this purpose. Swaps are agreements between two companies to exchange cash flows in the future according to a prearranged formula. Swaps, therefore, may be regarded as a portfolio of forward contracts. Swaps are traded on over the counter derivatives markets and are most common in interest rates, currencies and commodities. They often extend much further into the future than exchange contracts. The parties to a swap set: the notional amount; the tenor or maturity of the swap; the payment dates; the floating price index; and the fixed price. The following discussion on the swap market and development in the swap market excerpts from the CFTC Commodity Swap Dealers & Index Traders with Commission Recommendations report. 5 The first swap contracts were negotiated in In order to reduce overall funding costs for both parties, the World Bank and IBM entered into what has become known as a currency swap. The swap essentially involved a loan in Swiss francs by IBM to the World Bank and a loan in U.S. dollars by the World Bank to IBM. This structure of swapping cash flows ultimately served as the template for swaps on any number of financial assets and commodities. Swaps serve as an effective hedging vehicle in much the same way that financial futures contracts do. For example, a typical futures contract has many of the same characteristics as a swap in that it is essentially a contract where the buyer of the contract agrees at the outset to pay a fixed price for a commodity in return for future delivery of the commodity, which will have an uncertain or floating value at the time of expiration of the contract. 5 See APRIL

27 3. SWAPS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS The party offering the swap, typically called a swap dealer, takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. In the early development of swap markets, investment banks often served in a brokering capacity to bring together parties with opposite hedging needs. The currency swap between the World Bank and IBM, for example, was brokered by Salomon Brothers. While brokering swaps eliminates market price and credit risk to the broker, the process of matching and negotiating swaps between counterparties with opposite hedging needs could be difficult. As a result, swap brokers (who took on no market risk) evolved into swap dealers (who took the contract onto their books). As noted, when a swap dealer takes a swap onto its books, it takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. In addition, the counterparty bears a credit risk that the swap dealer may not honour its commitment. This risk can be significant in the case of a swap dealer because it is potentially entering into numerous transactions involving many counterparties, each of which exposes the swap dealer to additional credit risks. As a result of these risks, there has been a natural tendency for financial intermediaries (e.g., commercial banks, investment banks, insurance companies) to become swap dealers. These firms typically have the capitalisation to support their creditworthiness as well as the expertise to manage the market price risks that they take on. In addition, for particular commodity classes, such as agriculture and energy, large commercial companies that have the expertise to manage market price risks have set up affiliates to specialise as swap dealers for those commodities. The utility of swap agreements as a hedging vehicle has led to significant growth in both the size and complexity of the swap market. During the early period in the development of the swap market, the majority of swap agreements involved financial assets. In fact, even today the vast majority of swaps outstanding involve either interest rates or currencies. The OTC swap market has grown significantly because, for many financial entities, the OTC derivatives products offered by swap dealers have distinct advantages relative to futures contracts. While futures markets offer a high degree of liquidity (i.e., the ability to quickly execute trades due to the high number of participants willing to buy and sell contracts), futures contracts are more standardised, meaning that they may not meet the exact needs of a hedger. Swaps, on the other hand, offer additional flexibility since the counterparties can tailor the terms of the contract to meet specific hedging needs. 24 APRIL 2011

28 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS As an example of the flexibility that swaps can offer, consider again the case of an airline wanting to hedge future jet fuel purchases. Currently there is no jet fuel futures contract available to the airlines to directly hedge their price exposure. Contracts for crude oil (from which jet fuel is made) and heating oil (which is a fuel having similar chemical characteristics to jet fuel) do exist. But while these contracts can be used to hedge jet fuel, the dissimilarities between jet fuel and crude oil or heating oil mean that the airline will inevitably take on what was referred to above as basis risk. That is, the price of jet fuel and the prices of these futures contracts will not tend to move perfectly together, diminishing the utility of the hedge. In contrast, swap dealers can offer the airline the alternative of entering into a contract that directly references the cash price for jet fuel at the specific time and location where the product is needed. By creating a customised OTC derivative product that specifically addresses the price risks faced by the airline, by taking on the administrative costs associated with managing that contract over time, and by assuming the price risks attendant to that contract, the swap dealer facilitates the airline s risk management. When a commercial entity uses a swap to offset its risk, the swap dealer assumes the price risk of the commodity. For example, if the swap dealer enters into a jet fuel swap with an airline, the airline agrees to periodically pay a fixed amount on the swap while the swap dealer pays a floating amount based on a cash market price. At each point in time when the payments are due, a netting of the obligations takes place and the party responsible for the larger payment pays the difference to the other party. Thus, if prices rise, the floating payment will be larger than the fixed price and the swap dealer pays the net amount to the airline. Conversely, if prices fall, the airline will be required to make a payment to the swap dealer. Recall, however, that when the airline makes a payment on the swap to the swap dealer, it means that at the same time, it is paying a lower price to acquire jet fuel in the cash market. The swap dealer, however, has no natural offsetting transaction to counterbalance the risk. That is why swap dealers will, in turn, hedge this price risk in the regulated futures markets. Swap agreements have also become a popular vehicle for noncommercial participants, such as hedge funds, pension funds, large speculators, commodity index traders, and others with large pools of cash, to gain exposure to commodity prices. Recently, portfolio managers have sought to invest in commodities because of the lack of correlation, or even negative correlation, that commodities tend to have with traditional investments in stocks and bonds. In addition, because APRIL

29 3. SWAPS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS of the ability to tailor transactions, swaps can represent a more efficient means by which these participants can enter the market. Hence, many of the benefits that swap agreements offer commercial hedgers also attract noncommercial interests to the swap market. Since swap dealers are willing to enter into swap contracts on either side of a market, at times they will enter into swaps that create offsetting exposures, reducing the swap dealer s overall market price risk associated with the firm s individual positions opposite its counterparties. Since it is unlikely, however, that a swap dealer could completely offset the market price risks associated with its swap business at all times, dealers often enter the futures markets to offset the residual market price risk. As a result of the growth of the swap market and the dealers who support the market, there has been an associated growth in the open interest of the futures markets related to the commodities for which swaps are offered, as these swap dealers attempt to lay off the residual risk of their swap book. A more recent phenomenon in the derivatives market has been the development of commodity index funds and exchange traded funds for commodities (ETFs) and exchange traded notes (ETNs), which are mainly transacted through swap dealers. Both products are designed to produce a return that mimics a passive investment in a commodity or group of commodities. ETFs and ETNs are traded on securities exchanges and are backed by physical commodities or long futures positions held in a trust. Commodity index funds are funds that enter into swap contracts that track published commodity indexes such as the S&P Goldman Sachs Commodity Index or the Dow Jones AIG Commodity Index. 3.1 Mechanics of Swaps When two parties enter a swap contract, one party makes a payment to the other depending upon whether a price turns out to be greater or less than a reference price that is specified in the swap contract. For example by entering into an oil swap, an oil buyer confronting a stream of uncertain oil payments can lock in a fixed price for oil over a period of time. The swap payments would be based on the fixed price for oil and a market price that varies over time. Suppose Untied Airlines (UA) is going to buy barrels of oil one year from today and two years from today. Suppose that the forward price for delivery in one year is $75/bbl and in two years is $90/bbl. Suppose one year and two year zero coupon bond yields are 5% and 5.5%. UA can use a 26 APRIL 2011

30 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS forward contract to guarantee the cost of buying oil for the next two years. The present value of this cost will be $ $ $ UA could invest this amount to buy oil in one and two years, or it could pay an oil supplier $ who would commit to delivering one barrel in each of the next two years. This is a prepaid swap. If the payment is done after two years, this is a postpaid swap. Typically, a swap will call equal payments in each year, or $82.28/bbl. This is the price of a two year swap. However, any payments that have a present value of $ are acceptable. In exchange, the swap counterparty delivers barrels of crude oil each year. The notional value of the swap can be calculated by multiplying all cash flows by Instead of delivery, if the swap counterparties settled with cash, the oil buyer, UA, pays the swap counterparty the difference between $82.28/bbl and the spot price (if the difference is negative, the counterparty pays the buyer), and the oil buyer then buys the oil in the spot market. For example, if the spot price is $90/bbl, the swap counterparty pays the buyer Spot price swap price=$90 $82.28=$7.72 If the spot price is $80/bbl, then oil buyer makes a payment to the swap counterparty Spot price swap price=$80 $82.28= $2.28 Whatever the spot price, the net cost to the buyer is the swap price, $82.28/bbl Although the swap price is close to the mean of forward prices ($82.50/bbl), it is not exactly the same. Why? Suppose the swap price is $82.50/bbl, then the oil buyer would then be committing to pay more than $7.50 more than the forward price the first year and would pay $7.50 less than the forward price the second year. Thus relative to the forward curve, the buyer would have made an interest free loan to the counterparty. If the swap price is $82.28, then we are overpaying $7.28 in the first year and underpaying $7.72 in the second year, relative to the forward curve. The swap is equivalent to being long on the two forward contracts, coupled with an agreement to lend $7.28 to the counterparty in the first year, and receive $7.72 in second year. The interest rate on this loan is $7.72/$7.28 1=6%. Where does 6% come from? 6% is the one year implied forward yield from year one to year two. APRIL

31 4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 4. OPTIONS An option is a contract that gives the option holder the right/option, but no obligation, to buy or sell a security (or a futures contract) to the option writer/seller at (or up to) a given time in the future (the expiry date or maturity date) for a pre specified price (the strike price or exercise price, K). The option purchaser (holder) is the person who buys a call or a put option and pays the option premium, i.e. the person who establishes a long options position. This is the party with the right, but not the obligation, under the terms of the contract. The option writer, or grantor, is the person who sells a call or put option and receives the option premium, i.e. the person who establishes a short position. This party is obligated to perform under the terms of such an option. A call option gives the holder the right to buy a security and a put option gives the holder the right to sell a security. Where the underlying interest is represented by a futures contract, the right to buy is actually a right to be long on a futures contract at a specified price level. Conversely, the right to sell represents the right to a short futures position at a specified price level. Options allow one to take advantage of changes in futures prices without actually having a position in the futures market. Options can be American, European or Bermudan. American options can be exercised at any time prior to expiry. European options can only be exercised at the expiry. Bermudan option can only be exercised during the specified period. The price at which the futures contract underlying an option can be purchased (if a call) or sold (if a put) is called the strike price or the exercise price. In the call and put definitions above, this is the predetermined price. It is important to note that for every option buyer there is an option seller. At any time before the option expires, the option buyer can exercise the option. Since the buyer decides whether to exercise, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. The option premium is determined through trading on an exchange market. Therefore, we should expect to see different option premia for different strike prices. Effectively, the exercise of a call gives the option purchaser a long position in the underlying futures contract at the option s strike price; the exercise of a put option gives the option purchaser a short futures position at the option s strike price. The option buyer can also sell the option to someone else or 28 APRIL 2011

32 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES do nothing and let the option expire. The choice of action is left entirely up to the option buyer. The option buyer obtains this right by paying the premium to the option seller. A call option buyer will only choose to exercise if the stock price is greater/higher than the strike price. If the stock price is less than the strike price, the investor would clearly choose not to exercise the option, and the investor only loses the option premium. On the other hand, a put option buyer will only to choose to exercise the option when the stock price is less than strike price. If the stock price is more than the strike price, the investor would clearly choose not to exercise the option and would only lose the option premium. What about the option seller? The option seller receives the premium from the option buyer. If the option buyer exercises the option, the option seller is obligated to take the opposite futures position at the same strike price. Because of the seller s obligation to take a futures position if the option is exercised, an option seller must post a margin and faces the possibility that the margin will be called if the market moves against his potential futures position. 4.1 Call Option A call option is a contract where the buyer has the right, but not the obligation, to buy an underlying security. Since the buyer decides whether or not to buy, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. Consider a call option on the S&R index with six months to expiration and strike price of $1000 and premium of $ And assume that the risk free rate is 2% over six months. Suppose that the index in six months is $1100. Clearly it is worthwhile to pay the $1000 strike price to acquire the index worth $1100. If on the other hand the index is $900 at expiration, it is not worthwhile paying the $1000 strike price to buy the index worth $900. In this case: The buyer is not obliged to buy the index and hence will only exercise the option if the payoff is positive. Purchased call payoff = max(0,s T K) In our example, K=1000. If S=1100 then the call payoff Purchased call payoff = max(0, )=$100 If S=900, then the call payoff is Purchased call payoff = max(0, )=$0 6 The discussions on call and put options draws upon McDonald (2006). APRIL

33 4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS The payoff does not take into account the initial cost (option premium) of acquiring the position. For a purchased option, the premium is paid at the time the option is acquired. In computing profit at expiration, we use the future value of the premium. Purchased call profit = max(0,s T K) future value of option premium Purchased call profit = Purchased call payoff future value of option premium If the index at the expiration is 1100, then profit is Purchased call profit=max(0, ) =$4.32 If the index at the expiration is 900, then the owner does not exercise the option. The loss will be future value of option premium. Maximum loss will be the option premium. Purchased call profit=max(0, ) = $95.68 The Payoff at Expiration with a Strike Price of $1000 Payoff ($) S&R Index Price ($) Call Payoff 30 APRIL 2011

34 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES Profit at Expiration for Call Option with K=1000 and Long Forward Profit ($) Index price= Call Profit Long Forward Profit S&R Index Price ($) The option writer (seller of option) has a short position in a call option. The writer receives the premium for the option and then has an obligation to sell the underlying security in exchange for the strike price if the option buyer exercises the option. The payoff and profit to a written call are just the opposite of those for a purchased call. Written call payoff = max(0,s T K) = min(0,k S T ) Written call profit = max(0,s T K)+future value of option premium In our example, if S=1100 then the option writer payoff will be $100 and profit will be $4.32. If on the other hand, S=900, then payoff will be 0 and profit will be the future value of premium, $ APRIL

35 4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Payoff ($) Payoff for Option Writer with Strike Price of $ S&R Index Price ($) Written Call Payoff Profit for Option Writer with Strike Price of $1000 Profit ($) S&R Price Index ($) Index Price= 1020 Index Price= Written Call Profit Short Forward 4.2 Put Option A put option is a contract where the buyer has the right to sell, but not the obligation. Since the buyer decides whether to sell, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. Example: Put Option Consider a put option on the S&R index with six months to expiration and strike price of $1000 and premium of $ And assume that the risk free rate is 2% over six months. Suppose that the index in 32 APRIL 2011

36 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES six months is $1100. Clearly it is not worthwhile to sell the index worth $1100 for the strike price of $1000. If on the other hand the index is $900 at expiration, it is worthwhile selling the index for $1000. The buyer is not obliged to sell the index and hence will only exercise the option if the payoff is positive. Purchased put payoff = max(0,k S T ) In our example, K=1000. If S=1100 then the put payoff Purchased put payoff = max(0, )=$0 If S=900, then the put payoff is Purchased put payoff = max(0, )=$100 The payoff does not take into account the initial cost of acquiring the position. For a purchased option, the premium is paid at the time the option is acquired. In computing profit at expiration, we use the future value of the premium. Purchased put profit = max(0,k S T ) future value of option premium Purchased put profit = Purchased put payoff future value of option premium If the index at the expiration is 1100, then the option buyer will not exercise his right to sell and the maximum loss will be the future value of the option premium. Purchased put profit = max(0, ) = $75.68 If the index at the expiration is 900, then the owner exercises the option i.e. sells. The profit will be Purchased put profit = max(0, ) =$24.32 The option writer (seller of option) has a long position in a put option. The writer receives the premium for the option and then has an obligation to buy the underlying security in exchange for the strike price if the option buyer exercises the option. The payoff and profit to a written put are just the opposite of those for a purchased put. Written put payoff = max(0,k S T ) = min(0,s T K) Written put profit= max(0,k S T )+future value of option premium In our example, if S=1100 then the put buyer will not exercise the put, thus put writer earns profit, which will be option premium. If, on the other hand, S=900, then the option buyer exercises the option and the option seller (writer) will lose $24.32 ( 100+$75.68). 4.3 Moneyness of Options Options are generally referred to as in the money, at the money, or out of money. The moneyness of an option depends on the strike price (K) relative to the spot (S t )/forward (F t ) price of the underlying asset. APRIL

37 4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS An option is said to be in the money if the option has positive value if exercised right now: S t > K for call options and S t < K for put options. Sometimes it is also defined in terms of the forward price at the same maturity (in the money forward): F t > K for call and F t < K for put. The option has positive intrinsic value (defined as the maximum of zero and the value the option would have if it is exercised today) when in the money. The intrinsic value is (S t K)+ for call, (K S t )+ for put options. We can also define intrinsic value in terms of the forward price. An option is said to be out of the money when it has zero intrinsic value. S t < K for call options and S t > K for put options. Out of the money forward: F t < K for call and F t > K for put. An option is said to be at the money spot (or forward) when the strike is equal to the spot (or forward). 4.4 Hedging Using Options Options can be used for hedging purposes. Consider a trader (an airline company) who thinks that oil prices are going to move substantially higher in the near future and wants some protection. In this case, the trader might buy a call option. Let us assume that it is 11 March and a July call contract with a $100 strike price is at $4 option premium. Assume that the July futures contract is currently trading at $100. If the trader decides to buy the call option, he has to pay the premium of (1000 4=$4000) per contract. By purchasing this call option, the trader has the right to buy a July futures contract at $100/bbl. The seller of the contract receives a $4000 option premium per contract and is obligated to take a short futures position at $100/bbl in the July contract if the option buyer chooses to exercise his option. Let s say that by May the July futures price has risen to $110/bbl. The trader s July contract has a value of at least $10 ($110 $100). The trader at this point can sell his option to someone else for $10/bbl and be out of the market. His total profit will be $6000 (1000 (10 4)) per contract. Or alternatively, he will exercise his option and he will get one long July futures contract. The hedger in this case limited his risk of a substantial rise in prices. If, on the other hand, prices decline, the trader will not exercise his option and he will lose only the premium he paid when he signed the contract. 34 APRIL 2011

38 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES 5. REFERENCES CFTC (2008) Commodity Swap Dealers & Index Traders with Commission Recommendations. McDonald, Robert L. (2006). Derivatives Markets. 2 nd Edition, Addison Wesley. Weber, Ernst Juerg (2008). A Short History of Derivative Security Markets. Available at SSRN: APRIL

39 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET TERMS 7 A Abandon: To elect not to exercise or offset a long option position. Accommodation Trading: Non competitive trading entered into by a trader, usually to assist another with illegal trades. Accumulator: A contract in which the seller agrees to deliver a specified quantity of a commodity or other asset to the buyer at a pre determined price on a series of specified accumulation dates over a specified period of time. The contract typically has a knock out price, which, if reached, will trigger the cancellation of all remaining accumulations. Moreover, the amount of the commodity to be delivered may be doubled or otherwise adjusted on those accumulation dates when the price of the asset reaches a specified price different from the knockout price. Actuals: The physical or cash commodity, as distinguished from a futures contract. See Cash and Spot Commodity. Agency Bond: A debt security issued by a government sponsored enterprise such as Fannie Mae or Freddie Mac, designed to resemble a U.S. Treasury bond. Agency Note: A debt security issued by a government sponsored enterprise such as Fannie Mae or Freddie Mac, designed to resemble a U.S. Treasury note. Aggregation: The principle under which all futures positions owned or controlled by one trader (or group of traders acting in concert) are combined to determine reporting status and compliance with speculative position limits. Agricultural Trade Option Merchant: Any person that is in the business of soliciting or entering option transactions involving an enumerated agricultural commodity that are not conducted or executed on or subject to the rules of an exchange. Algorithmic Trading: The use of computer programs for entering trading orders with the computer algorithm initiating orders or placing bids and offers. Allowances: (1) The discounts (premiums) allowed for grades or locations of a commodity lower (higher) than the par (or basis) grade or location specified in the futures contract. See Differentials. (2) The tradable right to emit a specified amount of a pollutant under a cap and trade system. American Option: An option that can be exercised at any time prior to or on the expiration date. See European Option. Approved Delivery Facility: Any bank, stockyard, mill, storehouse, plant, elevator, or other depository that is authorized by an exchange for the delivery of commodities tendered on futures contracts. 7 Source: CFTC. This glossary is available at 36 APRIL 2011

40 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Arbitrage: A strategy involving the simultaneous purchase and sale of identical or equivalent commodity futures contracts or other instruments across two or more markets in order to benefit from a discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for profitable arbitrage. See Spread. Arbitration: A process for settling disputes between parties that is less structured than court proceedings. The National Futures Association arbitration program provides a forum for resolving futures related disputes between NFA members or between NFA members and customers. Other forums for customer complaints include the American Arbitration Association. Artificial Price: A cash market or futures price that has been affected by a manipulation and is thus higher or lower than it would have been if it reflected the forces of supply and demand. Asian Option: An exotic option whose payoff depends on the average price of the underlying asset during a specified period preceding the option expiration date. Ask: The price level of an offer, as in bid ask spread. Assignable Contract: A contract that allows the holder to convey his rights to a third party. Exchangetraded contracts are not assignable. Assignment: Designation by a clearing organization of an option writer who will be required to buy (in the case of a put) or sell (in the case of a call) the underlying futures contract or security when an option has been exercised, especially if it has been exercised early. Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant. At the Market: An order to buy or sell a futures contract at whatever price is obtainable when the order reaches the trading facility. See Market Order. At the Money: When an option's strike price is the same as the current trading price of the underlying commodity, the option is at the money. Auction Rate Security: A debt security, typically issued by a municipality, in which the yield is reset on each payment date via a Dutch auction. Audit Trail: The record of trading information identifying, for example, the brokers participating in each transaction, the firms clearing the trade, the terms and time or sequence of the trade, the order receipt and execution time, and, ultimately, and when applicable, the customers involved. Automatic Exercise: A provision in an option contract specifying that it will be exercised automatically on the expiration date if it is in the money by a specified amount, absent instructions to the contrary. APRIL

41 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS B Back Months: Futures delivery months other than the spot or front month (also called deferred months). Back Office: The department in a financial institution that processes and deals and handles delivery, settlement, and regulatory procedures. Back pricing: Fixing the price of a commodity for which the commitment to purchase has been made in advance. The buyer can fix the price relative to any monthly or periodic delivery using the futures markets. Back Spread: A delta neutral ratio spread in which more options are bought than sold. A back spread will be profitable if volatility increases. See Delta. Backwardation: Market situation in which futures prices are progressively lower in the distant delivery months. For instance, if the gold quotation for January is $ per ounce and that for June is $ per ounce, the backwardation for five months against January is $15.00 per ounce. (Backwardation is the opposite of contango). See Inverted Market. Banging the Close: A manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract (that is, the period during which the futures settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative that is cash settled based on the futures settlement price on that day. Banker's Acceptance: A draft or bill of exchange accepted by a bank where the accepting institution guarantees payment. Used extensively in foreign trade transactions. Basis: The difference between the spot or cash price of a commodity and the price of the nearest futures contract for the same or a related commodity (typically calculated as cash minus futures). Basis is usually computed in relation to the futures contract next to expire and may reflect different time periods, product forms, grades, or locations. Basis Grade: The grade of a commodity used as the standard or par grade of a futures contract. Basis Point: The measurement of a change in the yield of a debt security. One basis point equals 1/100 of one percent. Basis Quote: Offer or sale of a cash commodity in terms of the difference above or below a futures price (e.g., 10 cents over December corn). Basis Risk: The risk associated with an unexpected widening or narrowing of the basis (that is, the difference between the futures price and the relevant cash price) between the time a hedge position is established and the time that it is lifted. Basis Swap: A swap whose cash settlement price is calculated based on the basis between a futures contract (e.g., natural gas) and the spot price of the underlying commodity or a closely related commodity (e.g., natural gas at a location other than the futures delivery location) on a specified date. 38 APRIL 2011

42 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Bear: One who expects a decline in prices. The opposite of a bull. A news item is considered bearish if it is expected to result in lower prices. Bear Market: A market in which prices generally are declining over a period of months or years. Opposite of bull market. Bear Market Rally: A temporary rise in prices during a bear market. See Correction. Bear Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and expiration date, but different strike prices. In a bear spread, the option that is purchased has a lower delta than the option that is bought. For example, in a call bear spread, the purchased option has a higher exercise price than the option that is sold. Also called bear vertical spread. (2) The simultaneous purchase and sale of two futures contracts in the same or related commodities with the intention of profiting from a decline in prices but at the same time limiting the potential loss if this expectation does not materialize. In agricultural products, this is accomplished by selling a nearby delivery and buying a deferred delivery. Bear Vertical Spread: See Bear Spread. Bermuda Option: An exotic option which can be exercised on a specified set of predetermined dates during the life of the option. Beta (Beta Coefficient): A measure of the variability of rate of return or value of a stock or portfolio compared to that of the overall market, typically used as a measure of riskiness. Bid: An offer to buy a specific quantity of a commodity at a stated price. Bid Ask Spread or Bid Offer Spread: The difference between the bid price and the ask or offer price. Binary Option: A type of option whose payoff is either a fixed amount or zero. For example, there could be a binary option that pays $100 if a hurricane makes landfall in Florida before a specified date and zero otherwise. Also called a digital option. Blackboard Trading: The practice, no longer used, of buying and selling commodities by posting prices on a blackboard on a wall of a commodity exchange. Black Scholes Model: An option pricing model initially developed by Fischer Black and Myron Scholes for securities options and later refined by Black for options on futures. Block Trade: A large transaction that is negotiated off an exchange s centralized trading facility and then executed on the trading facility, as permitted under exchange rules. Board Order: See Market if Touched Order. Board of Trade: Any organized exchange or other trading facility for the trading of futures and/or option contracts. APRIL

43 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Boiler Room: An enterprise that often is operated out of inexpensive, low rent quarters (hence the term boiler room ), that uses high pressure sales tactics (generally over the telephone), and possibly false or misleading information to solicit generally unsophisticated investors. Booking the Basis: A forward pricing sales arrangement in which the cash price is determined either by the buyer or seller within a specified time. At that time, the previously agreed basis is applied to the then current futures quotation. Book Transfer: A series of accounting or bookkeeping entries used to settle a series of cash market transactions. Box Spread: An option position in which the owner establishes a long call and a short put at one strike price and a short call and a long put at another strike price, all of which are in the same contract month in the same commodity. Break: A rapid and sharp price decline. Broad Based Security Index: Any index of securities that does not meet the legal definition of narrowbased security index. Broker: A person paid a fee or commission for executing buy or sell orders for a customer. In commodity futures trading, the term may refer to: (1) Floor broker, a person who actually executes orders on the trading floor of an exchange; (2) Account executive or associated person, the person who deals with customers in the offices of futures commission merchants; or (3) the futures commission merchant. Broker Association: Two or more persons with exchange trading privileges who (1) share responsibility for executing customer orders; (2) have access to each other's unfilled customer orders as a result of common employment or other types of relationships; or (3) share profits or losses associated with their brokerage or trading activity. Bucketing: Directly or indirectly taking the opposite side of a customer's order into a broker s own account or into an account in which a broker has an interest, without open and competitive execution of the order on an exchange. Also called trading against. Bucket Shop: A brokerage enterprise that books (i.e., takes the opposite side of) retail customer orders without actually having them executed on an exchange. Bull: One who expects a rise in prices. The opposite of a bear. A news item is considered bullish if it is expected to result in higher prices. Bullion: Bars or ingots of precious metals, usually cast in standardized sizes. Bull Market: A market in which prices generally are rising over a period of months or years. Opposite of a bear market. Bull Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and expiration date but different strike prices. In a bull vertical spread, the purchased option has a higher 40 APRIL 2011

44 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET delta than the option that is sold. For example, in a call bull spread, the purchased option has a lower exercise price than the sold option. Also called bull vertical spread. (2) The simultaneous purchase and sale of two futures contracts in the same or related commodities with the intention of profiting from a rise in prices but at the same time limiting the potential loss if this expectation is wrong. In agricultural commodities, this is accomplished by buying the nearby delivery and selling the deferred. Bull Vertical Spread: See Bull Spread. Bust: To cancel a trade that was executed in error. Buoyant: A market in which prices have a tendency to rise easily with a considerable show of strength. Bunched Order: A discretionary order entered on behalf of multiple customers. Bust: An executed trade cancelled by an exchange that is considered to have been executed in error. Butterfly Spread: A three legged option spread in which each leg has the same expiration date but different strike prices. For example, a butterfly spread in soybean call options might consist of one long call at a $5.50 strike price, two short calls at a $6.00 strike price, and one long call at a $6.50 strike price. Buyer: A market participant who takes a long futures position or buys an option. An option buyer is also called a taker, holder, or owner. Buyer s Call: A purchase of a specified quantity of a specific grade of a commodity at a fixed number of points above or below a specified delivery month futures price with the buyer allowed a period of time to fix the price either by purchasing a futures contract for the account of the seller or telling the seller when he wishes to fix the price. See Seller s Call. Buyer s Market: A condition of the market in which there is an abundance of goods available and hence buyers can afford to be selective and may be able to buy at less than the price that previously prevailed. See Seller's Market. Buying Hedge (or Long Hedge): Hedging transaction in which futures contracts are bought to protect against possible increases in the cost of commodities. See Hedging. Buy (or Sell) On Close: To buy (or sell) at the end of the trading session within the closing price range. Buy (or Sell) On Opening: To buy (or sell) at the beginning of a trading session within the open price range. C C & F: Cost and Freight paid to a point of destination and included in the price quoted; same as C.A.F. Calendar Spread: (1) The purchase of one delivery month of a given futures contract and simultaneous sale of a different delivery month of the same futures contract; (2) the purchase of a put or call option and the simultaneous sale of the same type of option with typically the same strike price but a different expiration date. Also called a horizontal spread or time spread. Call: (1) An option contract that gives the buyer the right but not the obligation to purchase a commodity, security, or other asset or to enter into a long futures position at a given price (the strike APRIL

45 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS price ) prior to or on a specified expiration date; (2) a period at the opening and the close of some futures markets in which the price for each futures contract was established by auction; or (3) the requirement that a financial instrument such as a bond be returned to the issuer prior to maturity, with principal and accrued interest paid off upon return. See Buyer s Call, Seller s Call. Call Around Market: A market, commonly used for options on futures on European exchanges, in which brokers contact each other outside of the exchange trading facility to arrange block trades. Call Cotton: Cotton bought or sold on call. See Buyer s Call, Seller s Call. Called: Another term for exercised when an option is a call. In the case of an option on a physical, the writer of a call must deliver the indicated underlying commodity when the option is exercised or called. In the case of an option on a futures contract, a futures position will be created that will require margin, unless the writer of the call has an offsetting position. Call Rule: An exchange regulation under which an official bid price for a cash commodity is competitively established at the close of each day's trading. It holds until the next opening of the exchange. Cap and Trade: A market based pollution control system in which total emissions of a pollutant are capped at a specified level. Allowances (or the right to emit a specified amount of a pollutant) are issued to firms and can be bought and sold on an organized market or OTC. Capping: Effecting transactions in an instrument underlying an option shortly before the option's expiration date to depress or prevent a rise in the price of the instrument so that previously written call options will expire worthless, thus protecting premiums previously received. See Pegging. Carrying Broker: An exchange member firm, usually a futures commission merchant, through whom another broker or customer elects to clear all or part of its trades. Carrying Charges: Also called Cost of Carry. Cost of storing a physical commodity or holding a financial instrument over a period of time. These charges include insurance, storage, and interest on the deposited funds, as well as other incidental costs. It is a carrying charge market when there are higher futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the holder, it is called full carry. See Negative Carry, Positive Carry, and Contango. Carry Trade: A trade where one borrows a currency or commoidity commodity or currency with a low cost of carry and lends a similar instrument with a high cost of carry in order to profit from the differential. Cascade: A situation in which the execution of market orders or stop loss orders on an electronic trading system triggers other stop loss orders which may, in turn, trigger still more stop loss orders. This may lead to a very large price move if there are no safety mechanisms to prevent cascading. Cash Commodity: The physical or actual commodity as distinguished from the futures contract, sometimes called spot commodity or actuals. Cash Forward Sale: See Forward Contract. 42 APRIL 2011

46 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Cash Market: The market for the cash commodity (as contrasted to a futures contract) taking the form of: (1) an organized, self regulated central market (e.g., a commodity exchange); (2) a decentralized over the counter market; or (3) a local organization, such as a grain elevator or meat processor, which provides a market for a small region. Cash Price: The price in the marketplace for actual cash or spot commodities to be delivered via customary market channels. Cash Settlement: A method of settling futures options and other derivatives whereby the seller (or short) pays the buyer (or long) the cash value of the underlying commodity or a cash amount based on the level of an index or price according to a procedure specified in the contract. Also called Financial Settlement. Compare to physical delivery. CCC: See Commodity Credit Corporation. CD: See Certificate of Deposit. CEA: Commodity Exchange Act or Commodity Exchange Authority. Certificate of Deposit (CD): A time deposit with a specific maturity traditionally evidenced by a certificate. Large denomination CDs are typically negotiable. CFTC: See Commodity Futures Trading Commission. CFTC Form 40: The form used by large traders to report their futures and option positions and the purposes of those positions. CFO: Cancel Former Order. Centralized Counterparty (CCP): See Clearing Organization. Certificated or Certified Stocks: Stocks of a commodity that have been inspected and found to be of a quality deliverable against futures contracts, stored at the delivery points designated as regular or acceptable for delivery by an exchange. In grain, called stocks in deliverable position. See Deliverable Stocks. Changer: Formerly, a clearing member of both the Mid America Commodity Exchange (MidAm) and another futures exchange who, for a fee, would assume the opposite side of a transaction on MidAm by taking a spread position between MidAm and the other futures exchange that traded an identical, but larger, contract. Through this service, the changer provided liquidity for MidAm and an economical mechanism for arbitrage between the two markets. MidAm was a subsidiary of the Chicago Board of Trade (CBOT). MidAm was closed by the CBOT in 2003 after MidAm s contracts were delisted on MidAm and relisted on the CBOT as Mini contracts. The CBOT continued to use changers for former MidAm contracts traded on an open outcry platform. Charting: The use of graphs and charts in the technical analysis of futures markets to plot trends of price movements, average movements of price, volume of trading, and open interest. APRIL

47 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Chartist: Technical trader who reacts to signals derived from graphs of price movements. Cheapest to Deliver: Usually refers to the selection of a class of bonds or notes deliverable against an expiring bond or note futures contract. The bond or note that has the highest implied repo rate is considered cheapest to deliver. Chooser Option: An exotic option that is transacted in the present, but that at some specified future date is chosen to be either a put or a call option. Churning: Excessive trading of a discretionary account by a person with control over the account for the purpose of generating commissions while disregarding the interests of the customer. Circuit Breakers: A system of coordinated trading halts and/or price limits on equity markets and equity derivative markets designed to provide a cooling off period during large, intraday market declines. The first known use of the term circuit breaker in this context was in the Report of the Presidential Task Force on Market Mechanisms (January 1988), which recommended that circuit breakers be adopted following the market break of October C.I.F: Cost, insurance, and freight paid to a point of destination and included in the price quoted. Class (of options): Options of the same type (i.e., either puts or calls, but not both) covering the same underlying futures contract or other asset (e.g., a March call with a strike price of 62 and a May call with a strike price of 58). Clearing: The procedure through which the clearing organization becomes the buyer to each seller of a futures contract or other derivative, and the seller to each buyer for clearing members. Clearing Association: See Clearing Organization. Clearing House: See Clearing Organization. Clearing Member: A member of a clearing organization. All trades of a non clearing member must be processed and eventually settled through a clearing member. Clearing Organization: An entity through which futures and other derivative transactions are cleared and settled. It is also charged with assuring the proper conduct of each contract s delivery procedures and the adequate financing of trading. A clearing organization may be a division of a particular exchange, an adjunct or affiliate thereof, or a freestanding entity. Also called a clearing house, multilateral clearing organization, or clearing association. See Derivatives Clearing Organization. Clearing Price: See Settlement Price. Close: The exchange designated period at the end of the trading session during which all transactions are considered made at the close. See Call. Closing Out: Liquidating an existing long or short futures or option position with an equal and opposite transaction. Also known as Offset. 44 APRIL 2011

48 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Closing Price (or Range): The price (or price range) recorded during trading that takes place in the final period of a trading session s activity that is officially designated as the close. Co Location: The placement of servers used by market participants in close physical proximity to an electronic trading facility's matching engine in order to facilitate high frequency trading. Combination: Puts and calls held either long or short with different strike prices and/or expirations. Types of combinations include straddles and strangles. Commercial: An entity involved in the production, processing, or merchandising of a commodity. Commercial Grain Stocks: Domestic grain in store in public and private elevators at important markets and grain afloat in vessels or barges in lake and seaboard ports. Commercial Paper: Short term promissory notes issued in bearer form by large corporations, with maturities ranging from 5 to 270 days. Since the notes are unsecured, the commercial paper market generally is dominated by large corporations with impeccable credit ratings. Commission: (1) The charge made by a futures commission merchant for buying and selling futures contracts; or (2) the fee charged by a futures broker for the execution of an order. Note: when capitalized, the word Commission usually refers to the CFTC. Commitments of Traders Report (COT): A weekly report from the CFTC providing a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Open interest is broken down by aggregate commercial, non commercial, and non reportable holdings. Commitments: See Open Interest. Commodity: (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural commodities enumerated in Section 1a(4) of the Commodity Exchange Act, 7 USC 1a(4), and all other goods and articles, except onions as provided in Public Law (7 USC 13 1), a 1958 law that banned futures trading in onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in. (2) A physical commodity such as an agricultural product or a natural resource as opposed to a financial instrument such as a currency or interest rate. Commodity Credit Corporation: A government owned corporation established in 1933 to assist American agriculture. Major operations include price support programs, foreign sales, and export credit programs for agricultural commodities. Commodity Exchange Act: The Commodity Exchange Act, 7 USC 1, et seq., provides for the federal regulation of commodity futures and options trading and was enacted in Commodity Exchange Authority: A regulatory agency of the U.S. Department of Agriculture established to regulate futures trading under the 1936 Commodity Exchange Act prior to The Commodity APRIL

49 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Exchange Authority was the predecessor of the Commodity Futures Trading Commission. Before World War II, this agency was known as the Commodity Exchange Administration. Commodity Exchange Commission: A commission consisting of the Secretary of Agriculture, Secretary of Commerce, and the Attorney General, responsible for administering the Commodity Exchange Act prior to Among other things, the CEC was responsible for setting Federal speculative position limits. Commodity Futures Trading Commission (CFTC): The Federal regulatory agency established by the Commodity Futures Trading Act of 1974 to administer the Commodity Exchange Act. Commodity Index: An index of a specified set of (physical) commodity prices or commodity futures prices. Commodity Index Fund: An investment fund that enters into futures or commodity swap positions for the purpose of replicating the return of an index of commodity prices or commodity futures prices. Commodity Index Swap: A swap whose cash flows are intended to replicate a commodity index. Commodity Index Trader: An entity that conducts futures trades on behalf of a commodity index fund or to hedge commodity index swap positions. Commodity Linked Bond: A bond in which payment to the investor is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. Commodity Option: An option on a commodity or a futures contract. Commodity Pool: An investment trust, syndicate, or similar form of enterprise operated for the purpose of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the business of investing the collective or pooled funds of multiple participants in trading commodity futures or options, where participants share in profits and losses on a pro rata basis. Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so. Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options. Commodity Swap: A swap in which the payout to at least one counterparty is based on the price of a commodity or the level of a commodity index. Confirmation Statement: A statement sent by a futures commission merchant to a customer when a futures or options position has been initiated which typically shows the price and the number of contracts bought and sold. See P&S (Purchase and Sale Statement). Congestion: (1) A market situation in which shorts attempting to cover their positions are unable to find an adequate supply of contracts provided by longs willing to liquidate or by new sellers willing to enter 46 APRIL 2011

50 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET the market, except at sharply higher prices (see Squeeze, Corner); (2) in technical analysis, a period of time characterized by repetitious and limited price fluctuations. Consignment: A shipment made by a producer or dealer to an agent elsewhere with the understanding that the commodities in question will be cared for or sold at the highest obtainable price. Title to the merchandise shipped on consignment rests with the shipper until the goods are disposed of according to agreement. Contango: Market situation in which prices in succeeding delivery months are progressively higher than in the nearest delivery month; the opposite of backwardation. Contract: (1) A term of reference describing a unit of trading for a commodity future or option or other derivative; (2) an agreement to buy or sell a specified commodity, detailing the amount and grade of the product and the date on which the contract will mature and become deliverable. Contract Grades: Those grades of a commodity that have been officially approved by an exchange as deliverable in settlement of a futures contract. Contract Market: A board of trade or exchange designated by the Commodity Futures Trading Commission to trade futures or options under the Commodity Exchange Act. A contract market can allow both institutional and retail participants and can list for trading futures contracts on any commodity, provided that each contract is not readily susceptible to manipulation. Also called designated contract market. See Derivatives Transaction Execution Facility. Contract Month: See Delivery Month. Contract Size: The actual amount of a commodity represented in a contract. Contract Unit: See Contract Size. Controlled Account: An account for which trading is directed by someone other than the owner. Also called a Managed Account or a Discretionary Account. Convergence: The tendency for prices of physicals and futures to approach one another, usually during the delivery month. Also called a narrowing of the basis. Conversion: A position created by selling a call option, buying a put option, and buying the underlying instrument (for example, a futures contract), where the options have the same strike price and the same expiration. See Reverse Conversion. Conversion Factors: Numbers published by a futures exchange to determine invoice prices for debt instruments deliverable against bond or note futures contracts. A separate conversion factor is published for each deliverable instrument. Invoice price = Contract Size Futures Settlement Price Conversion Factor + Accrued Interest. Core Principle: A provision of the Commodity Exchange Act with which a contract market, derivatives transaction execution facility, or derivatives clearing organization must comply on an ongoing basis. APRIL

51 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS There are 18 core principles for contract markets, 9 core principles for derivatives transaction execution facilities, and 14 core principles for derivatives clearing organizations. Corner: (1) Securing such relative control of a commodity that its price can be manipulated, that is, can be controlled by the creator of the corner; or (2) in the extreme situation, obtaining contracts requiring the delivery of more commodities than are available for delivery. See Squeeze, Congestion. Corn Hog Ratio: See Feed Ratio. Correction: A temporary decline in prices during a bull market that partially reverses the previous rally. See Bear Market Rally. Cost of Carry: See Carrying Charges. Cost of Tender: Total of various charges incurred when a commodity is certified and delivered on a futures contract. COT: See Commitments of Traders Report. Counterparty: The opposite party in a bilateral agreement, contract, or transaction, such as a swap. In the retail foreign exchange (or Forex) context, the party to which a retail customer sends its funds; lawfully, the party must be one of those listed in Section 2(c)(2)(B)(ii)(I) (VI) of the Commodity Exchange Act. Counterparty Risk: The risk associated with the financial stability of the party entered into contract with. Forward contracts impose upon each party the risk that the counterparty will default, but futures contracts executed on a designated contract market are guaranteed against default by the clearing organization. Counter Trend Trading: In technical analysis, the method by which a trader takes a position contrary to the current market direction in anticipation of a change in that direction. Coupon (Coupon Rate): A fixed dollar amount of interest payable per annum, stated as a percentage of principal value, usually payable in semiannual installments. Cover: (1) Purchasing futures to offset a short position (same as Short Covering); see Offset, Liquidation; (2) to have in hand the physical commodity when a short futures sale is made, or to acquire the commodity that might be deliverable on a short sale. Covered Option: A short call or put option position that is covered by the sale or purchase of the underlying futures contract or other underlying instrument. For example, in the case of options on futures contracts, a covered call is a short call position combined with a long futures position. A covered put is a short put position combined with a short futures position. Cox Ross Rubinstein Option Pricing Model: An option pricing model developed by John Cox, Stephen Ross, and Mark Rubinstein that can be adopted to include effects not included in the Black Scholes Model (e.g., early exercise and price supports). CPO: See Commodity Pool Operator. 48 APRIL 2011

52 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Crack Spread: (1) In energy futures, the simultaneous purchase of crude oil futures and the sale of petroleum product futures to establish a refining margin. One can trade a gasoline crack spread, a heating oil crack spread, or a crack spread which consists of three crude oil futures contracts spread against two gasoline futures contracts and one heating oil futures contract. The crack spread is designed to approximate the typical ratio of gasoline and heating oil that results from refining a barrel of crude oil. See Gross Processing Margin. (2) Calculation showing the theoretical market value of petroleum products that could be obtained from a barrel of crude after the oil is refined or cracked. This does not necessarily represent the refining margin because a barrel of crude yields varying amounts of petroleum products. Credit Default Option: A put option that makes a payoff in the event the issuer of a specified reference asset defaults. Also called default option. Credit Default Swap: A bilateral over the counter (OTC) contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of fixed payments; the most common type of credit derivative; also called credit swap; similar to credit default option. Credit Derivative: A derivative contract designed to assume or shift credit risk, that is, the risk of a credit event such as a default or bankruptcy of a borrower. For example, a lender might use a credit derivative to hedge the risk that a borrower might default or have its credit rating downgraded. Common credit derivatives include, credit default swaps, credit default options, credit spread options, downgrade options, and total return swaps. Credit Event: An event such as a debt default or bankruptcy that will affect the payoff on a credit derivative, as defined in the derivative agreement. Credit Rating: A rating determined by a rating agency that indicates the agency s opinion of the likelihood that a borrower such as a corporation or sovereign nation will be able to repay its debt. The rating agencies include Standard & Poor s, Fitch, and Moody s. Credit Spread: The difference between the yield on the debt securities of a particular corporate or sovereign borrower (or a class of borrowers with a specified credit rating) and the yield of similar maturity Treasury debt securities. Credit Spread Option: An option whose payoff is based on the credit spread between the debt of a particular borrower and similar maturity Treasury debt. Credit Swap: See Credit Default Swap. Crop Year: The time period from one harvest to the next, varying according to the commodity (e.g., July 1 to June 30 for wheat; September 1 to August 31 for soybeans). APRIL

53 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Cross Hedge: Hedging a cash market position in a futures or option contract for a different but price related commodity. Cross Margining: A procedure for margining related securities, options, and futures contracts jointly when different clearing organizations clear each side of the position. Cross Rate: In foreign exchange, the price of one currency in terms of another currency in the market of a third country. For example, the exchange rate between Japanese yen and Euros would be considered a cross rate in the U.S. market. Cross Trading: Offsetting or noncompetitive match of the buy order of one customer against the sell order of another, a practice that is permissible only when executed in accordance with the Commodity Exchange Act, CFTC rules, and rules of the exchange. Crush Spread: In the soybean futures market, the simultaneous purchase of soybean futures and the sale of soybean meal and soybean oil futures to establish a processing margin. See Gross Processing Margin, Reverse Crush Spread. CTA: See Commodity Trading Advisor. CTI (Customer Type Indicator) Codes: These consist of four identifiers that describe transactions by the type of customer for which a trade is effected. The four codes are: (1) trading by a person who holds trading privileges for his or her own account or an account for which the person has discretion; (2) trading for a clearing member s proprietary account; (3) trading for another person who holds trading privileges who is currently present on the trading floor or for an account controlled by such other person; and (4) trading for any other type of customer. Transaction data classified by the above codes is included in the trade register report produced by a clearing organization. Curb Trading: Trading by telephone or by other means that takes place after the official market has closed and that originally took place in the street on the curb outside the market. Under the Commodity Exchange Act and CFTC rules, curb trading is illegal. Also known as kerb trading. Currency Swap: A swap that involves the exchange of one currency (e.g., U.S. dollars) for another (e.g., Japanese yen) on a specified schedule. Current Delivery Month: See Spot Month D Daily Price Limit: The maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. Day Ahead: See Next Day. Day Order: An order that expires automatically at the end of each day's trading session. There may be a day order with time contingency. For example, an off at a specific time order is an order that remains 50 APRIL 2011

54 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET in force until the specified time during the session is reached. At such time, the order is automatically canceled. Day Trader: A trader, often a person with exchange trading privileges, who takes positions and then offsets them during the same trading session prior to the close of trading. DCM: Designated Contract Market. Dealer: An individual or firm that acts as a market maker in an instrument such as a security or foreign currency. Dealer/Merchant (AD): A large trader that declares itself a Dealer/Merchant on CFTC Form 40, which provides as examples wholesaler, exporter/importer, shipper, grain elevator operator, crude oilmarketer. Deck: The orders for purchase or sale of futures and option contracts held by a floor broker. Also referred to as an order book. Declaration Date: See Expiration Date. Declaration (of Options): See Exercise. Default: Failure to perform on a futures contract as required by exchange rules, such as failure to meet a margin call, or to make or take delivery. Default Option: See Credit Default Option. Deferred Futures: See Back Months. Deliverable Grades: See Contract Grades. Deliverable Stocks: Stocks of commodities located in exchange approved storage for which receipts may be used in making delivery on futures contracts. In the cotton trade, the term refers to cotton certified for delivery. Also see Certificated or Certified Stocks. Deliverable Supply: The total supply of a commodity that meets the delivery specifications of a futures contract. See Economically Deliverable Supply. Delivery: The tender and receipt of the actual commodity, the cash value of the commodity, or of a delivery instrument covering the commodity (e.g., warehouse receipts or shipping certificates), used to settle a futures contract. See Notice of Delivery, Delivery Notice. Delivery, Current: Deliveries being made during a present month. Sometimes current delivery is used as a synonym for nearby delivery. Delivery Date: The date on which the commodity or instrument of delivery must be delivered to fulfill the terms of a contract. Delivery Instrument: A document used to effect delivery on a futures contract, such as a warehouse receipt or shipping certificate. APRIL

55 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Delivery Month: The specified month within which a futures contract matures and can be settled by delivery or the specified month in which the delivery period begins. Delivery, Nearby: The nearest traded month, the front month. In plural form, one of the nearer trading months. Delivery Notice: The written notice given by the seller of his intention to make delivery against an open short futures position on a particular date. This notice, delivered through the clearing organization, is separate and distinct from the warehouse receipt or other instrument that will be used to transfer title. Also called Notice of Intent to Deliver or Notice of Delivery. Delivery Option: A provision of a futures contract that provides the short with flexibility in regard to timing, location, quantity, or quality in the delivery process. Delivery Point: A location designated by a commodity exchange where stocks of a commodity represented by a futures contract may be delivered in fulfillment of the contract. Also called Location. Delivery Price: The price fixed by the clearing organization at which deliveries on futures are invoiced generally the price at which the futures contract is settled when deliveries are made. Also called Invoice Price. Delta: The expected change in an option's price given a one unit change in the price of the underlying futures contract or physical commodity. For example, an option with a delta of 0.5 would change $.50 when the underlying commodity moves $1.00. Delta Margining or Delta Based Margining: An option margining system used by some exchanges that equates the changes in option premiums with the changes in the price of the underlying futures contract to determine risk factors upon which to base the margin requirements. Delta Neutral: Refers to a position involving options that is designed to have an overall delta of zero. Deposit: See Initial Margin. Depository Receipt: See Vault Receipt. Derivative: A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., derived from ) the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They are used to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures, options, and swaps. For example, futures contracts are derivatives of the physical contract and options on futures are derivatives of futures contracts. Derivatives Clearing Organization: A clearing organization or similar entity that, in respect to a contract (1) enables each party to the contract to substitute, through novation or otherwise, the credit of the derivatives clearing organization for the credit of the parties; (2) arranges or provides, on a multilateral 52 APRIL 2011

56 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET basis, for the settlement or netting of obligations resulting from such contracts; or (3) otherwise provides clearing services or arrangements that mutualize or transfer among participants in the derivatives clearing organization the credit risk arising from such contracts. Derivatives Transaction Execution Facility (DTEF): A board of trade that is registered with the CFTC as a DTEF. A DTEF is subject to fewer regulatory requirements than a contract market. To qualify as a DTEF, an exchange can only trade certain commodities (including excluded commodities and other commodities with very high levels of deliverable supply) and generally must exclude retail participants (retail participants may trade on DTEFs through futures commission merchants with adjusted net capital of at least $20 million or registered commodity trading advisors that direct trading for accounts containing total assets of at least $25 million). See Derivatives Transaction Execution Facilities. Designated Contract Market: See Contract Market. Designated Self Regulatory Organization (DSRO): Self regulatory organizations (i.e., the commodity exchanges and registered futures associations) must enforce minimum financial and reporting requirements for their members, among other responsibilities outlined in the CFTC's regulations. When a futures commission merchant (FCM) is a member of more than one SRO, the SROs may decide among themselves which of them will assume primary responsibility for these regulatory duties and, upon approval of the plan by the Commission, be appointed the designated self regulatory organization for that FCM. Diagonal Spread: A spread between two call options or two put options with different strike prices and different expiration dates. See Horizontal Spread, Vertical Spread. Differentials: The discount (premium) allowed for grades or locations of a commodity lower (higher) than the par of basis grade or location specified in the futures contact. See Allowances. Digital Option: See Binary Option. Directional Trading: Trading strategies designed to speculate on the direction of the underlying market, especially in contrast to volatility trading. Disclosure Document: A statement that must be provided to prospective customers that describes trading strategy, potential risk, commissions, fees, performance, and other relevant information. Discount: (1) The amount a price would be reduced to purchase a commodity of lesser grade; (2) sometimes used to refer to the price differences between futures of different delivery months, as in the phrase July at a discount to May, indicating that the price for the July futures is lower than that of May. Discretionary Account: An arrangement by which the holder of an account gives written power of attorney to someone else, often a commodity trading advisor, to buy and sell without prior approval of the holder; often referred to as a managed account or controlled account. Distillates: A category of petroleum products that includes diesel fuels and fuel oils such as heating oil. APRIL

57 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS DRT ( Disregard Tape ) or Not Held Order: Absent any restrictions, a DRT (Not Held Order) means any order giving the floor broker complete discretion over price and time in execution of an order, including discretion to execute all, some, or none of this order. Distant or Deferred Months: See Back Month. Dominant Future: That future having the largest amount of open interest. Double Hedging: As used by the CFTC, it implies a situation where a trader holds a long position in the futures market in excess of the speculative position limit as an offset to a fixed price sale, even though the trader has an ample supply of the commodity on hand to fill all sales commitments. DSRO: See Designated Self Regulatory Organization. DTEF: See Derivatives Transaction Execution Facility. Dual Trading: Dual trading occurs when: (1) a floor broker executes customer orders and, on the same day, trades for his own account or an account in which he has an interest; or (2) a futures commission merchant carries customer accounts and also trades or permits its employees to trade in accounts in which it has a proprietary interest, also on the same trading day. Dutch Auction: An auction of a debt instrument (such as a Treasury note) in which all successful bidders receive the same yield (the lowest yield that results in the sale of the entire amount to be issued). Duration: A measure of a bond's price sensitivity to changes in interest rates. E Ease Off: A minor and/or slow decline in the price of a market. ECN: Electronic Communications Network, frequently used for creating electronic stock or futures markets. Economically Deliverable Supply: That portion of the deliverable supply of a commodity that is in position for delivery against a futures contract, and is not otherwise unavailable for delivery. For example, Treasury bonds held by long term investment funds are not considered part of the economically deliverable supply of a Treasury bond futures contract. Efficient Market: In economic theory, an efficient market is one in which market prices adjust rapidly to reflect new information. The degree to which the market is efficient depends on the quality of information reflected in market prices. In an efficient market, profitable arbitrage opportunities do not exist and traders cannot expect to consistently outperform the market unless they have lower cost access to information that is reflected in market prices or unless they have access to information before it is reflected in market prices. See Random Walk. EFP: See Exchange for Physical. EIA: See Energy Information Administration. 54 APRIL 2011

58 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Electronic Trading Facility: A trading facility that operates by an electronic or telecommunications network instead of a trading floor and maintains an automated audit trail of transactions. Eligible Commercial Entity: An eligible contract participant or other entity approved by the CFTC that has a demonstrable ability to make or take delivery of an underlying commodity of a contract; incurs risks related to the commodity; or is a dealer that regularly provides risk management, hedging services, or market making activities to entities trading commodities or derivative agreements, contracts, or transactions in commodities. Eligible Contract Participant: An entity, such as a financial institution, insurance company, or commodity pool, that is classified by the Commodity Exchange Act as an eligible contract participant based upon its regulated status or amount of assets. This classification permits these persons to engage in transactions (such as trading on a derivatives transaction execution facility) not generally available to non eligible contract participants, i.e., retail customers. Elliot Wave: (1) A theory named after Ralph Elliot, who contended that the stock market tends to move in discernible and predictable patterns reflecting the basic harmony of nature and extended by other technical analysts to futures markets; (2) in technical analysis, a charting method based on the belief that all prices act as waves, rising and falling rhythmically. E Local: A person with trading privileges at an exchange with an electronic trading facility who trades electronically (rather than in a pit or ring) for his or her own account, often at a trading arcade. E Mini: A mini contract that is traded exclusively on an electronic trading facility. E Mini is a trademark of the Chicago Mercantile Exchange. Emergency: Any market occurrence or circumstance which requires immediate action and threatens or may threaten such things as the fair and orderly trading in, or the liquidation of, or delivery pursuant to, any contracts on a contract market. Energy Information Administration (EIA): An agency of the US Department of Energy that provides statistics, data, analysis on resources, supply, production, consumption for all energy sources. EIA data includes weekly inventory statistics for crude oil and petroleum products as well as weekly natural storage data. Enumerated Agricultural Commodities: The commodities specifically listed in Section 1a(3) of the Commodity Exchange Act: wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice. Equity: As used on a trading account statement, refers to the residual dollar value of a futures or option trading account, assuming it was liquidated at current prices. APRIL

59 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS ETF: See Exchange Traded Fund. EURIBOR (Euro Interbank Offered Rate): The euro denominated rate of interest at which banks borrow funds from other banks, in marketable size, in the interbank market. Euribor is sponsored by the European Banking Federation. See LIBOR, TIBOR.Euro: The official currency of most members of the European Union. Eurocurrency: Certificates of Deposit (CDs), bonds, deposits, or any capital market instrument issued outside of the national boundaries of the currency in which the instrument is denominated (for example, Eurodollars, Euro Swiss francs, or Euroyen). Eurodollars: U.S. dollar deposits placed with banks outside the U.S. Holders may include individuals, companies, banks, and central banks. European Option: An option that may be exercised only on the expiration date. See American Option. Even Lot: A unit of trading in a commodity established by an exchange to which official price quotations apply. See Round Lot. Event Market: A market in derivatives whose payoff is based on a specified event or occurrence such as the release of a macroeconomic indicator, a corporate earnings announcement, or the dollar value of damages caused by a hurricane. Exchange: A central marketplace with established rules and regulations where buyers and sellers meet to trade futures and options contracts or securities. Exchanges include designated contract markets and derivatives transaction execution facilities. Exchange for Physicals (EFP): A transaction in which the buyer of a cash commodity transfers to the seller a corresponding amount of long futures contracts, or receives from the seller a corresponding amount of short futures, at a price difference mutually agreed upon. In this way, the opposite hedges in futures of both parties are closed out simultaneously. Also called Exchange of Futures for Cash, AA (against actuals), or Ex Pit transactions. Exchange of Futures for Cash: See Exchange for Physicals. Exchange of Futures for Swaps (EFS): A privately negotiated transaction in which a position in a physical delivery futures contract is exchanged for a cash settled swap position in the same or a related commodity, pursuant to the rules of a futures exchange. See Exchange for Physicals. Exchange Rate: The price of one currency stated in terms of another currency. Exchange Risk Factor: The delta of an option as computed daily by the exchange on which it is traded. Exchange Traded Fund (ETF): An investment vehicle holding a commodity or other asset that issues shares that are traded like a stock on a securities exchange. Excluded Commodity: In general, the Commodity Exchange Act defines an excluded commodity as: any financial instrument such as a security, currency, interest rate, debt instrument, or credit rating; any 56 APRIL 2011

60 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET economic or commercial index other than a narrow based commodity index; or any other value that is out of the control of participants and is associated with an economic consequence. See the Commodity Exchange Act definition of excluded commodity. Exempt Board of Trade: A trading facility that trades commodities (other than securities or securities indexes) having a nearly inexhaustible deliverable supply and either no cash market or a cash market so liquid that any contract traded on the commodity is highly unlikely to be susceptible to manipulation. An exempt board of trade s contracts must be entered into by parties that are eligible contract participants. Exempt Commercial Market: An electronic trading facility that trades exempt commodities on a principal to principal basis solely between persons that are eligible commercial entities. Exempt Commodity: The Commodity Exchange Act defines an exempt commodity as any commodity other than an excluded commodity or an agricultural commodity. Examples include energy commodities and metals. Exempt Foreign Firm: A foreign firm that does business with U.S. customers only on foreign exchanges and is exempt from registration under CFTC regulations based upon compliance with its home country s regulatory framework (also known as a Rule firm ). Exercise Price (Strike Price): The price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer. Exotic Options: Any of a wide variety of options with non standard payout structures or other features, including Asian options and lookback options. Exotic options are mostly traded in the over the counter market. Expiration Date: The date on which an option contract automatically expires; the last day an option may be exercised. Extrinsic Value: See Time Value. Ex Pit: See Transfer Trades and Exchange for Physicals F FAB (Five Against Bond) Spread: A futures spread trade involving the buying (selling) of a five year Treasury note futures contract and the selling (buying) of a long term (15 30 year) Treasury bond futures contract. Fannie Mae: A corporation (government sponsored enterprise) created by Congress to support the secondary mortgage market (formerly the Federal National Mortgage Association). It purchases and sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veteran's Administration (VA). See Freddie Mac. FAN (Five Against Note) Spread: A futures spread trade involving the buying (selling) of a five year Treasury note futures contract and the selling (buying) of a ten year Treasury note futures contract. APRIL

61 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Fast Market: An open outcry market situation where transactions in the pit or ring take place in such volume and with such rapidity that price reporters fall behind with price quotations, label each quote as FAST and show a range of prices. Also called a fast tape. The Federal Energy Regulatory Commission: (FERC): An independent agency of the U.S. Government that regulates the interstate transmission of natural gas, oil, and electricity. FERC also regulates natural gas and hydropower projects. Federal Limit: A speculative position limit that is established and administered by the CFTC rather than an exchange. Feed Ratio: The relationship of the cost of feed, expressed as a ratio to the sale price of animals, such as the corn hog ratio. These serve as indicators of the profit margin or lack of profit in feeding animals to market weight. FERC: See Federal Energy Regulatory Commission. FIA: See Futures Industry Association. Fibonacci Numbers: A number sequence discovered by a thirteenth century Italian mathematician Leonardo Fibonacci (circa ), who introduced Arabic numbers to Europe, in which the sum of any two consecutive numbers equals the next highest number i.e., following this sequence: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and so on. The ratio of any number to its next highest number approaches after the first four numbers. These numbers are used by technical analysts to determine price objectives from percentage retracements. Fictitious Trading: Wash trading, bucketing, cross trading, or other schemes which give the appearance of trading but actually no bona fide, competitive trade has occurred. Fill: The execution of an order. Fill or Kill Order (FOK): An order that demands immediate execution or cancellation. Typically involving a designation, added to an order, instructing the broker to offer or bid (as the case may be) one time only; if the order is not filled immediately, it is then automatically cancelled. Final Settlement Price: The price at which a cash settled futures contract is settled at maturity, pursuant to a procedure specified by the exchange. Financial: Can be used to refer to a derivative that is financially settled or cash settled. See Physical. Financial Commodity: Any futures or option contract that is not based on an agricultural commodity or a natural resource such as energy or metals. It includes currencies, equity securities, fixed income securities, and indexes of various kinds. Financial Future: A futures contract on a financial commodity. Financial Settlement: See Cash settlement 58 APRIL 2011

62 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET First Notice Day: The first day on which notices of intent to deliver actual commodities against futures market positions can be received. First notice day may vary with each commodity and exchange. Fix, Fixing: See Gold Fixing. Fixed Income Security: A security whose nominal (or current dollar) yield is fixed or determined with certainty at the time of purchase, typically a debt security. Floor Broker: A person with exchange trading privileges who, in any pit, ring, post, or other place provided by an exchange for the meeting of persons similarly engaged, executes for another person any orders for the purchase or sale of any commodity for future delivery. Floor Trader: A person with exchange trading privileges who executes his own trades by being personally present in the pit or ring for futures trading. See Local. F.O.B. (Free On Board): Indicates that all delivery, inspection and elevation, or loading costs involved in putting commodities on board a carrier have been paid. Forced Liquidation: The situation in which a customer's account is liquidated (open positions are offset) by the brokerage firm holding the account, usually after notification that the account is under margined due to adverse price movements and failure to meet margin calls. Force Majeure: A clause in a supply contract that permits either party not to fulfill the contractual commitments due to events beyond their control. These events may range from strikes to export delays in producing countries. Foreign Exchange: Trading in foreign currency. Forex: Refers to the over the counter market for foreign exchange transactions. Also called the foreign exchange market. Forwardation: See Contango. Forward Contract: A cash transaction common in many industries, including commodity merchandising, in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods at a specified future date. Terms may be more personalized than is the case with standardized futures contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery. Forward Market: The over the counter market for forward contracts. Forward Months: Futures contracts, currently trading, calling for later or distant delivery. See Deferred Futures, Back Months. Forward Rate Agreement (FRA): An OTC forward contract on short term interest rates. The buyer of a FRA is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional amount that is never actually exchanged. The seller of a FRA agrees notionally to lend a sum of money to APRIL

63 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS a borrower. FRAs can be used either to hedge interest rate risk or to speculate on future changes in interest rates. Freddie Mac: A corporation (government sponsored enterprise) created by Congress to support the secondary mortgage market (formerly the Federal Home Loan Mortgage Corporation). It purchases and sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veterans Administration (VA). See Fannie Mae. Front Month: The spot or nearby delivery month, the nearest traded contract month. See Back Month. Front Running: With respect to commodity futures and options, taking a futures or option position based upon non public information regarding an impending transaction by another person in the same or related future or option. Also known as trading ahead. Front Spread: A delta neutral ratio spread in which more options are sold than bought. Also called ratio vertical spread. A front spread will increase in value if volatility decreases. Full Carrying Charge, Full Carry: See Carrying Charges. Fund of Funds: A commodity pool that invests in other commodity pools rather than directly in futures and options contracts. Fundamental Analysis: Study of basic, underlying factors that will affect the supply and demand of the commodity being traded in futures contracts. See Technical Analysis. Fungibility: The characteristic of interchangeability. Futures contracts for the same commodity and delivery month traded on the same exchange are fungible due to their standardized specifications for quality, quantity, delivery date, and delivery locations. Futures: See Futures Contract. Futures Commission Merchant (FCM): Individuals, associations, partnerships, corporations, and trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any exchange and that accept payment from or extend credit to those whose orders are accepted. Futures Contract: An agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset. Futures equivalent: A term frequently used with reference to speculative position limits for options on futures contracts. The futures equivalent of an option position is the number of options multiplied by the previous day's risk factor or delta for the option series. For example, ten deep out of money options with a delta of 0.20 would be considered two futures equivalent contracts. The delta or risk factor used for this purpose is the same as that used in delta based margining and risk analysis systems. 60 APRIL 2011

64 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Futures Industry Association (FIA): A membership organization for futures commission merchants (FCMs) which, among other activities, offers education courses on the futures markets, disburses information, and lobbies on behalf of its members. Futures Option: An option on a futures contract. Futures Price: (1) Commonly held to mean the price of a commodity for future delivery that is traded on a futures exchange; (2) the price of any futures contract. G Gamma: A measurement of how fast the delta of an option changes, given a unit change in the underlying futures price; the delta of the delta. Ginzy Trading: A non competitive trade practice in which a floor broker, in executing an order particularly a large order will fill a portion of the order at one price and the remainder of the order at another price to avoid an exchange's rule against trading at fractional increments or "split ticks." Give Up: A contract executed by one broker for the client of another broker that the client orders to be turned over to the second broker. The broker accepting the order from the customer collects a fee from the carrying broker for the use of the facilities. Often used to consolidate many small orders or to disperse large ones. Gold Certificate: A certificate attesting to a person's ownership of a specific amount of gold bullion. Gold Fixing (Gold Fix): The setting of the gold price at 10:30 a.m. (first fixing) and 3:00 p.m. (second fixing) in London by representatives of the London gold market. Gold/Silver Ratio: The number of ounces of silver required to buy one ounce of gold at current spot prices. Good This Week Order (GTW): Order which is valid only for the week in which it is placed. Good 'Till Canceled Order (GTC): An order which is valid until cancelled by the customer. Unless specified GTC, unfilled orders expire at the end of the trading day. See Open Order. GPM: See Gross Processing Margin. Grades: Various qualities of a commodity. Grading Certificates: A formal document setting forth the quality of a commodity as determined by authorized inspectors or graders. Grain Futures Act: Federal statute that provided for the regulation of trading in grain futures, effective June 22, 1923; administered by the Grain Futures Administration, an agency of the U.S. Department of Agriculture. The Grain Futures Act was amended in 1936 by the Commodity Exchange Act and the Grain Futures Administration became the Commodity Exchange Administration, later the Commodity Exchange Authority. APRIL

65 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Grantor: The maker, writer, or issuer of an option contract who, in return for the premium paid for the option, stands ready to purchase the underlying commodity (or futures contract) in the case of a put option or to sell the underlying commodity (or futures contract) in the case of a call option. Gross Processing Margin (GPM): Refers to the difference between the cost of a commodity and the combined sales income of the finished products that result from processing the commodity. Various industries have formulas to express the relationship of raw material costs to sales income from finished products. See Crack Spread, Crush Spread, and Spark Spread. GTC: See Good 'Till Canceled Order. GTW: See Good This Week Order. Guaranteed Introducing Broker: An introducing broker that has entered into a guarantee agreement with a futures commission merchant (FCM), whereby the FCM agrees to be jointly and severally liable for all of the introducing broker s obligations under the Commodity Exchange Act. By entering into the agreement, the introducing broker is relieved from the necessity of raising its own capital to satisfy minimum financial requirements. In contrast, an independent introducing broker must raise its own capital to meet minimum financial requirements. H Haircut: In computing the value of assets for purposes of capital, segregation, or margin requirements, a percentage reduction from the stated value (e.g., book value or market value) to account for possible declines in value that may occur before assets can be liquidated. Hand Held Terminal: A small computer terminal used by floor brokers or floor traders on an exchange to record trade information and transmit that information to the clearing organization. Hardening: (1) Describes a price which is gradually stabilizing; (2) a term indicating a slowly advancing market. Hard Position Limit: A Speculative Position Limit, especially in contrast to a position accountability level. Head and Shoulders: In technical analysis, a chart formation that resembles a human head and shoulders and is generally considered to be predictive of a price reversal. A head and shoulders top (which is considered predictive of a price decline) consists of a high price, a decline to a support level, a rally to a higher price than the previous high price, a second decline to the support level, and a weaker rally to about the level of the first high price. The reverse (upside down) formation is called a head and shoulders bottom (which is considered predictive of a price rally). Heavy: A market in which prices are demonstrating either an inability to advance or a slight tendency to decline. Hedge Exemption: An exemption from speculative position limits for bona fide hedgers and certain other persons who meet the requirements of exchange and CFTC rules. 62 APRIL 2011

66 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Hedge Fund: A private investment fund or pool that trades and invests in various assets such as securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals. Some commodity pool operators operate hedge funds. Hedge Ratio: Ratio of the value of futures contracts purchased or sold to the value of the cash commodity being hedged, a computation necessary to minimize basis risk. Hedger: A trader who enters into positions in a futures market opposite to positions held in the cash market to minimize the risk of financial loss from an adverse price change; or who purchases or sells futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future). Henry Hub: A natural gas pipeline hub in Louisiana that serves as the delivery point for New York Mercantile Exchange natural gas futures contracts and often serves as a benchmark for wholesale natural gas prices across the U.S. Hidden Quantity Order: An order placed on an electronic trading system whereby only a portion of the order is visible to other market participants. As the displayed part of the order is filled, additional quantities become visible. Also called Iceberg, Max Show. High Frequency Trading: Computerized or algorithmic trading in which transactions are completed in very small fractions of a second. Historical Volatility: A statistical measure (specifically, the annualized standard deviation) of the volatility of a futures contract, security, or other instrument over a specified number of past trading days. Hog Corn Ratio: See Feed Ratio. Horizontal Spread (also called Time Spread or Calendar Spread): An option spread involving the simultaneous purchase and sale of options of the same class and strike prices but different expiration dates. See Diagonal Spread, Vertical Spread. Hybrid Instruments: Financial instruments that possess, in varying combinations, characteristics of forward contracts, futures contracts, option contracts, debt instruments, bank depository interests, and other interests. Certain hybrid instruments are exempt from CFTC regulation. IJK IB: See Introducing Broker. Iceberg: See Hidden Quantity Order. Implied Repo Rate: The rate of return that can be obtained from selling a debt instrument futures contract and simultaneously buying a bond or note deliverable against that futures contract with borrowed funds. The bond or note with the highest implied repo rate is cheapest to deliver. APRIL

67 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Implied Volatility: The volatility of a futures contract, security, or other instrument as implied by the prices of an option on that instrument, calculated using an option pricing model. Index Arbitrage: The simultaneous purchase (sale) of stock index futures and the sale (purchase) of some or all of the component stocks that make up the particular stock index to profit from sufficiently large intermarket spreads between the futures contract and the index itself. Also see Arbitrage, Program Trading. Indirect Bucketing: Also referred to as indirect trading against. Refers to when a floor broker effectively trades opposite his customer in a pair of non competitive transactions by buying (selling) opposite an accommodating trader to fill a customer order and by selling (buying) for his personal account opposite the same accommodating trader. The accommodating trader assists the floor broker by making it appear that the customer traded opposite him rather than opposite the floor broker. Inflation Indexed Debt Instrument: Generally a debt instrument (such as a bond or note) on which the payments are adjusted for inflation and deflation. In a typical inflation indexed instrument, the principal amount is adjusted monthly based on an inflation index such as the Consumer Price Index. Initial Deposit: See Initial Margin. Initial Margin: Customers' funds put up as security for a guarantee of contract fulfillment at the time a futures market position is established. See Original Margin. In Position: Refers to a commodity located where it can readily be moved to another point or delivered on a futures contract. Commodities not so situated are "out of position." Soybeans in Mississippi are out of position for delivery in Chicago, but in position for export shipment from the Gulf of Mexico. In Sight: The amount of a particular commodity that arrives at terminal or central locations in or near producing areas. When a commodity is in sight, it is inferred that reasonably prompt delivery can be made; the quantity and quality also become known factors rather than estimates. Instrument: A tradable asset such as a commodity, security, or derivative, or an index or value that underlies a derivative or could underlie a derivative. Intercommodity Spread: A spread in which the long and short legs are in two different but generally related commodity markets. Also called an intermarket spread. See Spread. Interdelivery Spread: A spread involving two different months of the same commodity. Also called an intracommodity spread. See Spread. Interest Rate Futures: Futures contracts traded on fixed income securities such as U.S. Treasury issues, or based on the levels of specified interest rates such as LIBOR (London Interbank Offered Rate). Currency is excluded from this category, even though interest rates are a factor in currency values. Interest Rate Swap: A swap in which the two counterparties agree to exchange interest rate flows. Typically, one party agrees to pay a fixed rate on a specified series of payment dates and the other party 64 APRIL 2011

68 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET pays a floating rate that may be based on LIBOR (London Interbank Offered Rate) on those payment dates. The interest rates are paid on a specified principal amount called the notional principal. Intermarket Spread: See Spread and Intercommodity Spread. Intermediary: A person who acts on behalf of another person in connection with futures trading, such as a futures commission merchant, introducing broker, commodity pool operator, commodity trading advisor, or associated person. International Swaps and Derivatives Association (ISDA): A New York based group of major international swaps dealers, that publishes the Code of Standard Wording, Assumptions and Provisions for Swaps, or Swaps Code, for U.S. dollar interest rate swaps as well as standard master interest rate, credit, and currency swap agreements and definitions for use in connection with the creation and trading of swaps. In The Money: A term used to describe an option contract that has a positive value if exercised. A call with a strike price of $390 on gold trading at $400 is in the money 10 dollars. See Intrinsic Value. Intracommodity Spread: See Spread and Interdelivery Spread. Intrinsic Value: A measure of the value of an option or a warrant if immediately exercised, that is, the extent to which it is in the money. The amount by which the current price for the underlying commodity or futures contract is above the strike price of a call option or below the strike price of a put option for the commodity or futures contract. Introducing Broker (IB): A person (other than a person registered as an associated person of a futures commission merchant) who is engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery on an exchange who does not accept any money, securities, or property to margin, guarantee, or secure any trades or contracts that result therefrom. Inverted Market: A futures market in which the nearer months are selling at prices higher than the more distant months; a market displaying inverse carrying charges, characteristic of markets with supply shortages. See Backwardation. Invisible Supply: Uncounted stocks of a commodity in the hands of wholesalers, manufacturers, and producers that cannot be identified accurately; stocks outside commercial channels but theoretically available to the market. See Visible Supply. Invoice Price: The price fixed by the clearing house at which deliveries on futures are invoiced generally the price at which the futures contract is settled when deliveries are made. Also called Delivery Price. ISDA: See International Swaps and Derivatives Association. Job Lot: A form of contract having a smaller unit of trading than is featured in a regular contract. Kerb Trading or Dealing: See Curb Trading. Knock In: A provision in an option or other derivative contract, whereby the contract is activated only if the price of the underlying instrument reaches a specified level before a specified expiration date. APRIL

69 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Knock Out: A provision in an option or other derivative contract, whereby the contract is immediately canceled if the price of the underlying instrument reaches a specified level during the life of the contract. L Large Order Execution (LOX) Procedures: Rules in place at the Chicago Mercantile Exchange that authorize a member firm that receives a large order from an initiating party to solicit counterparty interest off the exchange floor prior to open execution of the order in the pit and that provide for special surveillance procedures. The parties determine a maximum quantity and an "intended execution price." Subsequently, the initiating party's order quantity is exposed to the pit; any bids (or offers) up to and including those at the intended execution price are hit (acceptable). The unexecuted balance is then crossed with the contraside trader found using the LOX procedures. Large Traders: A large trader is one who holds or controls a position in any one future or in any one option expiration series of a commodity on any one exchange equaling or exceeding the exchange or CFTC specified reporting level. Last Notice Day: The final day on which notices of intent to deliver on futures contracts may be issued. Last Trading Day: Day on which trading ceases for the maturing (current) delivery month. Latency: The amount of time that elapses between the placement of a market order or marketable limit order on an electronic trading system and the execution of that order. Latency: The amount of time that elapses between the placement of a market order or marketable limit order on an electronic trading system and the execution of that order. Leaps: Long dated, exchange traded options. Stands for Long term Equity Anticipation Securities. Leverage: The ability to control large dollar amounts of a commodity or security with a comparatively small amount of capital. LIBOR: The London Interbank Offered Rate. The rate of interest at which banks borrow funds (denominated in U.S. dollars) from other banks, in marketable size, in the London interbank market. LIBOR rates are disseminated by the British Bankers Association, which also disseminates LIBOR rates for British pounds sterling. Some interest rate futures contracts, including Eurodollar futures, are cash settled based on LIBOR. Also see EURIBOR and TIBOR. Licensed Warehouse: A warehouse approved by an exchange from which a commodity may be delivered on a futures contract. See Regular Warehouse. Life of Contract: Period between the beginning of trading in a particular futures contract and the expiration of trading. In some cases, this phrase denotes the period already passed in which trading has already occurred. For example, The life of contract high so far is $2.50. Same as life of delivery or life of the future. 66 APRIL 2011

70 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Limit (Up or Down): The maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. See Daily Price Limit. Limit Move: See Locked Limit. Limit Only: The definite price stated by a customer to a broker restricting the execution of an order to buy for not more than, or to sell for not less than, the stated price. Limit Order: An order in which the customer specifies a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. Liquidation: The closing out of a long position. The term is sometimes used to denote closing out a short position, but this is more often referred to as covering. See Cover, Offset. Liquid Market: A market in which selling and buying can be accomplished with minimal effect on price. Local: An individual with exchange trading privileges who trades for his own account, traditionally on an exchange floor, and whose activities provide market liquidity. See Floor Trader, E Local. Location: A Delivery Point for a futures contract. Locked In: A hedged position that cannot be lifted without offsetting both sides of the hedge (spread). See Hedging. Also refers to being caught in a limit price move. Locked Limit: A price that has advanced or declined the permissible limit during one trading session, as fixed by the rules of an exchange. Also called Limit Move. London Gold Market: Refers to the dealers in the London Bullion Market Association who set (fix) the gold price in London. See Gold Fixing. Long: (1) One who has bought a futures contract to establish a market position; (2) a market position that obligates the holder to take delivery; (3) one who owns an inventory of commodities. See Short. Long Hedge: See Buying Hedge. Long the Basis: A person or firm that has bought the spot commodity and hedged with a sale of futures is said to be long the basis. Lookalike Option: An over the counter option that is cash settled based on the settlement price of a similar exchange traded futures contract on a specified trading day. Lookalike Swap: An over the counter swap that is cash settled based on the settlement price of a similar exchange traded futures contract on a specified trading day. Lookback Option: An exotic option whose payoff depends on the minimum or maximum price of the underlying asset during some portion of the life of the option. Lookback options allow the buyer to pay or receive the most favorable underlying price during the lookback period. APRIL

71 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Lot: A unit of trading. See Even Lot, Job Lot, and Round Lot. M Macro Fund: A hedge fund that specializes in strategies designed to profit from expected macroeconomic events. Maintenance Margin: See Margin. Managed Account: See Controlled Account and Discretionary Account. Managed Money Trader (MMTs): A futures market participant who engages in futures trades on behalf of investment funds or clients. While MMTs are commonly equated with hedge funds, they may include Commodity Pool Operators and other managed accounts as well as hedge funds. While CFTC Form 40 does not provide a place to declare oneself a Managed Money Trader, a large trader can declare itself a Hedge Fund (H) or Managed Accounts and Commodity Pools. Manipulation: Any planned operation, transaction, or practice that causes or maintains an artificial price. Specific types include corners and squeezes as well as unusually large purchases or sales of a commodity or security in a short period of time in order to distort prices, and putting out false information in order to distort prices. Manufacturer (AM): A large trader that declares itself a Manufacturer on CFTC Form 40, which provides as examples refiner, miller, crusher, fabricator, sawmill, coffee roaster, cocoa grinder. Many to Many: Refers to a trading platform in which multiple participants have the ability to execute or trade commodities, derivatives, or other instruments by accepting bids and offers made by multiple other participants. In contrast to one to many platforms, many to many platforms are considered trading facilities under the Commodity Exchange Act. Traditional exchanges are many to many platforms. Margin: The amount of money or collateral deposited by a customer with his broker, by a broker with a clearing member, or by a clearing member with a clearing organization. The margin is not partial payment on a purchase. Also called Performance Bond. (1) Initial margin is the amount of margin required by the broker when a futures position is opened; (2) Maintenance margin is an amount that must be maintained on deposit at all times. If the equity in a customer's account drops to or below the level of maintenance margin because of adverse price movement, the broker must issue a margin call to restore the customer's equity to the initial level. See Variation Margin. Exchanges specify levels of initial margin and maintenance margin for each futures contract, but futures commission merchants may require their customers to post margin at higher levels than those specified by the exchange. Futures margin is determined by the SPAN margining system, which takes into account all positions in a customer s portfolio. 68 APRIL 2011

72 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Margin Call: (1) A request from a brokerage firm to a customer to bring margin deposits up to initial levels; (2) a request by the clearing organization to a clearing member to make a deposit of original margin, or a daily or intra day variation margin payment because of adverse price movement, based on positions carried by the clearing member. Market if Touched (MIT) Order: An order that becomes a market order when a particular price is reached. A sell MIT is placed above the market; a buy MIT is placed below the market. Also referred to as a board order. Compare to Stop Order. Market Maker: A professional securities dealer or person with trading privileges on an exchange who has an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy orders. By maintaining an offering price sufficiently higher than their buying price, these firms are compensated for the risk involved in allowing their inventory of securities to act as a buffer against temporary order imbalances. In the futures industry, this term is sometimes loosely used to refer to a floor trader or local who, in speculating for his own account, provides a market for commercial users of the market. Occasionally a futures exchange will compensate a person with exchange trading privileges to take on the obligations of a market maker to enhance liquidity in a newly listed or lightly traded futures contract. See Specialist System. Market on Close: An order to buy or sell at the end of the trading session at a price within the closing range of prices. See Stop Close Only Order. Market on Opening: An order to buy or sell at the beginning of the trading session at a price within the opening range of prices. Market Order: An order to buy or sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other trading platform. See At the Market Limit Order. Mark to Market: Part of the daily cash flow system used by U.S. futures exchanges to maintain a minimum level of margin equity for a given futures or option contract position by calculating the gain or loss in each contract position resulting from changes in the price of the futures or option contracts at the end of each trading session. These amounts are added or subtracted to each account balance. Maturity: Period within which a futures contract can be settled by delivery of the actual commodity. Max Show: See Hidden Quantity Order. Maximum Price Fluctuation: See Limit (Up or Down) and Daily Price Limit. Member Rate: Commission charged for the execution of an order for a person who is a member of or has trading privileges at the exchange. Mini: Refers to a futures contract that has a smaller contract size than an otherwise identical futures contract. APRIL

73 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Minimum Price Contract: A hybrid commercial forward contract for agricultural products that includes a provision guaranteeing the person making delivery a minimum price for the product. For agricultural commodities, these contracts became much more common with the introduction of exchange traded options on futures contracts, which permit buyers to hedge the price risks associated with such contracts. Minimum Price Fluctuation (Minimum Tick): Smallest increment of price movement possible in trading a given contract. Minimum Tick: See Minimum Price Fluctuation. MMBTU: Million British Thermal Units, the unit of trading in the natural gas futures market. MOB Spread: A spread between the municipal bond futures contract and the Treasury bond contract, also known as munis over bonds. Momentum: In technical analysis, the relative change in price over a specific time interval. Often equated with speed or velocity and considered in terms of relative strength. Money Market: The market for short term debt instruments. Multilateral Clearing Organization: See Clearing Organization N Naked Option: The sale of a call or put option without holding an equal and opposite position in the underlying instrument. Also referred to as an uncovered option, naked call, or naked put. Narrow Based Security Index: In general, the Commodity Exchange Act defines a narrow based security index as an index of securities that meets one of the following four requirements (1) it has nine or fewer components; (2) one component comprises more than 30 percent of the index weighting; (3) the five highest weighted components comprise more than 60 percent of the index weighting, or (4) the lowest weighted components comprising in the aggregate 25 percent of the index s weighting have an aggregate dollar value of average daily volume over a six month period of less than $50 million ($30 million if there are at least 15 component securities). However, the legal definition in Section 1a(25) of the Commodity Exchange Act, 7 USC 1a(25), contains several exceptions to this provision. See Broad Based Security Index, Security Future. National Futures Association (NFA): A self regulatory organization whose members include futures commission merchants, commodity pool operators, commodity trading advisors, introducing brokers, commodity exchanges, commercial firms, and banks, that is responsible under CFTC oversight for certain aspects of the regulation of FCMs, CPOs, CTAs, IBs, and their associated persons, focusing primarily on the qualifications and proficiency, financial condition, retail sales practices, and business conduct of these futures professionals. NFA also performs arbitration and dispute resolution functions for industry participants. Nearbys: The nearest delivery months of a commodity futures market. 70 APRIL 2011

74 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Nearby Delivery Month: The month of the futures contract closest to maturity; the front month or lead month. Negative Carry: The cost of financing a financial instrument (the short term rate of interest), when the cost is above the current return of the financial instrument. See Carrying Charges and Positive Carry. Net Asset Value (NAV): The value of each unit of participation in a commodity pool. Net Position: The difference between the open long contracts and the open short contracts held by a trader in any one commodity. NFA: National Futures Association. Next Day: A spot contract that provides for delivery of a commodity on the next calendar day or the next business day. Also called day ahead. NOB (Note Against Bond) Spread: A futures spread trade involving the buying (selling) of a ten year Treasury note futures contract and the selling (buying) of a Treasury bond futures contract. Non Member Traders: Speculators and hedgers who trade on the exchange through a member or a person with trading privileges but who do not hold exchange memberships or trading privileges. Nominal Price (or Nominal Quotation): Computed price quotation on a futures or option contract for a period in which no actual trading took place, usually an average of bid and asked prices or computed using historical or theoretical relationships to more active contracts. Notice Day: Any day on which notices of intent to deliver on futures contracts may be issued. Notice of Intent to Deliver: A notice that must be presented by the seller of a futures contract to the clearing organization prior to delivery. The clearing organization then assigns the notice and subsequent delivery instrument to a buyer. Also notice of delivery. Notional Principal: In an interest rate swap, forward rate agreement, or other derivative instrument, the amount or, in a currency swap, each of the amounts to which interest rates are applied in order to calculate periodic payment obligations. Also called the notional amount, the contract amount, the reference amount, and the currency amount. NYMEX Lookalike: A lookalike swap or lookalike option that is based on a futures contract traded on the New York Mercantile Exchange (NYMEX). O OCO: See One Cancels the Other Order. Offer: An indication of willingness to sell at a given price; opposite of bid, the price level of the offer may be referred to as the ask. Off Exchange: See Over the Counter. APRIL

75 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Offset: Liquidating a purchase of futures contracts through the sale of an equal number of contracts of the same delivery month, or liquidating a short sale of futures through the purchase of an equal number of contracts of the same delivery month. See Closing Out and Cover. Omnibus Account: An account carried by one futures commission merchant, the carrying FCM, for another futures commission merchant, the originating FCM, in which the transactions of two or more persons, who are customers of the originating FCM, are combined and carried by the carrying FCM. Omnibus account titles must clearly show that the funds and trades therein belong to customers of the originating FCM. An originating broker must use an omnibus account to execute or clear trades for customers at a particular exchange where it does not have trading or clearing privileges. On Track (or Track Country Station): (1) A type of deferred delivery in which the price is set f.o.b. seller's location, and the buyer agrees to pay freight costs to his destination; (2) commodities loaded in railroad cars on tracks. One Cancels the Other (OCO) Order: A pair of orders, typically limit orders, whereby if one order is filled, the other order will automatically be cancelled. For example, an OCO order might consist of an order to buy 10 calls with a strike price of 50 at a specified price or buy 20 calls with a strike price of 55 (with the same expiration date) at a specified price. One to Many: Refers to a proprietary trading platform in which the platform operator posts bids and offers for commodities, derivatives, or other instruments and serves as a counterparty to every transaction executed on the platform. In contrast to many to many platforms, one to many platforms are not considered trading facilities under the Commodity Exchange Act. Opening Price (or Range): The price (or price range) recorded during the period designated by the exchange as the official opening. Opening: The period at the beginning of the trading session officially designated by the exchange during which all transactions are considered made at the opening. Open Interest: The total number of futures contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. Also called open contracts or open commitments. Open Order (or Orders): An order that remains in force until it is canceled or until the futures contracts expire. See Good 'Till Canceled and Good This Week orders. Open Outcry: A method of public auction, common to most U.S. commodity exchanges during the 20 th century, where trading occurs on a trading floor and traders may bid and offer simultaneously either for their own accounts or for the accounts of customers. Transactions may take place simultaneously at different places in the trading pit or ring. At most exchanges been replaced or largely replaced by electronic trading platforms. See Specialist System. 72 APRIL 2011

76 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Open Trade Equity: The unrealized gain or loss on open futures positions. Option: A contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument. Also see Put and Call. Option Buyer: The person who buys calls, puts, or any combination of calls and puts. Option Delta: See Delta. Option Writer: The person who originates an option contract by promising to perform a certain obligation in return for the price or premium of the option. Also known as option grantor or option seller. Option Pricing Model: A mathematical model used to calculate the theoretical value of an option. Inputs to option pricing models typically include the price of the underlying instrument, the option strike price, the time remaining till the expiration date, the volatility of the underlying instrument, and the risk free interest rate (e.g., the Treasury bill interest rate). Examples of option pricing models include Black Scholes and Cox Ross Rubinstein. Original Margin: Term applied to the initial deposit of margin money each clearing member firm is required to make according to clearing organization rules based upon positions carried, determined separately for customer and proprietary positions; similar in concept to the initial margin or security deposit required of customers by exchange rules. See Initial Margin. OTC: See Over the Counter. Out of Position: See In Position. Out Of The Money: A term used to describe an option that has no intrinsic value. For example, a call with a strike price of $400 on gold trading at $390 is out of the money 10 dollars. Outright: An order to buy or sell only one specific type of futures contract; an order that is not a spread order. Out Trade: A trade that cannot be cleared by a clearing organization because the trade data submitted by the two clearing members or two traders involved in the trade differs in some respect (e.g., price and/or quantity). In such cases, the two clearing members or traders involved must reconcile the discrepancy, if possible, and resubmit the trade for clearing. If an agreement cannot be reached by the two clearing members or traders involved, the dispute would be settled by an appropriate exchange committee. Overbought: A technical opinion that the market price has risen too steeply and too fast in relation to underlying fundamental factors. Rank and file traders who were bullish and long have turned bearish. Overnight Trade: A trade which is not liquidated during the same trading session during which it was established. APRIL

77 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Oversold: A technical opinion that the market price has declined too steeply and too fast in relation to underlying fundamental factors; rank and file traders who were bearish and short have turned bullish. Over the Counter (OTC): The trading of commodities, contracts, or other instruments not listed on any exchange. OTC transactions can occur electronically or over the telephone. Also referred to as Off Exchange. P P&S (Purchase and Sale Statement): A statement sent by a futures commission merchant to a customer when any part of a futures position is offset, showing the number of contracts involved, the prices at which the contracts were bought or sold, the gross profit or loss, the commission charges, the net profit or loss on the transactions, and the balance. FCMs also send P&S Statements whenever any other event occurs that alters the account balance including when the customer deposits or withdraws margin and when the FCM places excess margin in interest bearing instruments for the customer s benefit. Paper Profit or Loss: The profit or loss that would be realized if open contracts were liquidated as of a certain time or at a certain price. Par: (1) Refers to the standard delivery point(s) and/or quality of a commodity that is deliverable on a futures contract at contract price. Serves as a benchmark upon which to base discounts or premiums for varying quality and delivery locations; (2) in bond markets, an index (usually 100) representing the face value of a bond. Path Dependent Option: An option whose valuation and payoff depends on the realized price path of the underlying asset, such as an Asian option or a Lookback option. Pay/Collect: A shorthand method of referring to the payment of a loss (pay) and receipt of a gain (collect) by a clearing member to or from a clearing organization that occurs after a futures position has been marked to market. See Variation Margin. Pegged Price: The price at which a commodity has been fixed by agreement. Pegging: Effecting transactions in an instrument underlying an option to prevent a decline in the price of the instrument shortly prior to the option s expiration date so that previously written put options will expire worthless, thus protecting premiums previously received. See Capping. Performance Bond: See Margin. Physical: A contract or derivative that provides for the physical delivery of a commodity rather than cash settlement. See Financial. Physical Commodity: A commodity other than a financial commodity, typically an agricultural commodity, energy commodity or a metal. Physical Delivery: A provision in a futures contract or other derivative for delivery of the actual commodity to satisfy the contract. Compare to cash settlement. 74 APRIL 2011

78 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Pip: The smallest price unit of a commodity or currency. Pit: A specially constructed area on the trading floor of some exchanges where trading in a futures contract or option is conducted. On other exchanges, the term ring designates the trading area for commodity contract. Pit Brokers: See Floor Broker. Point and Figure: A method of charting that uses prices to form patterns of movement without regard to time. It defines a price trend as a continued movement in one direction until a reversal of a predetermined criterion is met. Point Balance: A statement prepared by futures commission merchants to show profit or loss on all open contracts using an official closing or settlement price, usually at calendar month end. Ponzi Scheme: Named after Charles Ponzi, a man with a remarkable criminal career in the early 20 th century, the term has been used to describe pyramid arrangements whereby an enterprise makes payments to investors from the proceeds of a later investment rather than from profits of the underlying business venture, as the investors expected, and gives investors the impression that a legitimate profitmaking business or investment opportunity exists, where in fact it is a mere fiction. Pork Bellies: One of the major cuts of the hog carcass that, when cured, becomes bacon. Portfolio Insurance: A trading strategy that uses stock index futures and/or stock index options to protect stock portfolios against market declines. Portfolio Margining: A method for setting margin requirements that evaluates positions as a group or portfolio and takes into account the potential for losses on some positions to be offset by gains on others. Specifically, the margin requirement for a portfolio is typically set equal to an estimate of the largest possible decline in the net value of the portfolio that could occur under assumed changes in market conditions. Sometimes referred to as risked based margining. Also see Strategy Based Margining. Position: An interest in the market, either long or short, in the form of one or more open contracts. Position Accountability: A rule adopted by an exchange requiring persons holding a certain number of outstanding contracts to report the nature of the position, trading strategy, and hedging information of the position to the exchange, upon request of the exchange. See Speculative Position Limit. Position Limit: See Speculative Position Limit. Position Trader: A commodity trader who either buys or sells contracts and holds them for an extended period of time, as distinguished from a day trader, who will normally initiate and offset a futures position within a single trading session. Positive Carry: The cost of financing a financial instrument (the short term rate of interest), where the cost is less than the current return of the financial instrument. See Carrying Charges and Negative Carry. APRIL

79 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Posted Price: An announced or advertised price indicating what a firm will pay for a commodity or the price at which the firm will sell it. Prearranged Trading: Trading between brokers in accordance with an expressed or implied agreement or understanding, which is a violation of the Commodity Exchange Act and CFTC regulations. Premium: (1) The payment an option buyer makes to the option writer for granting an option contract; (2) the amount a price would be increased to purchase a better quality commodity; (3) refers to a futures delivery month selling at a higher price than another, as July is at a premium over May. Price Banding: A CME Group and ICE instituted mechanism to ensure a fair and orderly market on an electronic trading platform. This mechanism subjects all incoming orders to price verification and rejects all orders with clearly erroneous prices. Price bands are monitored throughout the day and adjusted if necessary. Price Basing: A situation where producers, processors, merchants, or consumers of a commodity establish commercial transaction prices based on the futures prices for that or a related commodity (e.g., an offer to sell corn at 5 cents over the December futures price). This phenomenon is commonly observed in grain and metal markets. Price Discovery: The process of determining the price level for a commodity based on supply and demand conditions. Price discovery may occur in a futures market or cash market. Price Movement Limit: See Limit (Up or Down). Primary Market: (1) For producers, their major purchaser of commodities; (2) to processors, the market that is the major supplier of their commodity needs; and (3) in commercial marketing channels, an important center at which spot commodities are concentrated for shipment to terminal markets. Producer (AP): A large trader that declares itself a Producer on CFTC Form 40, which provides as examples, farmer and miner. A firm that extracts crude oil or natural gas from the ground would also be considered a Producer. Program Trading: The purchase (or sale) of a large number of stocks contained in or comprising a portfolio. Originally called program trading when index funds and other institutional investors began to embark on large scale buying or selling campaigns or programs to invest in a manner that replicates a target stock index, the term now also commonly includes computer aided stock market buying or selling programs, and index arbitrage. Prompt Date: The date on which the buyer of an option will buy or sell the underlying commodity (or futures contract) if the option is exercised. Prop Shop: A proprietary trading group, especially one where the group's traders trade electronically at a physical facility operated by the group. 76 APRIL 2011

80 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Proprietary Account: An account that a futures commission merchant carries for itself or a closely related person, such as a parent, subsidiary or affiliate company, general partner, director, associated person, or an owner of 10 percent or more of the capital stock. The FCM must segregate customer funds from funds related to proprietary accounts. Proprietary Trading Group: An organization whose owners, employees, and/or contractors trade in the name of accounts owned by the group and exclusively use the funds of the group for all of their trading activity. Public: In trade parlance, non professional speculators as distinguished from hedgers and professional speculators or traders. Public Elevators: Grain elevators in which bulk storage of grain is provided to the public for a fee. Grain of the same grade but owned by different persons is usually mixed or commingled as opposed to storing it "identity preserved." Some elevators are approved by exchanges as regular for delivery on futures contracts, see Regular Warehouse. Purchase and Sale Statement: See P&S. Put: An option contract that gives the holder the right but not the obligation to sell a specified quantity of a particular commodity, security, or other asset or to enter into a short futures position at a given price (the "strike price") prior to or on a specified expiration date. Pyramiding: The use of profits on existing positions as margin to increase the size of the position, normally in successively smaller increments. QR Qualified Eligible Person (QEP): The definition of QEP is too complex to summarize here; please see CFTC Regulation 4.7(a)(2) and (a)(3), 17 CFR 4.7(a)(2) and (a)(3), for the full definition. Quick Order: See Fill or Kill Order. Quotation: The actual price or the bid or ask price of either cash commodities or futures contracts. Rally: An upward movement of prices. Random Walk: An economic theory that market price movements move randomly. This assumes an efficient market. The theory also assumes that new information comes to the market randomly. Together, the two assumptions imply that market prices move randomly as new information is incorporated into market prices. The theory implies that the best predictor of future prices is the current price, and that past prices are not a reliable indicator of future prices. If the random walk theory is correct, technical analysis cannot work. Range: The difference between the high and low price of a commodity, futures, or option contract during a given period. APRIL

81 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Ratio Hedge: The number of options compared to the number of futures contracts bought or sold in order to establish a hedge that is neutral or delta neutral. Ratio Spread: This strategy, which applies to both puts and calls, involves buying or selling options at one strike price in greater number than those bought or sold at another strike price. Ratio spreads are typically designed to be delta neutral. Back spreads and front preads are types of ratio spreads. Ratio Vertical Spread: See Front Spread. Reaction: A downward price movement after a price advance. Recovery: An upward price movement after a decline. Reference Asset: An asset, such as a corporate or sovereign debt instrument, that underlies a credit derivative. Regular Warehouse: A processing plant or warehouse that satisfies exchange requirements for financing, facilities, capacity, and location and has been approved as acceptable for delivery of commodities against futures contracts. See Licensed Warehouse. Replicating Portfolio: A portfolio of assets for which changes in value match those of a target asset. For example, a portfolio replicating a standard option can be constructed with certain amounts of the asset underlying the option and bonds. Sometimes referred to as a synthetic asset. Repo or Repurchase Agreement: A transaction in which one party sells a security to another party while agreeing to repurchase it from the counterparty at some date in the future, at an agreed price. Repos allow traders to short sell securities and allow the owners of securities to earn added income by lending the securities they own. Through this operation the counterparty is effectively a borrower of funds to finance further. The rate of interest used is known as the repo rate. Reporting Level: Sizes of positions set by the exchanges and/or the CFTC at or above which commodity traders or brokers who carry these accounts must make daily reports about the size of the position by commodity, by delivery month, and whether the position is controlled by a commercial or noncommercial trader. See the Large Trader Reporting Program. Resistance: In technical analysis, a price area where new selling will emerge to dampen a continued rise. See Support. Resting Order: A limit order to buy at a price below or to sell at a price above the prevailing market that is being held by a floor broker. Such orders may either be day orders or open orders. Retail Customer: A customer that does not qualify as an eligible contract participant under Section 1a(12) of the Commodity Exchange Act, 7 USC 1a(12). An individual with total assets that do not exceed $10 million, or $5 million if the individual is entering into an agreement, contract, or transaction to manage risk, would be considered a retail customer. 78 APRIL 2011

82 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Retender: In specific circumstances, some exchanges permit holders of futures contracts who have received a delivery notice through the clearing organization to sell a futures contract and return the notice to the clearing organization to be reissued to another long; others permit transfer of notices to another buyer. In either case, the trader is said to have retendered the notice. Retracement: A reversal within a major price trend. Reversal: A change of direction in prices. See Reverse Conversion. Reverse Conversion or Reversal: With regard to options, a position created by buying a call option, selling a put option, and selling the underlying instrument (for example, a futures contract). See Conversion. Reverse Crush Spread: The sale of soybean futures and the simultaneous purchase of soybean oil and meal futures. See Crush Spread. Riding the Yield Curve: Trading in an interest rate futures contract according to the expectations of change in the yield curve. Ring: A circular area on the trading floor of an exchange where traders and brokers stand while executing futures trades. Some exchanges use pits rather than rings. Risked Based Margining: See Portfolio Margining. Risk Factor: See Delta. Risk/Reward Ratio: The relationship between the probability of loss and profit. This ratio is often used as a basis for trade selection or comparison. Roll Over: A trading procedure involving the shift of one month of a straddle into another future month while holding the other contract month. The shift can take place in either the long or short straddle month. The term also applies to lifting a near futures position and re establishing it in a more deferred delivery month. Round Lot: A quantity of a commodity equal in size to the corresponding futures contract for the commodity. See Even Lot. Round Trip Trading: See Wash Trading. Round Turn: A completed transaction involving both a purchase and a liquidating sale, or a sale followed by a covering purchase. Rules: The principles for governing an exchange. In some exchanges, rules are adopted by a vote of the membership, while in others, they can be imposed by the governing board. Runners: Messengers or clerks who deliver orders received by phone clerks to brokers for execution in the pit. APRIL

83 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS S Sample Grade: Usually the lowest quality of a commodity, too low to be acceptable for delivery in satisfaction of futures contracts. Scale Down (or Up): To purchase or sell a scale down means to buy or sell at regular price intervals in a declining market. To buy or sell on scale up means to buy or sell at regular price intervals as the market advances. Scalper: A speculator often with exchange trading privileges who buys and sells rapidly, with small profits or losses, holding his positions for only a short time during a trading session. Typically, a scalper will stand ready to buy at a fraction below the last transaction price and to sell at a fraction above, e.g., to buy at the bid and sell at the offer or ask price, with the intent of capturing the spread between the two, thus creating market liquidity. See Day Trader, Position Trader, High Frequency Trading. Seasonality Claims: Misleading sales pitches that one can earn large profits with little risk based on predictable seasonal changes in supply or demand, published reports or other well known events. Seat: An instrument granting trading privileges on an exchange. A seat may also represent an ownership interest in the exchange. Securities and Exchange Commission (SEC): The Federal regulatory agency established in 1934 to administer Federal securities laws. Security: Generally, a transferable instrument representing an ownership interest in a corporation (equity security or stock) or the debt of a corporation, municipality, or sovereign. Other forms of debt such as mortgages can be converted into securities. Certain derivatives on securities (e.g., options on equity securities) are also considered securities for the purposes of the securities laws. Security futures products are considered to be both securities and futures products. Futures contracts on broad based securities indexes are not considered securities. Security Deposit: See Margin. Security Future: A contract for the sale or future delivery of a single security or of a narrow based security index. Security Futures Product: A security future or any put, call, straddle, option, or privilege on any security future. Self Regulatory Organization (SRO): Exchanges and registered futures associations that enforce financial and sales practice requirements for their members. See Designated Self Regulatory Organizations. Seller's Call: Seller's call, also referred to as call purchase, is the same as the buyer's call except that the seller has the right to determine the time to fix the price. See Buyer s Call. Seller's Market: A condition of the market in which there is a scarcity of goods available and hence sellers can obtain better conditions of sale or higher prices. See Buyer's Market. 80 APRIL 2011

84 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Seller's Option: The right of a seller to select, within the limits prescribed by a contract, the quality of the commodity delivered and the time and place of delivery. Selling Hedge (or Short Hedge): Selling futures contracts to protect against possible decreased prices of commodities. See Hedging. Series (of Options): Options of the same type (i.e., either puts or calls, but not both), covering the same underlying futures contract or other underlying instrument, having the same strike price and expiration date. Settlement: The act of fulfilling the delivery requirements of the futures contract. Settlement Price: The daily price at which the clearing organization clears all trades and settles all accounts between clearing members of each contract month. Settlement prices are used to determine both margin calls and invoice prices for deliveries. The term also refers to a price established by the exchange to even up positions which may not be able to be liquidated in regular trading. Shipping Certificate: A negotiable instrument used by several futures exchanges as the futures delivery instrument for several commodities (e.g., soybean meal, plywood, and white wheat). The shipping certificate is issued by exchange approved facilities and represents a commitment by the facility to deliver the commodity to the holder of the certificate under the terms specified therein. Unlike an issuer of a warehouse receipt, who has physical product in store, the issuer of a shipping certificate may honor its obligation from current production or through put as well as from inventories. Shock Absorber: A temporary restriction in the trading of certain stock index futures contracts that becomes effective following a significant intraday decrease in stock index futures prices. Designed to provide an adjustment period to digest new market information, the restriction bars trading below a specified price level. Shock absorbers are generally market specific and at tighter levels than circuit breakers. Short: (1) The selling side of an open futures contract; (2) a trader whose net position in the futures market shows an excess of open sales over open purchases. See Long. Short Covering: See Cover. Short Hedge: See Selling Hedge. Short Selling: Selling a futures contract or other instrument with the idea of delivering on it or offsetting it at a later date. Short Squeeze: See Squeeze. Short the Basis: The purchase of futures as a hedge against a commitment to sell in the cash or spot markets. See Hedging. APRIL

85 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Significant Price Discovery Contract (SPDC): A contract traded on an Exempt Commercial Market (ECM) which performs a significant price discovery function as determined by the CFTC pursuant to CFTC Regulation 36.3 (c). ECMs with SPDCs are subject to additional regulatory and reporting requirements. Single Stock Future: A futures contract on a single stock as opposed to a stock index. Single stock futures were illegal in the U.S. prior to the passage of the Commodity Futures Modernization Act in See Security Future, Security Futures Product. Small Traders: Traders who hold or control positions in futures or options that are below the reporting level specified by the exchange or the CFTC. Soft: (1) A description of a price that is gradually weakening; or (2) this term also refers to certain soft commodities such as sugar, cocoa, and coffee. Sold Out Market: When liquidation of a weakly held position has been completed, and offerings become scarce, the market is said to be sold out. SPAN (Standard Portfolio Analysis of Risk ): As developed by the Chicago Mercantile Exchange, the industry standard for calculating performance bond requirements (margins) on the basis of overall portfolio risk. SPAN calculates risk for all enterprise levels on derivative and non derivative instruments at numerous exchanges and clearing organizations worldwide. Spark Spread: The differential between the price of electricity and the price of natural gas or other fuel used to generate electricity, expressed in equivalent units. See Gross Processing Margin. SPDC: See Significant Price Discovery Contract. Specialist System: A type of trading formerly used for the exchange trading of securities in which one individual or firm acts as a market maker in a particular security, with the obligation to provide fair and orderly trading in that security by offsetting temporary imbalances in supply and demand by trading for the specialist s own account. Like open outcry, the specialist system was supplanted by electronic trading during the early 21st century. In 2008, the New York Stock Exchange replaced the specialist system with a competitive dealer system. Specialists were converted into Designated Market Makers who have a different set of privileges and obligations than specialists had. Speculative Bubble: A rapid run up in prices caused by excessive buying that is unrelated to any of the basic, underlying factors affecting the supply or demand for a commodity or other asset. Speculative bubbles are usually associated with a bandwagon effect in which speculators rush to buy the commodity (in the case of futures, to take positions ) before the price trend ends, and an even greater rush to sell the commodity (unwind positions) when prices reverse. Speculative Limit: See Speculative Position Limit. Speculative Position Limit: The maximum position, either net long or net short, in one commodity future (or option) or in all futures (or options) of one commodity combined that may be held or controlled by 82 APRIL 2011

86 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET one person (other than a person eligible for a hedge exemption) as prescribed by an exchange and/or by the CFTC. Speculator: In commodity futures, a trader who does not hedge, but who trades with the objective of achieving profits through the successful anticipation of price movements. Split Close: A condition that refers to price differences in transactions at the close of any market session. Spot: Market of immediate delivery of and payment for the product. Spot Commodity: (1) The actual commodity as distinguished from a futures contract; (2) sometimes used to refer to cash commodities available for immediate delivery. See Actuals or Cash Commodity. Spot Month: The futures contract that matures and becomes deliverable during the present month. Also called Current Delivery Month. Spot Price: The price at which a physical commodity for immediate delivery is selling at a given time and place. See Cash Price. Spread (or Straddle): The purchase of one futures delivery month against the sale of another futures delivery month of the same commodity; the purchase of one delivery month of one commodity against the sale of that same delivery month of a different commodity; or the purchase of one commodity in one market against the sale of the commodity in another market, to take advantage of a profit from a change in price relationships. The term spread is also used to refer to the difference between the price of a futures month and the price of another month of the same commodity. A spread can also apply to options. See Arbitrage. Squeeze: A market situation in which the lack of supplies tends to force shorts to cover their positions by offset at higher prices. Also see Congestion, Corner. SRO: See Self Regulatory Organization. Stop Close Only Order: A stop order that can be executed, if possible, only during the closing period of the market. See also Market on Close Order. Stop Limit Order: A stop limit order is an order that goes into force as soon as there is a trade at the specified price. The order, however, can only be filled at the stop limit price or better. Stop Logic Functionality: A provision applicable to futures traded on the CME s Globex electronic trading system designed to prevent excessive price movements caused by cascading stop orders. Stop Logic Functionality introduces a momentary pause in matching (Reserved State) when triggered stops would cause the market to trade outside predefined values. The momentary pause provides an opportunity for additional bids or offers to be posted Stop Loss Order: See Stop Order. APRIL

87 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Stop Order: This is an order that becomes a market order when a particular price level is reached. A sell stop is placed below the market, a buy stop is placed above the market. Sometimes referred to as stop loss order. Compare to market if touched order. Straddle: (1) See Spread; (2) an option position consisting of the purchase of put and call options having the same expiration date and strike price. Strangle: An option position consisting of the purchase of put and call options having the same expiration date, but different strike prices. Strategy Based Margining: A method for setting margin requirements whereby the potential for gains on one position in a portfolio to offset losses on another position is taken into account only if the portfolio implements one of a designated set of recognized trading strategies as set out in the rules of an exchange or clearing organization. Also see Portfolio Margining. Street Book: A daily record kept by futures commission merchants and clearing members showing details of each futures and option transaction, including date, price, quantity, market, commodity, future, strike price, option type, and the person for whom the trade was made. Strike Price (Exercise Price): The price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer. Strip: A sequence of futures contract months (e.g., the June, July, and August natural gas futures contracts) that can be executed as a single transaction. STRIPS (Separate Trading of Registered Interest and Principal Securities): A book entry system operated by the Federal Reserve permitting separate trading and ownership of the principal and coupon portions of selected Treasury securities. It allows the creation of zero coupon Treasury securities from designated whole bonds. Strong Hands: When used in connection with delivery of commodities on futures contracts, the term usually means that the party receiving the delivery notice probably will take delivery and retain ownership of the commodity; when used in connection with futures positions, the term usually means positions held by trade interests or well financed speculators. Support: In technical analysis, a price area where new buying is likely to come in and stem any decline. See Resistance. Swap: In general, the exchange of one asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. This may entail selling one securities issue and buying another in foreign currency; it may entail buying a currency on the spot market and simultaneously selling it forward. Swaps also may involve exchanging income flows; for example, exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa, 84 APRIL 2011

88 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET while not swapping the principal component of the bond. Swaps are generally traded over the counter. See Commodity Swap. Swap Dealer (AS): An entity such as a bank or investment bank that markets swaps to end users. Swap dealers often hedge their swap positions in futures markets. Alternatively, an entity that declares itself a Swap/Derivatives Dealer on CFTC Form 40. Swaption: An option to enter into a swap i.e., the right, but not the obligation, to enter into a specified type of swap at a specified future date. Switch: Offsetting a position in one delivery month of a commodity and simultaneous initiation of a similar position in another delivery month of the same commodity, a tactic referred to as rolling forward. Synthetic Futures: A position created by combining call and put options. A synthetic long futures position is created by combining a long call option and a short put option for the same expiration date and the same strike price. A synthetic short futures contract is created by combining a long put and a short call with the same expiration date and the same strike price. Systematic Risk: Market risk due to factors that cannot be eliminated by diversification. Systemic Risk: The risk that a default by one market participant will have repercussions on other participants due to the interlocking nature of financial markets. For example, Customer A s default in X market may affect Intermediary B s ability to fulfill its obligations in Markets X, Y, and Z. T Taker: The buyer of an option contract. TAS: See Trading at Settlement. T Bond: See Treasury Bond. Technical Analysis: An approach to forecasting commodity prices that examines patterns of price change, rates of change, and changes in volume of trading and open interest, without regard to underlying fundamental market factors. Technical analysis can work consistently only if the theory that price movements are a random walk is incorrect. See Fundamental Analysis. TED Spread: (1) The difference between the interest rate on three month U.S. Treasury bills and threemonth LIBOR; (2) the difference between the price of the three month U.S. Treasury bill futures contract and the price of the three month Eurodollar time deposit futures contract with the same expiration month (Treasury Over Eurodollar). Tender: To give notice to the clearing organization of the intention to initiate delivery of the physical commodity in satisfaction of a short futures contract. Also see Retender. Tenderable Grades: See Contract Grades. APRIL

89 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Terminal Elevator: An elevator located at a point of greatest accumulation in the movement of agricultural products that stores the commodity or moves it to processors. Terminal Market: Usually synonymous with commodity exchange or futures market, specifically in the United Kingdom. TIBOR (Tokyo Interbank Offered Rate): A daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the Japan wholesale money market (or interbank market). TIBOR is published daily by the Japanese Bankers Association (JBA). See EURIBOR, LIBOR. Tick: Refers to a minimum change in price up or down. An up tick means that the last trade was at a higher price than the one preceding it. A down tick means that the last price was lower than the one preceding it. See Minimum Price Fluctuation. Time Decay: The tendency of an option to decline in value as the expiration date approaches, especially if the price of the underlying instrument is exhibiting low volatility. See Time Value. Time of Day Order: This is an order that is to be executed at a given minute in the session. For example, Sell 10 March corn at 12:30 p.m. Time Spread: The selling of a nearby option and buying of a more deferred option with the same strike price. Also called Horizontal Spread. Time Value: That portion of an option's premium that exceeds the intrinsic value. The time value of an option reflects the probability that the option will move into the money. Therefore, the longer the time remaining until expiration of the option, the greater its time value. Also called Extrinsic Value. Total Return Swap: A type of credit derivative in which one counterparty receives the total return (interest payments and any capital gains or losses) from a specified reference asset and the other counterparty receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset. Also called total rate of return swap, or TR swap. To Arrive Contract: A transaction providing for subsequent delivery within a stipulated time limit of a specific grade of a commodity. Trade Option: A commodity option transaction in which the purchaser is reasonably believed by the writer to be engaged in business involving use of that commodity or a related commodity. Trader: (1) A merchant involved in cash commodities; (2) a professional speculator who trades for his own account and who typically holds exchange trading privileges. Trading Ahead: See Front Running. Trading Arcade: A facility, often operated by a clearing member that clears trades for locals, where e locals who trade for their own account can gather to trade on an electronic trading facility (especially if the exchange is all electronic and there is no pit or ring). 86 APRIL 2011

90 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Trading at Settlement (TAS): An exchange rule which permits the parties to a futures trade during a trading day to agree that the price of the trade will be that day s settlement price (or the settlement price plus or minus a specified differential). Trading Facility: A person or group of persons that provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts, or transactions by accepting bids and offers made by other participants in the facility or system. See Many to Many. Trading Floor: A physical trading facility where traders make bids and offers via open outcry or the specialist system. Transaction: The entry or liquidation of a trade. Transfer Trades: Entries made upon the books of futures commission merchants for the purpose of: (1) transferring existing trades from one account to another within the same firm where no change in ownership is involved; (2) transferring existing trades from the books of one FCM to the books of another FCM where no change in ownership is involved. Also called Ex Pit transactions. Transferable Option (or Contract): A contract that permits a position in the option market to be offset by a transaction on the opposite side of the market in the same contract. Transfer Notice: A term used on some exchanges to describe a notice of delivery. See Retender. Treasury Bills (or T Bills): Short term zero coupon U.S. government obligations, generally issued with various maturities of up to one year. Treasury Bonds (or T Bonds): Long term (more than ten years) obligations of the U.S. government that pay interest semiannually until they mature, at which time the principal and the final interest payment is paid to the investor. Treasury Notes: Same as Treasury bonds except that Treasury notes are medium term (more than one year but not more than ten years). Trend: The general direction, either upward or downward, in which prices have been moving. Trendline: In charting, a line drawn across the bottom or top of a price chart indicating the direction or trend of price movement. If up, the trendline is called bullish; if down, it is called bearish. UV Unable: All orders not filled by the end of a trading day are deemed unable and void, unless they are designated GTC (Good Until Canceled) or open. Uncovered Option: See Naked Option. Underlying Commodity: The cash commodity underlying a futures contract. Also, the commodity or futures contract on which a commodity option is based, and which must be accepted or delivered if the option is exercised. APRIL

91 6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Variable Price Limit: A price limit schedule, determined by an exchange, that permits variations above or below the normally allowable price movement for any one trading day. Variation Margin: Payment made on a daily or intraday basis by a clearing member to the clearing organization based on adverse price movement in positions carried by the clearing member, calculated separately for customer and proprietary positions. Vault Receipt: A document indicating ownership of a commodity stored in a bank or other depository and frequently used as a delivery instrument in precious metal futures contracts. Vega: Coefficient measuring the sensitivity of an option value to a change in volatility. Vertical Spread: Any of several types of option spread involving the simultaneous purchase and sale of options of the same class and expiration date but different strike prices, including bull vertical spreads, bear vertical spreads, back spreads, and front spreads. See Horizontal Spread and Diagonal Spread. Visible Supply: Usually refers to supplies of a commodity in licensed warehouses. Often includes floats and all other supplies in sight in producing areas. See Invisible Supply. Volatility: A statistical measurement (the annualized standard deviation of returns) of the rate of price change of a futures contract, security, or other instrument underlying an option. See Historical Volatility, Implied Volatility. Volatility Quote Trading: Refers to the quoting of bids and offers on option contracts in terms of their implied volatility rather than as prices. Volatility Spread: A delta neutral option spread designed to speculate on changes in the volatility of the market rather than the direction of the market. Volatility Trading: Strategies designed to speculate on changes in the volatility of the market rather than the direction of the market. Volume: The number of contracts traded during a specified period of time. It is most commonly quoted as the number of contracts traded, but for some physical commodities may be quoted as the total of physical units, such as bales, bushels, or barrels. Volume Weighted Average Price (VWAP): A method of determining the settlement price in certain futures contracts. It is the average futures transaction price, weighted by volume, during a specified period of time. WXYZ Warehouse Receipt: A document certifying possession of a commodity in a licensed warehouse that is recognized for delivery purposes by an exchange. Warrant: An issuer based product that gives the buyer the right, but not the obligation, to buy (in the case of a call) or to sell (in the case of a put) a stock or a commodity at a set price during a specified period. 88 APRIL 2011

92 INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Warrant or Warehouse Receipt for Metals: Certificate of physical deposit, which gives title to physical metal in an exchange approved warehouse. Wash Sale: See Wash Trading. Wash Trading: Entering into, or purporting to enter into, transactions to give the appearance that purchases and sales have been made, without incurring market risk or changing the trader's market position. The Commodity Exchange Act prohibits wash trading. Also called Round Trip Trading, Wash Sales. Weak Hands: When used in connection with delivery of commodities on futures contracts, the term usually means that the party probably does not intend to retain ownership of the commodity; when used in connection with futures positions, the term usually means positions held by small speculators. Weather Derivative: A derivative whose payoff is based on a specified weather event, for example, the average temperature in Chicago in January. Such a derivative can be used to hedge risks related to the demand for heating fuel or electricity. Wild Card Option: Refers to a provision of any physical delivery Treasury bond or Treasury note futures contract that permits shorts to wait until as late as 8:00 p.m. Chicago time on any notice day to announce their intention to deliver at invoice prices that are fixed at 2:00 p.m., the close of futures trading, on that day. Winter Wheat: Wheat that is planted in the fall, lies dormant during the winter, and is harvested beginning about May of the next year. Writer: The issuer, grantor, or seller of an option contract. Yield Curve: A graphic representation of market yield for a fixed income security plotted against the maturity of the security. The yield curve is positive when long term rates are higher than short term rates. Yield to Maturity: The rate of return an investor receives if a fixed income security is held to maturity. Zero Coupon: Refers to a debt instrument that does not make coupon payments, but, rather, is issued at a discount to par and redeemed at par at maturity. APRIL

93 OECD/IEA All Rights Reserved The International Energy Agency (IEA) makes every attempt to ensure, but does not guarantee, the accuracy and completeness of the information or the clarity of content of the Oil Market Report (hereafter the OMR). The IEA shall not be liable to any party for any inaccuracy, error or omission contained or provided in this OMR or for any loss, or damage, whether or not due to reliance placed by that party on information in this OMR. The Executive Director and Secretariat of the IEA are responsible for the publication of the OMR. Although some of the data are supplied by IEA Member country governments, largely on the basis of information they in turn receive from oil companies, neither these governments nor these oil companies necessarily share the Secretariat s views or conclusions as expressed in the OMR. The OMR is prepared for general circulation and is distributed for general information only. Neither the information nor any opinion expressed in the OMR constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities. This OMR is the copyright of the OECD/IEA and is subject to terms and conditions of use. These terms and conditions are available on the IEA website at In relation to the Subscriber Edition (as defined in the OMR's online terms and conditions), the spot crude and product price assessments are based on daily Platts prices, converted when appropriate to US$ per barrel according to the Platts specification of products ( Platts a division of McGraw Hill Inc.). The graphs marked Source: Platts are also based on Platts data. Any reproduction of information from the spot crude and product price tables, or of the graphs marked Source: Platts requires the prior permission of Platts.

94 Editorial Enquiries Editor David Fyfe Head, Oil Industry and Markets Division (+33) 0 * [email protected] Oil Price Formation Bahattin Buyuksahin (+33) 0 * [email protected] Editorial Assistant Esther Ha (+33) 0 * [email protected] Fax: (+33) 0 * Media Enquiries * 0 - only within France IEA Press Office (+33) 0 * [email protected] Subscription and Delivery Enquiries Oil Market Report Subscriptions International Energy Agency BP PARIS Cedex 15, France (+33) 0 * [email protected] (+33) 0 * User s Guide and Glossary to the IEA Oil Market Report For information on the data sources, definitions, technical terms and general approach used in preparing the Oil Market Report (OMR), Medium-Term Oil and Gas Markets (MTOGM) and Annual Statistical Supplement (current issue of the Statistical Supplement dated 11 August 2010), readers are referred to the Users Guide at It should be noted that the spot crude and product price assessments are based on daily Platts prices, converted when appropriate to US$ per barrel according to the Platts specification of products ( 2011 Platts - a division of McGraw-Hill Inc.). The Oil Market Report is published under the responsibility of the Executive Director and Secretariat of the International Energy Agency. Although some of the data are supplied by Member-country Governments, largely on the basis of information received from oil companies, neither governments nor companies necessarily share the Secretariat s views or conclusions as expressed therein. OECD/IEA 2011

95 OTC Commodity Derivatives Trade Processing Lifecycle Events An ISDA Whitepaper April 2012 This whitepaper provides a summary of key trade processing lifecycle events in the over-thecounter (OTC) commodity derivatives markets, with an overview of the current state of processing, related issues and opportunities for further improvement. Additionally, the paper analyzes existing and potential opportunities for further standardization in these markets. For further information, contact: Nichole Framularo [email protected] International Swaps and Derivatives Association, Inc.

96 2 TABLE OF CONTENTS SECTION I: OTC COMMODITY DERIVATIVES MARKET OVERVIEW INTRODUCTION CURRENT LEVEL OF STANDARDIZATION IN THE COMMODITY DERIVATIVES MARKETS EXECUTION CONFIRMATION SETTLEMENT CLEARING CCPS TRANSPARENCY FUTURE STANDARDIZATION INITIATIVES SECTION II: SUMMARY OF COMMODITY MARKETS' TRADE PROCESSING LIFECYCLE EVENTS TRADE CAPTURE AND REVISIONS (a) Initial Trade Capture (b) Trade Capture Revisions CONTROLS PROCESSING (a) Broker Recap (b) Counterparty Affirmation (c) Confirmation SETTLEMENTS (a) Pre-Settlement Activity (b) Post-Settlement Activity (c) Nuances to Settlements Activity in Commodities OPTION EXERCISE (a) Financially Settled Options (b) Physically Settled Options COLLATERAL MARGINING CLOSE-OUTS (a) Terminations (b) Trade Compressions (c) Assignments and Novations NATURAL MATURITY SECTION III: CURRENT STATE OF LIFECYCLE EVENT PROCESSING TRADE CAPTURE AND REVISIONS (a) Initial Trade Capture (b) Trade Capture Revisions CONTROLS PROCESSING (a) Broker Recap (b) Counterparty Affirmation (c) Confirmation SETTLEMENTS OPTION EXERCISE OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

97 3 (a) Financially Settled Options (b) Physically Settled Options COLLATERAL MARGINING CLOSE-OUTS (a) Terminations (b) Trade Compressions (c) Assignments and Novations NATURAL MATURITY SECTION IV: ISSUES WITH CURRENT PROCESS...24 SECTION V: POTENTIAL END STATE...28 SECTION VI: CONCLUDING REMARKS...28 ANNEX A: BEST PRACTICE GUIDELINES FOR ELECTRONIC CONFIRMATION MATCHING...30 ANNEX B: KEY INDUSTRY FORUMS...37 ANNEX C: ISSUES WITH CURRENT PROCESS (REF. SECTION IV(A)) BY LIFECYCLE EVENT TYPE...38 OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

98 4 SECTION I: OTC COMMODITY DERIVATIVES MARKET OVERVIEW 1. Introduction In March 2011, the International Swaps and Derivatives Association (ISDA) Commodities Steering Committee (COSC) and Commodities Major Dealers Implementation Group (CMD) made a commitment to global supervisors 1 to continue to drive a high level of product, processing and legal standardization, with a goal of securing further operational efficiency, mitigating operational risk and increasing the netting and clearing potential for appropriate products. 2 This whitepaper (the Paper) analyzes existing and, where appropriate, potential opportunities for further standardization in the over-the-counter (OTC) commodity derivatives market. Additionally, the Paper includes a summary of key commodities trade processing lifecycle events, aligned, where appropriate, with established industry programs concerning metrics, documentation and electronic processing 3. Listed trades and cleared OTC trades have been specifically excluded from the scope of this Paper due to the high degree of automation inherent in the processing of such trade types. 2. Current level of standardization in the commodity derivatives markets OTC commodity derivatives have been in existence for centuries, far longer than some of the other OTC derivatives asset classes. The vast majority of commodity derivatives products have become standardized over time and, since the 1990s, additional standardization has occurred with a specific focus on electronic confirmation, lifecycle event processing and clearing. OTC commodity derivatives are a highly standardized asset class with the majority of its turnover occurring on regulated exchanges globally. The ISDA Commodities Steering Committee conducted a 2010 survey of members to ascertain the volume of financial oil business that is conducted on exchange or cleared OTC. The essential conclusion from this survey was that the significant majority of business is conducted through exchange or is cleared, 4 meaning that the data is readily accessible in support of post-trade transparency. There is a proportion of business that is more structured in nature which will be client driven, with the payouts, contract terms and collateral arrangements designed to meet the risk management needs and requirements of the particular target end-user client base. Within the OTC commodity derivatives market there is already a high degree of standardization. The OTC commodity derivatives market features: Well-understood product mechanics Robust, proven legal framework 1 See the March 2011 Supervisory Commitment Letter available via 2 Recognizing that standardization is only one of a number of criteria for clearing eligibility. 3 Please note that there are various proposed and final regulations implementing the Dodd-Frank Act in regard to trade reporting, processing, execution and confirmations. These best practices are meant as guidelines prior to the formal implementation of regulatory requirements. 4 According to the survey, approximately 55% of OTC financial oil for all counterparties is conducted via exchange, 19% is cleared and the remaining 26% is OTC. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

99 5 Standardized documentation 5 Electronic trade affirmation / legal confirmation Extensive electronic execution capabilities Active clearing across a variety of central clearing counterparties (CCPs) High and improving rates of straight-through-processing (STP) Robust bilateral settlement The OTC commodity derivatives market benefits from a diversity of market participants ranging from commercial producers to local energy distribution companies to banks. 6 Many individual asset classes are covered within the broader commodities umbrella. The OTC commodity derivatives market is comprised of several different market segments including the trading of agriculture, base metals, coal, commodity index products, crude oil, emissions, freight, gas, oil products, plastics products, power, precious metals and weather. 7 Therefore, the concentration of market risk is diversified and not in any one particular product. A large amount of commercial information in relation to OTC commodity derivatives transactions is already publicly available from commercial service providers Definitions Almost all OTC commodity derivative trades are executed under standard legal terms. Typically, they are contained in the ISDA Master Agreement between the parties, although in a limited number of cases they are contained in the national equivalent such as Rahmenvertrag in Germany, AFB in France (or in another master agreement between the parties). At the trade level, the standard trade incorporates the ISDA definitions, supplements, protocols and other documentation as set forth for that particular product in the ISDA Commodities Documentation Matrix, all of which have been developed over the past decade. This development has included incremental modification and standardization over time in order to make trades on the same underlying, to the same maturity date fungible in order to facilitate compression and clearing, where appropriate. For trades confirmed electronically, these standard provisions are typically incorporated via the rules and procedures governing use of the platform. For trades confirmed on paper, these standard provisions are usually incorporated via the relevant standard documentation forms. It is important to note that standardized agreements still require bilateral agreement for novations. 2.2 Contracts Across the OTC commodity derivatives market, the vast majority of all contracts are confirmed electronically via confirmation matching platforms. To date, more than 85% of eligible inter- CMD metals trades and 90% of energy trades are confirmed electronically. There is no material backlog of unexecuted confirmations. 9 The small subset of transactions that are not confirmed electronically are confirmed via paper. The monthly metrics provided by the CMD also include data on G15 to non-g15 electronic matching. The metrics indicate that the average percentage of 5 The ISDA Commodities Documentation Matrix summarizes various types of OTC commodity derivatives documentation and their current state. The Documentation Matrix is also available on the ISDA website via the following link: 6 The G15 comprise approximately 24% of the OTC commodity derivatives market, according to the Q metrics reporting. 7 See ISDA Commodities Documentation Matrix: 8 See service providers list on page The level of outstanding confirmations continues to fall, with the business days outstanding Q average at 0.059, down from for Q Source: Markit Metrics. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

100 6 total volume that is electronically eligible has increased for G15 to non-g15 transactions from 70% in March 2009, trending at around 90% across all quarters in 2010 and into 2011, and has shown a steady 95% average for the G15-to-G15 transactions. 10 The confirmation matching process is accomplished by the bilateral electronic submission or affirmation of confirmable transaction details by each party to the trade. Any unmatched trades (or unmatched fields of linked trades) are investigated and resolved by the parties to the trade. The electronic confirmation platforms provide both detail and summary analysis of the current status of all transactions within their respective platforms for efficient risk management of the confirmation process. Market participants have well-established processes for escalation and resolution of trade breaks. 2.3 Market Practices Standardized Terms: OTC commodity derivatives transactions are effectively standardized through product templates and market practice standards for the majority of non-economic fields. The industry framework enables end users to customize transactions to meet their specific requirements without having to forego the benefits that a standardized infrastructure delivers. 2.4 Lifecycle Events Confirmable Events: New trades Amendments Partial unwinds Notional increases/decreases (relative to commodity index transactions) Novations/partial novations As outlined above, electronically eligible activity on trades is typically confirmed via electronic confirmation mechanisms or bi-lateral agreement to modify master agreements and supporting annexes. This item will be further discussed later in this Paper. 2.5 Other Standardization Features STP: The OTC commodity derivatives market has developed a very high level of straightthrough-processing (STP). From the use of electronic trade booking to central clearing counterparty (CCP) processing, the industry continues to leverage the established infrastructure to drive further efficiency in trade processing and a reduction in operational risk. 11 CCPs: central clearing has been in place for a number of years across a variety of products. See below for further information. Collateral: For non-cleared transactions, there is widespread use of bilateral collateral arrangements (via the ISDA Credit Support Annex (CSA), and approximately 60% of all 10 Source: Markit Metrics 11 See ISDA 2011 Operations Benchmarking Survey; available via OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

101 7 commodity derivatives trades are subject to such arrangements. 12 Additionally, the dealers in the CMD are meeting the daily reconciliation requirements for portfolios greater than 500 trades, 13 in line with the ISDA Collateral Steering Committee commitments. There has been significant progress with regard to agreement for standardization of fields needed to improve portfolio reconciliation matching rates, as well as setting the groundwork for the commodities trade repository. 3. Execution OTC commodity products are traded across both exchange and OTC venues, providing adequate pre-trade transparency to market participants. A significant percentage of the commodity futures, options and forwards are executed on exchanges and settled via central counterparties. In terms of pre-trade execution venues, there are voice execution venues, electronic trading venues and exchanges available. Hence, exchanges, brokers, MTFs and clearing houses 14 provide data that is already sufficient to their participants on the most pricing-relevant transactions. 4. Confirmation As highlighted above, the combination of the established documentation and electronic affirmation/confirmation rates means that there is a highly standardized and efficient legal framework in place. Market participants and supervisors continue to work with the confirmation platform providers to expand the population of transactions covered by electronic confirmation. Continued industry efforts, in conjunction with continued documentation take-up, 15 will move more types of products onto electronic confirmation platforms and will further mitigate risks and increase automation in this process. For cleared transactions, the prime record of the transaction is automatically processed and maintained within the respective CCP. 5. Settlement Current levels of nostros breaks outstanding on bilateral trades are extremely low, evidencing the effectiveness of existing settlement mechanisms. 16 These are typically managed via in-house automated derivatives processing systems and via standardized messaging to correspondent banks, with any settlement netting pre-agreed on a bilateral basis. Additionally, all cleared transactions have settlement automatically executed via the respective clearing process. 12 According to the ISDA 2011 Margin Survey; available via 13 Achieving matching rates greater than 97%. 14 See 'Execution and Clearing' appendix for further information in relation to a sample list of various service providers that offer these types of services. 15 See ISDA Documentation Matrix via 16 See ISDA 2011 Operations Benchmarking Survey; available via OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

102 8 6. Clearing CCPs The OTC commodity derivatives market has a significant number of central counterparty and clearing infrastructures in place today. Examples include: Agriculture CME Clearing / ICEClear US Base Metals LCH / CME ClearPort Coal CME ClearPort Crude Oil ICEClear / CME ClearPort/ NGX Emissions ICEClear / NOS Clearing / ECC / CME GreenEx Freight NOS Clearing / LCH Gas European Commodities Clearing (ECC) / ICEClear / CME ClearPort / APX / NGX Oil Products ICEClear / CME ClearPort Plastics Products LCH Power European Commodities Clearing (ECC) / APX / ICEClear / CME ClearPort / NGX Precious Metals LCH / CME ClearPort Weather CME ClearPort A significant percentage of the commodity futures, options and forwards are executed on exchanges and settled via central counterparties. Several of the institutions named above provide for central counterparties for non-exchangetraded transactions. Based on Q4 2011metrics provided by the CMD, ~30% of the CMD OTC commodity derivatives are settled via central counterparties (~50% for Energy) ); YTD 2011 metrics 17 evidence an uptick in energy cleared OTC in line with increased overall reported volumes. 7. Transparency The OTC commodity derivatives market is relatively transparent (pre and post-trade), with a significant proportion of transactions centrally cleared, electronically confirmed and bilaterally collateralized. 18 The market is a heterogeneous market, although there are some market niches with great standardization. Market participants are varied and financial investors coexist with non-financial investors, whose main purpose is to hedge risk. Additionally, there are several different market segments that allow for diversification of product risk. The OTC commodity derivatives market already provides central clearing for swaps that are suitable to be centrally cleared. Based on monthly metrics provided by the CMD, over 35% of 17 Note: Volume reported to the supervisory community includes OTC financial, physical and cleared OTC products transactions with G15 and non-g15 counterparties and clients. Listed derivatives volume is reported separately (at present) to the CFTC and other supervisors. 18 See which includes output from the ISDA COSC process and partnership with FRB-NY and the co-chairs of the IOSCO Commodities Futures Task Force (UK FSA and CFTC). Also see OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

103 9 their OTC commodity derivatives are settled via central counterparties (over 45% for Energy). Other market-led initiatives include monthly reporting on a number of key performance indicators, a 61% decrease in the gross number of outstanding confirmations since September 2008 and an increase in the average percentage of total volume that is electronically eligible from 52% (Dec 07) to a high of 70% (March 09) Pre-Trade Transparency There is excellent pre-trade transparency, via a variety of platforms, to a wide array of end-users. The sources of pre-trade information that the OTC commodity derivatives markets utilize include brokers, price reporting agencies, electronic trading platforms and bilateral price discovery methodologies. The sources of post-trade information utilized within the OTC commodity derivatives markets include electronic trading platforms, electronic confirmation services, and clearing venues. Pre-trade transparency is available via a variety of mechanisms including exchanges, brokerages, electronic trading platforms and bilateral arrangements. Pre-trade information in relation to exchange prices can be accessed on reasonable commercial terms. The information is consolidated via exchanges, electronic trading platforms and major dealer pricing information. There is already a highly developed exchange-traded market with high levels of consolidated pretrade transparency. At present, there does not seem to be demand for additional pre-trade transparency for non-standardized OTC deals. The vast majority of OTC transactions in commodity derivatives markets are priced with reference to readily observable market prices (either a benchmark futures contract or physical underlying).. Potential drawbacks include exposing firms proprietary positions that could impact trade size and frequency. Also, there are potential risks to liquidity and the willingness of market participants to commit liquidity. There are no clear benefits on what would accrue as a result of increased pre-trade transparency, particularly in respect of non-standardized bilateral OTC contracts, as the pricing of each deal is different and takes into account a wide range of factors specific to that deal (i.e, creditworthiness of counterparty, physical market conditions, etc.). In a market where market participants are hedging against specific risks, pre-trade transparency would do little good and significant harm (exposing commercially sensitive risk positions to other market participants). Ill-conceived pre- and post-trade transparency requirements for commodity derivatives risk negatively impacting liquidity and exacerbating volatility in the market Post-Trade Transparency Post-trade transparency is available to global supervisors, who receive reports on a regular basis. Commodity derivative volume reported to the supervisory community includes OTC financial, physical and cleared OTC products transactions with CMD and non-cmd counterparties and clients. Listed derivatives volume is reported separately (at present) to the CFTC and other supervisors. Post-trade transparency is available to the broader marketplace via commercial venues and processes that provide various types of information, examples below. 19 Source: Markit Metrics 20 Additionally, CESR and ERGEG, in their advice to the European Commission came to the conclusion that there is no need to take action in relation to purely bilateral trading which often is so bespoke that transparency information would not add materially to the price discovery process. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

104 10 CCPs: Clearinghouses provide end of day prices for contracts that are eligible to be cleared. The clearinghouse end-of-day process typically requires executable pricing from all participating members. Valuation Reports: Another important source of post-trade transparency to clients can be found in the valuation reports that are provided to clients by dealers, which typically include a position level mark-to-market valuation on the positions that the client has facing the dealer. Industry Metrics: There are extensive metrics across a variety of indicators provided to primary regulators on a monthly basis providing strong transparency regarding the performance of the industry in the areas identified as important by regulators. 8. Future Standardization Initiatives 8.1 Electronic Affirmation/Confirmation/STP The markets continue to strive for further operational standardization. There is a strong industry focus on the industry utilities keeping up with developing volumes in the marketplace. This is tracked and managed via an established and mature reporting process that confirms the level of penetration of electronic versus paper confirmation. 8.2 Trade Repository In June 2011, the COSC selected DTCC/EFETnet to partner with them in building the commodities trade repository. The industry has met its commitment to establish a central trade reporting repository to deliver a first phase by Q There are concerns in relation to the likely proliferation of global, regional and local/country-specific trade repositories. The industry view is that a single global trade repository per asset class would provide Supervisors and market participants with valuable efficiencies. 22 In particular, there would be no redundancy of platforms, no need for additional levels of data aggregation and reduced risk of errors and greater transparency. A single trade repository per asset class would avoid the risk of errors associated with transmitting, aggregating and analyzing multiple sources of potentially incompatible and duplicative trade data. A single global trade repository would also reduce the risk of reporting to multiple repositories in different jurisdictions. 21 See 2011 March Supervisory Commitment Letter and ISDA Commodities Trade Repository RFP, available via 22 See Enactment_and_TransitionSwaps.pdf. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

105 11 SECTION II: SUMMARY OF COMMODITY MARKETS' TRADE PROCESSING LIFECYCLE EVENTS The following bilateral OTC trade processing lifecycle events are considered in this Paper: 1. Trade Capture and Revisions initial trade capture, trade capture revisions 2. Controls Processing broker recap, counterparty affirmation, confirmation 3. Settlement pre-settlement activity, post-settlement activity 4. Option Exercise financially-settled options, physically-settled options 5. Collateral Margining 6. Close-Out terminations, trade compressions, assignments/novations 7. Natural Maturity 1. Trade Capture and Revisions (a) Initial Trade Capture Once a transaction has been executed, both of the parties to the trade must enter the full terms of the transaction into their respective trade capture systems. The Trade Capture System, either independently or through a technological interface, should provide robust, accurate, reliable, real-time information related to credit risk, market risk and position exposure management, as well as provide trade support functionality to enable processes such as position verification, broker recaps, counterparty affirmations, confirmations, settlements, collateral margining, and financial control. (b) Trade Capture Revisions Trade capture revisions can be categorized as either economic or non-economic. Economic trade capture revisions can arise from any post-trade capture control processes, including during the risk management and position verification processes, or the broker recaps, counterparty affirmation and confirmation or settlements processes. The need for these revisions may occur on or after trade date (T) according to the timeframe of the process that highlights such need. Regardless of the source of identification of the need for the revision, modifications to any existing transaction details recorded should always be done at the trade capture level, and not within the downstream processing environment. economic trade capture revisions will typically have an impact on downstream processing, such as the need for a revised confirmation or a revised invoice being raised. Non-economic trade capture revisions can also arise from post-trade capture. Examples include an incorrectly identified broker, or a re-modeling of a transaction for internal purposes, where such re-modeling maintains the original economic intent of the transaction without altering the terms of the trade as agreed between the two parties. With the exception of electronic broker matching, Non-economic trade capture revisions will typically have minimal impact on downstream processing. 2. Controls Processing (a) Broker Recap OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

106 12 For trades executed via a broker, the broker recap process typically occurs on T or T+1 for standardized vanilla trade types (but may take place on a longer time frame for the more structured trade types). Traditionally, the broker will send a written recap of the economic details of the trade to both parties involved in the transaction by either facsimile or . However, there is now some take-up of both the ability of parties to download their own broker recaps from a web portal, and also, increasingly, the available use of electronic broker matching. This independent third-party verification of trade details is used by each of the two contracting parties to validate the accuracy of their trade capture in order to gain confidence that the economic details of the trade are correctly understood and reflected in the official records of the parties concerned. This process often serves as the earliest point of risk mitigation in correctly securing the economic details of the trade. (b) Counterparty Affirmation Counterparty affirmation also typically occurs on T or T+1. According to a party s internal organization and processes, the counterparty affirmation process may be done (i) only for transactions that are traded direct (i.e, non brokered transactions) and which are not confirmed with the counterparty by means of electronic matching, or (ii) for non-brokered transactions irrespective of the method used for the counterparty confirmation, or (iii) brokered and non-brokered trades which are not confirmed with the Counterparty by means of electronic matching, or (iv) all trades. The process is performed between the two parties to the transaction via telephone or through the delivery of a trade summary by . It should be noted that some parties choose not to participate in the verbal affirmation process because their internal structural organization of resources responsibilities does not support this lifecycle event. (c) Confirmation Confirmation is the process by which, either through electronic messaging or through the use of paper confirmations, the parties legally memorialize the terms of the trade. Confirmation is typically performed on T, or as soon as practical thereafter. Confirmation execution is the process by which the two parties confirm their agreement to the full terms of the trade as set out in the confirmation. The parties may confirm a transaction by matching electronically on a bilateral basis, or on a third-party vendor matching platform. Paper confirmations may be created manually, systemically with some user interaction, or systemically with full STP. According to the terms of any prevailing Master Agreement and/or the governing law, confirmations may be legally binding by (i) one party signing and returning the other party s confirmation, (ii) an exchange of confirmations between the parties, (iii) one party affirming their agreement to the terms of the confirmation by some means but without actually signing the confirmation, or (iv) one party implying their acceptance of the other party s confirmation by virtue of not having disputed it within a given specified timeframe. Paper confirmations that are not executed/agreed by both parties may be an indication of disagreement on the terms of the trade, and in such case a verbal counterparty affirmation of the core economic trade details should occur between the parties pending the resolution of the any legal, credit, or other provision(s) that remain in discussion. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

107 13 For a more detailed discussion of the controls processing lifecycle events, CMD members should refer, and adhere, to the Best Practice Guidelines as issued by the CMD, where applicable. Parties not included in the CMD are referred to the Best Practice Guidelines on Electronic Confirmation Matching for Commodities Products (which is based on the CMD Guidelines) as issued by the ISDA Commodity Operations Working Group, and published on the ISDA website (a copy of the current version is appended hereto as Annex A). 3. Settlements (a) Pre-Settlement Activity Settlement prices for transactions can be obtained either electronically or manually, but in any event should be done on a timely basis, at the latest the opening of business on the day following the day, or last day, of pricing in question. When obtained electronically, the relevant prices are taken from the price source through a technological interface, most commonly by way of a Logical Information Machine (LIM) feed or a data scrape of a particular website. When obtained manually, operations personnel will consult the appropriate price source based on the relevant pricing convention for the particular trade type and commodity product to be settled and manually input the relevant price(s). Best practices dictate that settlement prices that are input by one person (Maker) should be verified by a separate person (Checker). Irrespective of whether the prices are taken by automated or manual means, they must be input into a system or format that will ultimately be used for the purposes of trade valuation, collateral margining and invoicing. Once prices are updated and available for invoicing purposes, invoices are issued, reconciliation occurs between the parties, and any discrepancies between the payment amounts calculated by each of the parties are investigated and resolved. Payment affirmation is then exchanged between the parties either in the form of affirmation of settlement amounts or an exchange of invoices, and cash movements are effected for the correct value date. (b) Post-Settlement Activity Once cash movements are effected, operations personnel will conduct a nostro reconciliation of ledger entries against cash movement. Discrepancies between cash and ledger entries are typically the result of failure to pay, underpayment or overpayment of agreed amounts, inadvertent payment to a different legal entity, or withholding of wire transfer fees. Operations personnel will investigate the discrepancies and resolve the matter via their individual organization s escalation controls, procedures and processes, but always with the goal of obtaining complete and accurate recording of cash movements (or exceptions) to the general ledger. (c) Nuances to Settlements Activity in Commodities Bilateral Settlements consist of the settlement of (i) financial transactions and (ii) physical transactions for which delivery either occurs or is booked out by another physical transaction with similar characteristics. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

108 14 Settlement frequency varies according to trade type and commodity product. For example: Financial transactions are typically settled a specific number of days after the final pricing date of the relevant pricing period, depending on the market convention for the underlying commodity product. For transactions involving calendar monthly pricing periods, this often results in a high volume of settlements on a few specific days during the early part of the following month. For financial transactions with pricing periods that comprise a single day, settlements will occur throughout the month, on the specified day after the pricing period. Option premiums are typically settled a specific number of days after the trade date, although they can also be netted with the final settlement. Precious metals and base metals settlement takes place on the day of delivery of the commodity. Transactions where physical delivery of electricity or gas occurs possess product-specific settlement conventions, where the delayed settlement provides for reconciliation of physical deliveries and book-out of transactions between counterparties at delivery points on natural gas pipelines and within electricity ISOs and RTOs, or at other regional scheduling locations on the grid. For example: North American Physical Power and European and UK Physical Natural Gas transactions settle on a monthly cycle 20 days after the end of the delivery month; UK Physical Power transactions settle on a monthly cycle 10 days after the end of the delivery month; and North American Physical Gas transactions settle 25 days after the end of the delivery month. Bilateral physical power settlements consists of the purchase and sale of electricity as it moves across one or a series of power grids from point A to point B. Often times there are cuts along the way as power that has been contracted is not actually delivered. Investigating these curtailments in the power flow of buyers and sellers comprises a significant portion of the settlement effort. However, each movement along the grid(s) is tracked via a tag that aids in the investigation of the discrepancy. Power transacted with an Independent System Operator (ISO) must be settled according to the ISO s invoice and timeline. Disputes may only be raised via the ISO s dispute resolution service. ISOs also remain risk neutral; for each settlement cycle they require that all receivable payments are made before their payables are made, and if a participant fails to make a scheduled payment, the ISO remits payment, resulting in a pro-rata shortfall to the paying participants. Physical natural gas settlement is the settlement of the purchase, sales, storage, or transportation of natural gas either between parties or via a natural gas pipeline. Since physical natural gas being delivered from point A to point B may involve various parties and/or pipelines, imbalances may occur as the result of imbalances along the path. Volume actualization between the parties in the daisy chain comprises a significant portion of the settlement effort. The resolution process is manual and paper intensive, and takes place using data obtained from each individual pipeline s Electronic Bulletin Board (EBB). CMD members should adhere to any Best Practice Guidelines as issued by the CMD, where applicable. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

109 15 As a result of the physical power curtailments and physical natural gas imbalances mentioned above, it is not atypical for portions of these invoices to have incomplete reconciliation for several months (or longer) after the initial settlement cycle. Physical oil settlements vary in frequency and process by the type of product and transportation mode on the transaction and are governed by the individual purchase/sale contract. For waterborne transactions (barges and vessels of varying sizes), payment terms generally range from prepayment based on an estimated volume or estimated price, to monthly settlements in the month following delivery. For pipeline transactions, a similar range can be seen, but with the majority of the US refined product pipeline business transacted under two-day payment terms after movement and receipt of the invoice and backing documentation from the pipeline company. Although some of the liquidly traded physical oil transactions are booked out against a chain of other counterparty trades or bilaterally with a single opposing trade with the same counterparty, most oil trades go to physical delivery and settlement. These transactions, like the power and gas transactions described above, have to be actualized with actual volumes, dates, and product quality measurements based on what actually occurred. Thus two settlements are often required: a Provisional settlement for the estimated quantity and quality, and a Final settlement to true up to the actual amount due. In addition, some parties participate in payment netting in those instances where different commodity products settle on the same payment date and in the same currency. (d) Current Settlement Process (i) Over-the-Counter (OTC) Trades The OTC commodity derivatives settlement process is a date-driven process. Certain key dates each month correspond to the settlement of different products. In many cases, specific products are settled only once a month. For example: Many financial commodities (such as gas, crude and refined products) settle five business days after completion of pricing; and US financial power settles on the 10th business day of the month. Physical commodities also have different settlement conventions based on the product and region. For example: o North America physical power settles on the 20th calendar day of the month following flow month; o North America physical gas settles on the 25th calendar day of the month following flow month; o European physical natural gas settles on the 20th calendar day of the month following flow month; and o Spot precious metals trade for spot value, which is two business days after the trade date. The longer settlement times on physical energy products is reflective of the greater amount of reconciliation required in the event of a discrepancy due to the dependence upon transportation statements. Power prices are published on an hourly basis or, in some cases, every 15 minutes, which results in a large number of resets which need to be reconciled when OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

110 16 a discrepancy arises. In the event that agreement is not reached by parties by the settlement date, the undisputed amount is often paid. The settlement calculation for physical transactions is volume multiplied by price. Prices are either agreed upon at the time of the transaction ( fixed ) or settled against a published index ( floating ; ex. Platts Gas Daily).Some products require a provisional invoice since the quantity, the price or even both may not be known at the time at which a provisional payment is required. Final settlement is then performed to true-up to actuals. It is not uncommon when physical commodities are settled to see an actualization, where the contractual quantity is updated to reflect the actual quantity delivered. In addition, physical power and gas add a level of complexity as volumetric cuts need to be reconciled. Cut resolution can take months as all upstream and downstream parties need to agree. Settlement calculations for financial transactions are similar, volume multiplied by price, but more than one price is involved. One price may be fixed and compared against an index price (Fixed Swap) or there may be two index prices (Float-Float Swap or Basis Swap) multiplied by the volume and settled against one another (e.g, 310,000 mmbtu * 3.50 versus 310,000 mmbtu * Gas Daily-Texok.) Swaps are always settled net; individual legs are never settled gross. There also can be multiple prices with different weightings, which comprise a basket. Typically, invoices are settled net, meaning multiple transactions settling on the same day with the same counterparty in the same currency and same legal entity are netted together, with only one party moving the cash. In some jurisdictions, such as the European markets, tax requirements require sellers of physical commodities to invoice the counterparty for delivered goods, and only sell trades are on the invoice. Invoices include such relevant information as trade date, volume, fixed price and/or floating price, and settlement amount per trade. As soon as practicable after all prices are known, counterparties issue invoices to one another and, in the case of physical gas, either on nominated volumes or after volumes are actualized. Settlement affirmation is standard in the industry, where parties confirm cash amounts prior to the settlement date. This practice reduces settlement breaks and ensures that reconciliations are performed prior to cash moving. This is a major contributing factor to the low rate of settlement fails across commodities. According to the 2011 ISDA Operations Benchmarking Survey, the percent of monthly settlement volume resulting in nostro breaks is only 8% across the industry. There are a number of explanations for the low rate of outstanding settlement fails in commodities, partly explained by the well-controlled confirmation processes below, which allow for trade discrepancies to be remedied well in advance of settlement: The OTC commodity derivatives markets have a record of striving for electronic confirmation Matching. Vendor solutions such as ICE econfirm, EFETnet and SWIFT have facilitated this approach. The industry continues to add both products and trade types to these electronic platforms in order to decrease the number of trades requiring paper confirmations. Additional vendors are also beginning to enter this market (e.g, Markitwire and Misys). Many transactions are brokered by a third party. A broker recap is sent out (in addition to the Confirmation) and is diligently checked to ensure that trade economics are accurately booked. A number of market participants perform verbal confirmation of trade economics should there be no type of affirmation by Trade Date + 1. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

111 17 Pre-settlement affirmation of cash flows identifies discrepancies early and allows for reconciliations prior to settlement date. At times, the movement of the physical commodity serves as a pre-settlement affirmation of economics, with the exception of price. Discrepancies on physical transactions relate primarily to cuts in physical power and gas, where the actual quantity of the delivered commodity is different from the contractual quantity due to operational factors, e.g., congestion on the power grid. Each organization has its own, essentially similar, process for reconciling volumes (i.e., the use of pipeline statements and OATI tags) and, in the event of a volume discrepancy, the invoicing groups work together and share support to resolve any differences. Scheduling groups, and in the case of power, real-time trading desks, may get involved as well, to resolve volumetric differences. Should a difference remain at settlement time, counterparties will advise one another as to what the payment amount will be, and agree to continue working on the disputed portion of the invoice. Counterparties typically have a shared interest in resolving these outstanding items, so cooperation between counterparties is generally good. The UK power and gas markets are structured differently from North America markets and contractual obligations are usually met in full, with the financial impact of any changes in delivered volumes often managed centrally. (ii) Listed and OTC Cleared Trades Although this Paper does not focus on the specifics of the markets for Listed Trades and cleared OTC trades, OTC settlement risk in the OTC commodity derivatives markets has to be considered in the context of the overall commodity settlement volume. A significant percentage of commodities transaction volume is traded as futures and options on regulated exchanges run by entities such as the following: the CME Group, which controls the New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME); the Intercontinental Exchange, Inc. (ICE), which controls ICE Futures US and ICE Futures Europe; Commodity Exchange (COMEX); London Metal Exchange (LME); NYSE Euronext LIFFE (LIFFE); Singapore Exchange (SGX); Dubai Mercantile Exchange (DME); European Energy Exchange (EEX); and Tokyo Commodity Exchange (TOCOM) offering commodity products globally. The OTC commodity derivatives markets pioneered the development of central clearing of OTC transactions. In the late 1990s, NYMEX was one of the first exchanges to offer the ability to clear OTC contracts. Counterparty demand for alternate solutions to complement bilateral collateral arrangements led to the development of a platform to clear OTC as futures through NYMEX s Clearport mechanism. The subsequent growth and success of OTC clearing coincided with Enron's bankruptcy and subsequent credit instability in the energy markets. In 2001, NYMEX Clearport provided the industry with the ability to clear centrally. The continued credit instability experienced during the late period re-enforced the benefit of OTC clearing and its ability to provide capital efficiencies and access to a wide range of products. Other commodity exchanges and clearing houses followed the NYMEX OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

112 18 example with ICE Clear, CME Clearport, LCH.Clearnet, European Commodities Clearing (ECC), NOS Clearing, AsiaClear and many others offering central clearing of OTC products. Examples of commodity central counterparty and clearing organizations today include: Gas Trading: ECC / ICEClear / CME Clearport / APX Group Base Metals Trading: LCH.Clearnet / CME Clearport Precious Metals Trading: LCH.Clearnet / CME Clearport Power Trading: ECC, APX Group Plastics Products Trading: LCH.Clearnet Oil Products Trading: ICEClear / CME Clearport (formerly NYMEX Clear) Crude Oil Trading: ICEClear / CME Clearport Coal Trading: CME ClearPort, ICEClear Freight Trading: NOS Clearing / LCH.Clearnet Agriculture Trading: CME Clearport / ICEClear US Emissions Trading: ICEClear / NOS Clearing / ECC Iron Ore Trading: AsiaClear, LCH Clearnet To date, NYMEX has launched more than 650 OTC-cleared contracts, 23 and ICE Clear 24 more than 600. Market participants commonly use central clearing, and there is strong competition between exchanges and clearing houses to launch new products providing capital efficiencies and credit risk management. Some of the most recent examples include: ECC clearing contracts traded on the European Energy Exchange, European Energy Derivatives Exchange and Powernext; NASDAQ and Nordpool working together to deliver central clearing services for UK power; launch of Iron Ore OTC clearing by SGX/AsiaClear as well as LCH.Clearnet; launch of Coal Futures by EEX; and planned launch of gold forwards cleared by the CME Group, with LCH.Clearnet and NYSE Euronext also offering gold clearing solutions. Settlement risk is being reduced by the shift towards central clearing. The benefit of facing the exchange on cleared trades rather than having bilateral OTC trades on with multiple counterparts is (1) the reduction in counterparty credit risk and (2) the ability to net long and short positions across a range of different product types, which may reduce the amount of collateral that is required for posting. In December 2011, the CMD processed 443,492 commodity OTC derivatives transactions of which 68,894 (16%) were OTC-cleared. 25 Central clearing combined with the ongoing efforts to increase electronic confirmation matching has led to a significant continued decline in OTC settlement risk and a low number of aging fails amongst the CMD group. 23 See 24 See 25 Source: Markit Metrics OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

113 19 4. Option Exercise (a) Financially Settled Options Financially settled options are options that can be exercised automatically if, by comparing the reference price to the option strike price, the option is determined to be in-the-money. The option buyer is not required to give notice of exercise to the option seller. The automatic exercise will result in a payment by the option seller to the option buyer of the cash settlement amount, which may be netted with other transactions of the same commodity type and/or on the same settlement date. Financial settlement follows the same processes described in the Settlements section above. (b) Physically Settled Options Physically settled options that are in-the-money at expiry will result in the creation of a new transaction between the parties. The decision to exercise is based upon the value the option buyer places on the underlying product. Most physically settled options require the option buyer to notify the option seller (usually by telephone) by an agreed cutoff time on expiration date. Failure of the buyer to notify the seller by the cutoff time will result in the option expiring worthless. The new trade may be a swap (settles financially) or a forward (settles physically) depending on the nature of the option traded. Depending on the market convention for the product, a written notice of exercise delivered to the option seller by the option buyer may be required, and a confirmation may be generated for the new trade. 5. Collateral Margining Margining is the process by which collateral calls are made and collateral is exchanged between counterparties based on mark-to-market position valuation and the terms of the credit agreement between them. For any trade included within the scope of the relevant collateral provisions, collateral margining will commence the inclusion of that trade on T+1. Credit terms may be documented in a CSA or similar document, and are incorporated into the relevant Master Agreement. Credit terms may also be included in individual confirmations, particularly the independent amount, which is a cushion of additional collateral pledged by one party to the other that is held for the duration of the trade irrespective of the movement of variation margin. The credit terms specify terms such as the frequency of valuation, timing of margin calls, types of eligible collateral, minimum amounts of collateral that can be transferred, and interest on collateral. The ISDA Collateral Steering Committee has drafted both a Best Practices Whitepaper and a Dispute Resolution Procedure, available on the ISDA website. 26 Those documents are incorporated by reference herein. 26 See OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

114 20 6. Close-Outs (a) Terminations At any time during the term of a transaction, the parties may agree to terminate the transaction (i.e, end the trade early before its natural maturity date). The parties must agree on the terms, timing, and any payment relating to such termination. A termination agreement will be drafted and executed between the parties to memorialize this agreement. (b) Trade Compressions While the benefits of trade compression either by moving bilateral OTC trades to be cleared OTC trades, or by participating in tear-ups, are recognized, a number of obstacles exist that prevent wide-spread participation is such exercises. There is a separate Portfolio Compression Working Group operating under remit from the COIG currently addressing these issues through its membership. (c) Assignments and Novations At any time during the term of a transaction, the parties may agree that one or both parties may transfer (by means of an assignment or a novation, as appropriate) their position to another party, which may be either an affiliate or an external party. All parties to the transfer must agree to the terms and timing of the transfer by executing either an assignment agreement or novation agreement, as applicable. Depending on the nature of the transfer, the parties to the new transactions created through the transfer may draft the transfer agreement so that the New Transactions are either (i) reconfirmed between the remaining parties by separate Confirmations, or (ii) considered to have been re-confirmed between the remaining parties by way of the transfer agreement. 7. Natural Maturity A transaction matures naturally when it has completed its term and all obligations under the contract have been met. In this event, there is no impact on downstream processing. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

115 21 SECTION III: CURRENT STATE OF LIFECYCLE EVENT PROCESSING 1. Trade Capture and Revisions (a) Initial Trade Capture Trade capture is automated for most electronic trading platforms. The trade details are automatically fed to the risk system from external sources, greatly reducing the occurrence of errors. Bilateral OTC trades are entered manually into the trading application by the trader, marketer or trading assistant. Proper segregation of duties requires that trade capture is not performed by anyone who has access to confirmation or settlement systems. (b) Trade Capture Revisions Revisions are automated for most electronic trading platforms. For the remaining trades, revisions are performed manually by the trader, marketer or trading assistant. Again, proper segregation of duties requires that revisions are not performed by anyone who has access to confirmation or settlement systems. 2. Controls Processing (a) Broker Recap Affirmation is not required for trades that are counterparty-matched via an electronic platform, because the match takes place on T+0 or T+1, in the same timeframe that affirmation would normally take place. Electronically matched trades are binding, so the affirmation becomes unnecessary. For non-electronically bilaterally matched trades, some broker matching takes place electronically. However, the majority of broker affirmation is via faxed broker recaps that are manually reconciled against the trade entry. For direct deals, affirmation is manually performed via telephone or . (b) Counterparty Affirmation Affirmation is not required for trades that are counterparty-matched via an electronic platform, because the match takes place on T+0 or T+1, in the same timeframe that affirmation would normally take place. (c) Confirmation Many OTC commodity derivatives transactions are electronically matched via an electronic platform. The remaining transactions are executed via the use of paper confirmations. Metrics regarding the use of electronic confirmation matching systems versus Paper Confirmations, as between the members of the CMD, can be found in the Commodities Metrics Reports that are published each calendar month. By convention, in some physical markets, the seller s terms govern the transaction. For these trades only, the seller sends a confirmation (although in some cases the buyer may opt to also send their confirmation), and in the absence of a rejection of any terms by the buyer, the terms are deemed accepted. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

116 22 3. Settlements Settlement takes place after the receipt of a valid invoice agreed by the counterparty. Invoices are sent by facsimile or . In financial markets, the CMD and most high-volume counterparties will also send Invoices, enabling a reconciliation of settlement amounts. Alternatively, an exchange of settlement details only occurs if the paying party disputes the invoice. In physical markets, payment takes place after the receipt of a valid invoice, and if applicable also only after receipt of the relevant shipping documents. Invoices are sent by and facsimile. 4. Option Exercise (a) Financially Settled Options Because the exercise process for most financially settled options is automatic, trading and settlement systems are typically designed to calculate the settlement amount (or zero settlement amount for options which expire out of the money) without manual intervention. These cash settlement amounts can be grouped with other derivatives payments and settled as set out in Section III.3 Settlements. (b) Physically Settled Options As explained in Section II.4.(b), the decision to exercise a physically settled option is typically a commercial decision made by the option buyer. If exercised, two processes must take place. The buyer must notify the seller of their decision to exercise the option, and both the buyer and the seller must cause the resulting underlying transaction to be entered into their systems. Typically, the notification will be in the form of a phone call, instant message or from the buyer s trader to the seller s trader. The traders will then mark the options as exercised in the trading application, which will result in the automatic creation of the resulting underlying trade. These trades can then be settled in the normal manner. However, there can be variations to this process. For instance, the risk system might not have the functionality to automatically create the underlying trade. In this case, the trader will have to manually enter the resulting trade. Additionally, for some markets the option exercise notification may not be performed by the trader. If so, the trader will have to notify the middle office or operations department of their intention to exercise, who will in turn notify the counterparty of the option exercise. This process is typically performed by facsimile. 5. Collateral Margining For cleared transactions, the margining process is automated via the clearing house s initial margin requirements and subsequent variation margin calculations. For bilateral (i.e, non-cleared) transactions, the parties send margin calls via or fax, and acknowledgement is typically performed via or telephone. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

117 23 6. Close-outs (a) Terminations Termination of transactions prior to natural maturity occurs for only a small percentage of commodity trades. The termination agreements are manually drafted, and the degree of automation of the closeout process depends on each firm s processing capabilities. (b) Trade Compressions Since the summer of 2009, the commodities industry has seen a shift in transaction volume from OTC transactions to the clearing of transactions through an exchange. There is also an on-going effort to work with vendors to establish routine tear-up exercises amongst both the inter-dealer and non-inter-dealer groups. (c) Assignments and Novations Assignment and novations of transactions prior to natural maturity occurs for only a small percentage of commodity trades. Assignments and novations are manually drafted, and the degree of automation of the transfer process depends on each firm s processing capabilities. 7. Natural Maturity This implies settlement or option expiry, and so the processes are as described in the previous sections. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

118 24 SECTION IV: ISSUES WITH CURRENT PROCESS (a) Lifecycle Processes A limited number of lifecycle processing issues have been identified and are attached hereto as Annex C. (b) OTC Settlements Processes A number of issues related to the current settlement process for OTC trades have been identified where further thought and analysis are required before a potential end-state solution can be discussed. Different levels of automation among market participants The OTC commodity derivatives market is made up of a diverse range of participants of varying scale, including financial institutions, utilities, energy trading companies, hedge funds, end users, manufacturers and industrials. Levels of automation vary greatly among participants, where some have extremely high levels of automation, while others may have very manual processes. More automated groups have systems (either built in-house or by third-party vendors) which calculate settlement amounts and generate invoices to be sent to counterparties. Less automated participants may utilize spreadsheets to calculate amounts owed as well as prepare invoices. Invoice Distribution (a) The sender of the invoice can spend a lot of time trying to obtain and verify new counterparty contact information. (b) Invoices are sent by fax or , depending on counterparty preference. A potential electronic solution could create a uniform method to transfer invoices and a new method for distribution that has contact information for all participating counterparts in a single repository. Each company should maintain their own contact information to ensure the highest level of accuracy. Discrepancy Identification During the process of cash flow affirmation prior to settlement date, a discrepancy may be found. Currently, to resolve the discrepancy, a manual line -by-line reconciliation is performed which can be time consuming, particularly on an invoice that can contain over a thousand line items. A potential electronic matching solution would be able to quickly compare invoice amounts and filter out the few that do not match. This could allow users to focus on the identified discrepancies rather than line -by-line reconciliations. Rounding Even though there are industry standards addressing the number of decimal places a price should have for each product, because of the complexity of commodity calculations, often involving unit conversions, different counterparty systems calculate in different ways, resulting in small differences in settlement amounts, i.e, rounding in the middle of a conversion calculation from one unit to another versus truncating. The solution is usually agreed upon between the parties, often splitting the difference. Holiday Calendars The maintenance of holiday calendars can become quite tedious. Not only must attention be paid to bank holidays in the various currencies traded, but holidays relating to price source publications must be kept accurate and up-to-date as well. Often the price sources publish the holidays only one to two years in advance. Since commodity trades have tenors well exceeding two years, there is continual updating that needs to OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

119 25 occur in order to manage the life of the transaction. Additionally, unscheduled holidays e.g, President Reagan s or President Ford s funeral, must be updated in holiday calendars together with the correct pricing treatment. Different Trade Representation Counterparties may represent trades differently in their respective systems, often due to system constraints. For example, instead of having a single trade, e.g., a crack swaps where the differential between the two products is traded, the counterparty will enter the trade as two trades in their system. This structural difference should not affect the total value of the settlement, but it is difficult to match the two deals to the single differential deal. A potential solution would be to somehow identify that the two trades are indeed one with a link ID. This would assist not only in settlement matching, but also in the confirmation process and portfolio reconciliation. Affirmation of cash flow amount prior to settlement similar to invoice distribution, it is essential to have a good list of counterparty contacts for this stage of the process. Otherwise, inefficiencies can occur. Counterparties that refuse to net There are a number of exceptional counterparties that settle gross instead of net, usually driven by a limitation of their settlement systems. Since this poses an increased settlement risk to both parties, analysis should be done to eliminate this practice. Non-standard settlement terms Due to technical constraints, some participants are unable to customize settlement dates, resulting in the need to manually reconcile and process. Re-publishing of Settlement Prices There are times when published settlement prices are re-issued, i.e, a power ISO or Platts restating a settlement price. Depending on the timing of this re-settlement, this could require an invoice to be amended and resent or cash to be moved to compensate for the difference. Physical volume changes before settlement Examples could be differences in what was contracted to be delivered versus what was actually delivered or a force majeure event. This could require additional reconciliations, invoice amendments and reaffirmation with the counterparty. Market design changes in electricity markets Particularly in the US, there have been a number of market changes that impact scheduling and settlements processes. For example, on April 1st 2009, the CAISO (California) implemented MRTU, which modified delivery locations and revised market price calculations that resulted in changes to the settlement process. Additionally, an ERCOT (Texas) to redesign was implemented on Dec 1, These types of changes often require extensive system development and testing and have led to re-settlements of prior periods after go-live as the market adapts to the new market design. (c) Settlement Matching Processes Despite the issues raised in Section IV(b), the established OTC commodity derivatives settlement process has been successful overall, as evidenced by the low rate of outstanding settlement fails for this sector. Since levels of automation for the process differ among the OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

120 26 diverse base of market participants, it is believed that automated settlement matching would be instrumental in reducing the inefficiencies in the process. It was therefore agreed that this functionality could be the logical first step towards a more complete end state. The ISDA and LEAP Settlement Working Groups have been discussing automated settlement matching. The two groups have worked closely together, representing organizations such as banks, oil companies, trading houses, brokers and other service providers for the physical and financial energy trading industry. LEAP have published a whitepaper focused on settlement matching which we have leveraged in this document. The working group began to research settlement matching to help improve efficiency, provide scalability and to a lesser extent increase controls. As discussed in Section II A, there are manual components to the current settlements process. According to market conventions, parties either exchange invoices or the seller sends their invoice, the invoice amounts are then agreed upon, with any discrepancies identified and reconciled prior to settlement date. Each of these steps is communicated by telephone, facsimile, or web portal. For certain products it is common to share settlement data to aid the reconciliation. This data is usually in a spreadsheet format with each participant s information formatted differently and in varying levels of detail. Automated settlement matching would allow counterparties to upload their settlement (invoice) information to an industry platform. The platform would electronically match settlement details at both the summary level, e.g., total cash flow and at the detailed level, e.g. individual trade line items. The platform would highlight any exceptions (unmatched items), saving hours of manual reconciliation. The exception process should be managed on the platform and users should have the ability to remove disputed trades from an invoice to allow for payment of undisputed amounts. Once the settlement is agreed upon on the platform, the payments would be processed bilaterally outside of the platform (at least initially). The group also captured the following requirements: The platform should hold counterparty contact information. The platform should be able to capture settlement instructions. The platform should be accessible to all industry participants and should have very low barriers to entry. Parties should be able to agree via the platform to tolerances. Differences within the tolerance range would match without further reconciliation. Disputes/unmatched items should be highlighted and both parties information should be available to view side by side. Netting preferences can be updated on the platform. The platform should allow parties to communicate and resolve disputes. The platform should distinguish settlement items for current flow month from adjustments to prior periods (e.g, cash settlement relating to a dispute) which could appear on one invoice. The platform should allow real time updates (volumetric updates can be made right up to settlement due to the volume actualization process). The platform should provide different options depending on users preferences, for example; o Both parties submit their invoice information to the platform for electronic matching. This will be an automated process in which a user s internal system OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

121 27 o o sends the information to the platform. Once matched, the platform could notify a user s internal system that payment can be processed. One party uploads their invoice information to the platform. The other party would be able to review this information and approve the invoice, which would mean the payment has been agreed and could be processed. A party could submit their invoice information to the platform and upload their counterparty s invoice to the platform if it were in Microsoft excel and formatted appropriately. This would mean the matching functionality could be utilized. The ability to customize is important as it allows all types of market participants to choose what suits them best based on their individual circumstances and preferences. Considerations would be volume, technology budgets and products traded, among others. To date, there have been a number of presentations and demonstrations from three different vendors focused on the development of a settlement matching platform, though none are available for use at this point. The industry will continue working with the various vendors to provide additional requirements and address other open items such as matching logic and service cost. To summarize, a list is provided of the perceived advantages and challenges of a settlement matching service: Advantages : Efficiency benefits Processing would be more scalable Increased control Offsetting errors would be identified Users can select different levels of service Challenges: Difficulty/Cost of providing granular settlement data to the platform (e.g, hourly quantities and prices as seen in the power markets). Cost for creating an electronic settlement system would not be too beneficial given the fact that most financially settled activity is straight-through-processed (STP) for most organizations and most physical settlements will continue to need manual processing. Matching logic has not yet been completely defined. Parties structure trades differently (e.g, crack spreads may be booked as one trade by Party A and two trades by Party B). There is no clear solution for how this match would occur. Unlikely to improve the physical cut reconciliation and agreement process for physical power and physical gas. Re-publishing of settlement prices after invoice is sent or after settlement date requiring reprocessing. There would likely be significant implementation costs the ongoing cost as well as internal development costs to integrate with the service. These would have to be compared to proposed efficiency gains. Difficulty of on-boarding counterparties due to the diverse range of market participants. Any benefit will be reduced unless the majority utilizes the service. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

122 28 SECTION V: POTENTIAL END STATE There are number of broad challenges the OTC commodity derivatives industry faces, setting it apart from the other OTC asset classes, including: the diverse nature of the client base, which includes traditional financial houses, but also producers, consumers, wholesalers, municipalities and utilities, many of which have limited appetite for electronic processing; the diverse nature of the products presents challenges in that the client base has different needs depending on the type of commodity on which they transact. For example, Bullion, electricity, emissions and freight are all commodity products with quite different market conventions; and the lack of a single central body of governance, such as ISDA, which limits the ability forbroad industry participation. The ISDA Governance Structure, to the extent that it applies to the OTC commodity derivatives, contemplates a basis of joint collaborative efforts between the various industry organizations active for each commodity. SECTION VI: CONCLUDING REMARKS Whilst certain industry challenges do exist for OTC commodity derivatives which are not experienced by the other asset classes, lifecycle events in the commodities markets are not that unlike lifecycle events in the other asset classes. The OTC commodity derivatives markets are well-controlled, as evidenced by the monthly metrics submissions to the regulators. As amongst participating firms, the asset class has the lowest number of outstanding confirmations, though not the lowest volumes. 27 Similarly, the rate of settlement fails is extremely low. This Paper has identified areas where further efficiencies can be introduced in continuance of bringing these numbers down. As an asset class, the CMD laid out an aggressive plan in the July and October 2008 commitment letters to supervisors. Subsequent letters, including the March 2011 Supervisory Commitment letter, set forth a detailed industry which as of publication remains on target 28. Across the asset class, participants are committed to moving standardized products to cleared platforms and have made significant progress in this area. In fact, cleared OTC products were first developed in the commodities space. The CMD metrics now show increased transparency, categorizing the data in a more meaningful way and increasing the frequency of reporting. Industry working groups are driving the standardization of Annexes to the ISDA Master Agreement documentation structure to lay the groundwork for standard confirmation language and are adding both products and trade types to electronic confirmation matching systems. Participants are aggressively building out their infrastructure to add additional products like base metals, agricultural products, coal and freight onto electronic platforms. As a result, the number of electronically eligible trades will continue to increase through these efforts, while the number of outstanding confirmations should decrease. The OTC commodity derivatives markets participants have been extremely effective in making trading more standardized and are working towards the broader goals set up by the regulators. 27 Source: Markit Metrics 28 See: OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

123 29 This Paper discusses a number of ways in which the OTC commodity derivatives marketsare unique. These differences pose challenges to recent proposals that all standardized OTC derivatives be cleared through regulated central counterparties. Some such challenges are as follows: Physical products are made more complex by the need to reconcile physical deliveries in certain markets (e.g, North American power and gas). These actualizations result in actual quantities deviating from the contracted quantity. For example, in the US power markets, it can take months to retrieve meter data and supply documentation to both upstream and downstream participants in order to agree on amounts to settle. The use of an exchange to resolve volumetric cuts would be extremely burdensome. Financial products are often tied to the underlying physical commodity, this would make certain transactions difficult to standardize. For example, a unit contingent financial swap in power has notional quantities which can change on an hourly basis to mimic the energy output of a power plant. Many market participants are producers and consumers of a commodity and regularly hedge their production/consumption with OTC derivatives. Many are not market makers, but use the OTC markets as a vital risk management tool. Central clearing does not provide such participants with the customization that they get from OTC structures. While standardized products are one tool in a hedging portfolio, customized OTC transactions allow producers and consumers to tailor transactions to their risk profile by eliminating mismatches with standardized products. The recommendation is to allow the OTC commodity derivatives markets to continue on the path upon which they have conscientiously started. The number of cleared commodities products offered by exchanges is continually increasing. Most recently, there is new interest in offering a mechanism for clearing of OTC precious metals (bullion) trades. The OTC commodity derivatives markets participants and the regulators are aligned on the direction of focus. Settlement matching appears to be the logical first step to a potentially full-scale central settlement solution. A central repository for settlement prices, SSIs and contact information could address many of the outstanding efficiency issues. Work and further analysis is key to understanding the possibilities for formal central settlement of OTC not on an exchange, similar to CLS and FX markets. The settlement working group will continue to focus on the areas we have discussed and will update this Paper periodically to address changes as well as update on progress. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

124 30 ANNEX A: Best Practice Guidelines for Electronic Confirmation Matching Background This Annex offers a collection of best practice guidelines associated with the electronic confirmation matching of the standardized over- the- counter (OTC) financial and physical products in the OTC commodity derivatives markets (the Best Practices). The adoption of these Best Practices can mitigate operational risks that are specific to the confirmation matching process, and also help to reduce the level of risk in the OTC commodity derivatives markets more generally. In addition, these Best Practices can help reduce processing costs, encourage systems interoperability and increase operational scalability. These Best Practices are already used, to varying degrees, by the OTC commodity derivatives major market participants responsible for this paper and other market participants. Collectively, the OTC commodity derivatives major market participants feel that these are best practices towards which all market participants should actively strive. Therefore, these best practices serve both to provide recommendations and a checklist for organizations new to the OTC commodity derivatives markets as well as act as a benchmarking tool for all market participants as they periodically review the efficacy of their operations. These Best Practices are recommendations that all parties engaging in the OTC commodity derivatives markets, regardless of the organization s size or role in the marketplace, should consider adopting. In addition, it is clear that the greater the number of transactions executed by the organization, the more important it is to implement these Best Practices. Confirmation Matching Overview A confirmation evidences the economic terms of, and defines/references the legal framework applicable to, a bilateral OTC transaction entered into between two parties. The confirmation matching process is therefore an important control in reducing market and operational risk between the parties involved. It should be noted that certain short dated physical gas and power trades are not subject to the confirmation matching process because the scheduling of the physical flow, due to its nature and timeliness, provides a compensating control. These Best Practices do not assume the exclusive use of one electronic confirmation matching system, since the ideal industry scenario would be that any number of Electronic confirmation matching systems could be completely interoperable in order to provide maximum coverage of products and trade types within the OTC commodity derivatives markets (and even across some/all other OTC markets), and achieve the greatest risk mitigation and economies of scale. Best Practice no. 1: Single point of trade capture Potential Risk: Inconsistent representation of trade details within the organization s processing systems rendering the confirmation matching process ineffectual. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

125 31 Within an organization s technology infrastructure, there should be one single point for capturing the details of a transaction, and for capturing any subsequent Trade Event relating to that transaction. To eliminate the potential errors that can occur if trade details are entered independently into multiple systems across an organization, a single point of trade capture should be employed in the organization s technology infrastructure. Consequently, whenever there is a trade event, this should be updated once within the trade capture system (either manually or automatically via a data feed from the trade execution system), and that in turn should automatically update all downstream infrastructure systems. Where an organization is unable to support a single point of trade capture then, as a risk mitigant, comprehensive inter-system reconciliations should be employed to ensure trades are captured in a consistent and timely manner across the various systems. Best Practice no. 2: Employ electronic confirmation matching Potential Risk: Delays or errors in the confirmation matching process caused by manual intervention. Electronic confirmation matching, whether via an in-house or third-party system, should be employed by the organization. The confirmation matching process should involve the two parties to the transaction submitting electronic confirmations to either an in-house proprietary electronic confirmation matching system or a third-party vendor electronic confirmation matching system. This bilateral submission of electronic confirmations for automated matching is the most reliable and process-efficient method of confirming trades, and provides for the earliest possible means of risk mitigation within the Confirmation Matching Process. If only one of the parties is able to send electronic confirmations to the electronic confirmation matching system then, in order to support bilateral confirmation matching, the electronic confirmation matching system should provide a facility which allows one party to submit their electronic confirmation and the other party to view and then accept or reject the submitted confirmation via a secure on-line facility. Thus a positive confirmation match is still achieved. All parties should endeavor to utilize electronic confirmation matching system(s) to match as many standardized products and trade types as are generally available for such in the marketplace. Where a standardized product or trade type is not yet available via electronic confirmation matching system(s), parties should actively support industry initiatives to on-board such products so as to increase the range of products and trade types which are eligible via electronic confirmation matching system(s). Where a product or trade type is not yet standardized in its approach to confirmation terms, parties should actively support Industry Initiatives to reach general market agreement on standardized Confirmation terms and thereby support the evolutionary cycle of standardization facilitating automation (please reference Appendix A for a list of some of the key industry bodies that can be engaged in this respect). Best Practice no. 3: Electronic matching of broker recaps Potential Risk: Delays identifying inaccurate trader risk positions. OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

126 32 Broker recaps should be processed via an electronic confirmation matching system. Some trades between organizations are executed via brokers as an intermediary, rather than directly between the two parties concerned. Trades brokered in this manner allow for trade details to be checked against the broker recap, which is typically sent by the broker on trade date. Economic trade mismatches can be identified in advance of the confirmation matching process. It is important to note that broker recaps are not confirmations between the two parties of the transaction and therefore Broker recaps do not supersede or negate the need for the confirmation matching process. Whilst some brokers do engage in electronic messaging as a means of sending their broker recaps, this is separate to the confirmation matching process between the two parties to the trade. All parties should endeavor to utilize an electronic confirmation matching system for matching broker recaps. Two-way matching, with a broker, should be accomplished on trade date. Use of this process dramatically reduces the time involved in checking broker recaps and identifies errors in a timely fashion. Optimally, parties should utilize an electronic three-way match (broker and two counterparties, each matching with one another) via an electronic confirmation matching system. Where broker recaps are not yet available via electronic confirmation matching system(s), parties should actively support industry initiatives to on-board them (please reference Appendix A for a list of some of the key industry bodies that can be engaged in this respect). Best Practice no. 4: Electronic confirmation issuance Potential Risk: Delay in executing the confirmation matching process. Electronic Confirmations should be issued on a timely basis. An organization should support electronic confirmation matching on trade date. Therefore, an organization should issue (i.e, generate and make available for matching) electronic confirmations throughout the trading day (i.e, intra-day issuance). If an organization is unable to issue electronic confirmations intra-day then, as a minimum, electronic confirmations should be issued to the electronic confirmation matching system prior to the start of the next business day following the trade date. In the situation that a counterparty has been unable to issue a confirmation then, as part of this escalation process, it is recommended that an attempt is made between parties to verbally agree upon the trade economics. Best Practice no. 5: Confirmation matching status tracking Potential Risk: Ineffective escalation of confirmation matching delays or disputes. An organization should be able to track the real-time status of every confirmation processed by the electronic confirmation matching system. Reporting capability should exist within an electronic confirmation matching system which enables an organization to track the real-time status (e.g, unmatched, matched, partial-match, queried, etc.) of every Confirmation submitted to that electronic confirmation matching system. This reporting capability enables the operations staff to implement timely and proactive OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

127 33 escalation of every unmatched trade. It is recommended that intra-day escalation should be established, but if this is not possible then, as a minimum, end-of-day escalation should occur. Best Practice no. 6: Avoid updating trade-related information directly into the electronic confirmation matching system Potential risk: confirmation matching process is rendered ineffective as a result of data corruption. It is essential that the electronic confirmation matching system, operations processing system and trade capture system (if this is different from the operations processing system) remain synchronized. When an update to Trade information is required in the electronic confirmation matching system, this should be initiated by updating the information in the trade capture system (as the single point of record). This update should then automatically feed through to the electronic confirmation matching system as part of the normal deal life cycle trade event processing. Updating trade information into the electronic confirmation matching system independently of the trade capture system and/or the operations processing system should be prevented by technical system restrictions. If this is not possible then prevention should occur via the implementation of appropriate operational controls and checks, each performed by separate individuals. An exception to this best practice exists in the situation in which parties refer to the same trade data in different ways. For example, within the gold market, counterparties confirm the delivery location (e.g, London) and can refer to this in different ways (e.g, Ldn versus Lon ). In such situations, without the availability of corrective mapping rules within the in-house systems or electronic confirmation matching system, a confirmation can only be matched if either: a) the trade data is updated, and thus synchronized, directly in the electronic confirmation matching system or b) the trades are forced matched matched with the acknowledgement that differences exist within the electronic confirmation matching system. As a control, any updates of this type should be independently checked (i.e, one person performs the update and another validates that this update has been made correctly). Long-term solutions should be pursued in these situations via either establishing industry standards or creating systematic mapping tables. Best Practice no. 7: Ensure system integrity Potential Risk: Inconsistent representation of trade details within the organization s processing systems rendering the confirmation matching process ineffectual. To ensure the integrity of the confirmation matching process, the data contained in the electronic confirmation matching system must be consistent with that held in the other systems within the organization. There is a risk, as a result of a system issue, user error or malicious intent, that system data becomes corrupted or out of date. Therefore, data integrity reconciliation checks should be implemented between each of the trade capture system, the operations processing system and the electronic confirmation matching system. These integrity reconciliation checks should occur at least once per day. There should be an effective resolution process in place so that breaks highlighted on any particular business day (B) are addressed by close of business the following business day (B+1). OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012

128 34 Best Practice no. 8: Timely resolution of interface errors Potential Risk: Delay in executing the confirmation matching process. When submitting trades to an electronic confirmation matching system, Operations should regularly monitor available system interface error logs in order to identify and correct feed failures in a timely fashion. Trades submitted to an electronic confirmation matching system could potentially be rejected (i.e, they fail upon submission) due to system feed errors. Operation staff should regularly monitor available error logs in real-time throughout the day so that any such failed trades are identified intra-day. Whenever a failure is highlighted, the organization should endeavor to perform corrective action, and resubmit the trade to electronic confirmation matching system, on the same day that failure occurred. Best Practice no. 9: Timely electronic confirmation matching Potential Risk: Ineffective escalation of confirmation matching delays or disputes. By Trade date plus one business day, a trade should be electronically matched or, if this is not possible, an exception formally raised. Trades processed by the electronic confirmation matching system should be matched on trade date (T). If the electronic confirmation matching system is unable to establish a match by trade date plus one business day (T+1) then an exception, detailing an Unmatched Trade should be recorded and formally escalated by this time. In the situation that a Counterparty has been unable to upload their version of the trade, then, as part of this escalation process, an attempt should be made to verbally affirm the trade economics. Verbal affirmations do not supersede or negate the need for the confirmation matching process. Therefore a successful confirmation match is still required after a trade has been verbally agreed upon. The Counterparties of a trade should look to resolve any exceptions relating to the economics of a trade on the same day that the exception was raised. An organization should establish benchmark resolution times for the other types of trade mismatches based upon their materiality. Best Practice no. 10: Segregation of duties Potential Risk: Compromising the independence and effectiveness of the confirmation matching process. Management should ensure that appropriate segregation of duties exists between operational staff and their management, and those individuals involved in trade execution. All individuals involved in trade execution (such as traders, marketers and sales staff) should have no responsibility for the execution, supervision or management of the electronic confirmation matching process. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

129 35 Operations staff should be responsible for the execution and management of the electronic confirmation matching process. Resources permitting, there should be a distinct operational group whose sole responsibility is for matching confirmations and addressing associated exceptions. Best Practice no. 11: Control systems access Potential Risk: Malicious or accidental corruption of data and/or controls by a user. Users of any technology system should not be able to alter the functionality of that system directly within the production environment. Developers should have limited access to production systems, and only then within a strictly controlled environment. Each system should have robust and reliable access controls which allow only authorized individuals to alter the system and/or grant user access. To support this, the creation of a set of job function-specific user access profiles is recommended. Rigorous systems controls need to be implemented and monitored to ensure that data integrity and security are not sacrificed. External user access controls should be as robust as internal user access controls. Access to production systems should only be allowed for those individuals who require access in order to perform their job function. When creating user access profiles, system administrators should tailor the profile to match the user's specific job requirements, which may include "view only" access. System access and entitlements should be periodically reviewed, and users who no longer require access to a system should have their access revoked. Under no circumstance should operations staff have the ability to modify a production system for which they are not authorized. Best Practice no. 12: Reference data management Potential Risk: Effectiveness of the confirmation matching process is impacted as a result of incomplete or inaccurate data. The reference data associated with the electronic confirmation matching process should be managed in a robust and reliable manner. The integrity of the confirmation matching process is reliant on maintaining reference data that is correct and comprehensive. To ensure that this is the case, an organization should look to: maintain data via automated feeds from external sources, where possible; validate data that is manually received against independent sources; task qualified operations personnel with maintaining the reference data mapping tables; store and maintain reference data in one central source only; have rigorous controls to ensure the timely and accurate update of data into systems; and monitor all system interface feed failure logs to ensure that missing/incorrect mappings are corrected in a timely fashion. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

130 36 Best Practice no. 13: Contingency plans Potential Risk: Suspension of the confirmation matching process through a loss of key personnel or infrastructure. Operations groups should develop and test contingency plans for operating in the event of the incapacitation of any/all of their system(s), operational site(s) and/or staff. Contingency plans should be reviewed, updated, and tested at least annually. These contingency plans should cover both short-term (up to one month) and long-term (over one month) incapacitation associated with one or more of the following scenarios: failure or inaccessibility of operational site(s): resultant fall-back of function and primary staff (those who usually perform the function) to contingency site(s); system hardware failure: resultant fallback of system(s) to contingency hardware and backup data; and primary staff unavailability: resultant fallback of job functions to secondary staff (those who do not normally perform the function but are capable of doing so in a contingency) in a different location to the primary staff. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

131 37 ANNEX B: Key Industry Forums 1) LEAP: Specifically oil-focused ( 2) EFET: European gas and power trading. Coverage of regulatory and documentation issues ( 3) IETA: International Emissions Trading Association: Global trade association for primary emissions markets under the UN Kyoto Protocol. Standard documentation for primary markets (so-called ERPAs) and secondary trading ( 4) LBMA: London Bullion Market Association: Representatives of London wholesale bullion markets. Standard documentation being ISDA based ( 5) EEI: Edison Electric Institute. US association of power utilities ( 6) FOA: Futures & Options Association: Industry association for futures and options trading (mainly on UK exchanges). Regulatory affairs and standard docs (as administrators for UK power trading agreements -GTMA) ( 7) WRMA: Weather Risk Management Association: Service provider to the weather risk management industry (includes all kinds of weather protection products, insurance, exchange and off-exchange trading); global coverage. Standard documentation produced in cooperation with ISDA ( 8) FFABA: Forward Freight Agreement Brokers Association: Promotion of freight trading and standard documentation (ISDA based) ( 9) CTA: Coal Trading Association: ( North America-focused. 10) IECA: International Energy Credit Association ( Producers of some supplementary documentation to standardize contracts (e.g, ISDA CSA and EFET/SIFMA CPMA). 11) AIPN: Association of International Petroleum Negotiators ( Mission is to enhance cross-border trading in petroleum products. 12) Energy Institute ( Promotion of the safe, environmentally responsible and efficient supply and use of energy in all its forms and applications. Most recently the EI have started working on standard contracts for physical transactions in crude oil (in cooperation with LEAP and ISDA). 13) ISDA: International Swaps and Derivatives Association, Inc. ( represents participants in the privately negotiated derivatives industry and focuses its efforts on the identification and reduction of the sources of risk in the derivatives and risk management business. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

132 38 ANNEX C: ISSUES WITH CURRENT PROCESS (REF. SECTION IV(A)) BY LIFECYCLE EVENT TYPE Early Settlements Rationale for Inclusion 1. No standard industry practice for documentation. 2. No standard industry utility for processing. Ready for Industry Action? 1. Relatively low volume of early settlements in commodities (*validate with supporting metrics). 2. Majority of early settlement requests come from the buy side (investors, consumers and utilities) and so successful technology solutions would require take-up by a large number of relatively lower volume market participants (*validate with supporting metrics.) Impact: documentation 1. No standard early termination document. 2. Early settlement process may trigger the generation of standard invoices, which may need to be suppressed and replaced with a notification of early termination. 3. Partial early settlement (for example, early settlement of trades that do not fully offset) can require editing of existing trades and booking of new trades, potentially triggering new confirms or requiring manual intervention to prevent STP of confirms. Impact: Settlements 1. Manual calculation and booking of discount amount required. Impact: Metrics Minimal: 1. Potential reduction in unexecuted, if early settlement precedes execution 2. Possible noise from CnC and trade bookings related to partial closeouts. Novations Rationale for Inclusion 1. No standard industry utility for processing. Ready for Industry Action? 1. Relatively low volume of novations in commodities (*validate with supporting metrics). 2. Majority of novation requests come from the buy side (investors, consumers and utilities) and so successful technology solutions would require take up Impact: documentation 1. Standard ISDA novation templates are in use. 2. Depending on how market participant's systems work, offsetting close out trades may be required to process novations. This can trigger new confirms, or require Impact: Settlements 1. Careful monitoring to ensure pricing periods that are not novated are settled with the remaining party. Often short timelines between novation date and first settlement date. Impact: Metrics 1. Novated trades can lose their affirmation status, causing noise on confirm/affirm metrics until manually overridden. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

133 39 by a large number of relatively lower volume market participants (*validate with supporting metrics). However, although rare, novations between CMD members can involve a high volume of trades. manual intervention to prevent STP of new confirms. 2. Manual processing of payments for MTM gains/losses novated. Electricity 'Cuts' Rationale for Inclusion 1. Cuts are a major cause of settlement discrepancies and a main driver of settlement reconciliation effort for physical electricity. Master agreements typically allow for disputes to remain unresolved for up to two years. Ready for Industry Action? 1. Need to distinguish between two issues: (i) incorrect entry of cuts due to human oversight, which can cause discrepancies at settlement but are quickly resolved; and (ii) settlement disputes due to disagreements between the parties regarding liability for, or the amount of, liquidated damages. The former might be reduced by better interaction between scheduling and settlement systems. The latter are disputes in interpreting the liabilities and obligations resulting from physical supply events that will not be resolved through changes to trade processing. 2. Industry dominated by utilities with established processes and systems. Buy in from these participants would be necessary for a solution to have material impact. Impact: documentation 1. Cut trades need to be excluded from the confirm /affirm process. Impact: Settlements 1. Failure to book cuts, or disputes regarding the amount or liability for liquidated damages, are a major source of settlement disputes in the physical electricity markets. Impact: Metrics 1. Cuts are a significant cause of trial balances in the physical electricity markets. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

134 40 Physical Natural Gas Rationale for Inclusion 1. Volume actualization comprises a significant portion of settlements effort for physical natural gas. Unlike electricity, there are no scheduling Tags to assist with the reconciliation. Pipeline Tariffs typically allow for imbalances to remain unresolved for up to two years, which over the years has developed into an accepted industry standard. Ready for Industry Action? 1. Need to distinguish between two issues: (i) incorrect entry of cuts due to human oversight, which can cause discrepancies at settlement but are quickly resolved; and (ii) settlement disputes due to disagreements between the parties regarding liability for, or the amount of, liquidated damages. The former might be reduced by better interaction between scheduling and settlement systems. The latter are disputes in interpreting the liabilities and obligations resulting from physical supply events that will not be resolved through changes to trade processing. 2. Industry dominated by utilities with established processes and systems. Buy in from these participants would be necessary for a solution to have material impact. Impact: documentation 1. Cut trades need to be excluded from the confirm /affirm process. Impact: Settlements 1. Failure to book cuts, or disputes regarding the amount or liability for liquidated damages, are a major source of settlement disputes in the physical natural gas markets. Impact: Metrics 1. Cuts are a significant cause of trial balances in the physical natural gas market. Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

135 41 COMMODITIES TRADE PROCESSING LIFECYCLE EVENTS Commodities Trade Processing Lifecycle Events ISDA Whitepaper April 2012

136 OTC DERIVATIVES: A COMPARATIVE ANALYSIS OF REGULATION IN THE UNITED STATES, EUROPEAN UNION, AND SINGAPORE Rajarshi Aroskar* This study compares the regulation of OTC derivatives in the United States, European Union, and Singapore. All jurisdictions require central clearing and reporting of OTC derivatives. The onus of reporting falls primarily on financial counterparties to an OTC contract. The main difference in regulation is that only the United States and the European Union require mandatory trading of cleared derivatives. Additionally, implementation is proceeding in different stages across jurisdictions. These two differences have the potential to result in regulatory arbitrage across jurisdictions. The over-the-counter (OTC) derivatives market is the largest financial market worldwide. It represents various financial and nonfinancial participants in the United States, Europe, Hong Kong, Singapore, and other financial centers. Nonfinancial participants usually use these markets to hedge business risks, while financial participants use them for both speculation and hedging. According to the Bank of International Settlements semiannual survey, the OTC derivatives market has grown from $603.9 trillion in December 2009 to $647.8 trillion in December As seen in Figure 1, interest rate contracts represent 85% of the total OTC derivatives, while credit default swaps represent 5% of the total OTC derivatives and commodity contracts, equity linked contracts, and foreign exchange contracts each represent 1% of the total OTC derivatives contracts (BIS 2012). OTC contracts were blamed for the credit crisis of 2008 (Dømler 2012). This led to the Pittsburgh Declaration by G20 members to regulate the OTC derivatives market: All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its *Rajarshi Aroskar is an associate professor of finance in the Department of Accounting and Finance at the University of Wisconsin-Eau Claire. [email protected]. Acknowledgements: The author acknowledges a grant received from the Institute for Financial Markets. Keywords: OTC derivatives, regulation, Dodd-Frank Act, EMIR JEL Classification: G18, G28, K22

137 32 Review of Futures Markets Figure 1. Outstanding OTC Derivatives by Categories. 1% 1% 1% 5% 7% Commodity contracts Equity-linked contracts Fo reign exchange contracts Cred it default swaps Unallocated 85% In terest rate c ontracts relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse (Financial Times 2009). Ever since the declaration there has been sweeping regulation on both sides of the Atlantic with the Dodd-Frank Act in the United States and European Market Infrastructure Regulation (EMIR) in the European Union (EU). Other nations around the world have also formulated their own regulations to monitor and regulate the OTC markets. This study compares and contrasts regulation of the OTC derivatives markets in three different jurisdictions, the United States, the European Union, and Singapore. As depicted in Figure 2, 32% and 37% of the single currency interest rate OTC derivatives contracts were in US dollars and euros, respectively. These two regulatory regimes were the first to propose regulation of OTC derivatives. The advent of these regulations has led some to fear a loss of OTC markets in countries where there is less or no regulation. Additionally, it is possible for counterparties in countries that have less stringent regulation to avoid business with the US counterparties (e.g., Armstrong 2012). Singapore has been chosen in this study since regulation of its OTC market has only recently been proposed in February Also, Singapore does not form a part of the G20. Hence, it serves as an excellent case where there may be a perception that Singapore has less stringent regulations than the G20 countries The author would like to thank the anonymous reviewer who pointed out that this perception may not be correct, especially in light of the stricter requirements that go beyond Basel III. (See Armstrong and Lim 2011, UPDATE 1-Singapore banks to face tougher capital rules than Basel III. Reuters,

138 OTC Derivatives Regulation: A Comparison 33 Figure 2. Percentage of Outstanding OTC Single-Currency Interest Rate Derivatives. 6% 1% 1% 1% 13% 9% 37% Euro US dollar Japanese yen Pound sterling Other Canadian dollar Swedish krona Swiss franc 32% I. LITERATURE REVIEW A. Central Clearing An OTC derivative transaction between two parties has inherent risk of default by a counterparty. Before 2007, market participants preferred searching for the best value to close out an OTC position rather than looking for a reduction in counterparty credit risk. This meant that the close out of the OTC position may not have been with the original counterparty (Vause 2010). This resulted in offsetting contracts with a best value provider. Consequently, the number of outstanding OTC contracts increased. After the credit crisis, management of counterparty credit risk became important. There are various techniques used to reduce counterparty risk, including trade compression and central clearing through a central counterparty (CCP). Standardization of contracts is essential for using trade compression and CCPs (Vause 2010). Trade compression reduces counterparty risk by reducing the number of outstanding contracts among market participants. However, market participants are still subject to bilateral credit risk for the remaining contracts (Weistroffer 2009). This risk could be eliminated using a central counterparty. A central counterparty (CCP) provides risk mitigation by imposing itself between the buyer and the seller. Thus, it is a buyer to the seller and seller to the buyer. In case of a default by any one of its members, the CCP is the only party that will be affected. All other members of the CCP system remain unaffected. The CCP can reduce or eliminate the impact of default by a member through collateral management. A CCP could give an open offer to act as a counterparty to members or become

139 34 Review of Futures Markets a counterparty after an OTC contract has been signed between two parties. In the latter case, the original contract is void when the CCP becomes the counterparty. Using CCPs doubles the total number of contracts; however, there are also possibilities of netting across contracts (Vause 2010). Another advantage of a CCP is multilateral netting where, instead of there being one buyer to a seller, CCPs can take off-setting positions with multiple members and, thus, diversify away the risk. The CCP could provide anonymity to transactions and thereby reduce the impact of the trader s position. Additionally, the CCP could provide post-trade management and provide financial management of members collateral deposits. 2 Thus, a CCP is in a much better position to ensure fulfillment of obligations to its trading members than a bilateral OTC contract. Cecchetti, Gyntelberg, and Hollanders (2009) indicate that using CCPs improves counterparty risk management and multilateral netting and increases transparency of prices and volume to regulators and the public. Using a CCP can also reduce operational risks and efficiently manage collateral. A CCP is in a better position to mark to market and to manage and evaluate exposure. Acharya and Bisin (2010) indicate that OTC markets are opaque and participants possess private information that provides them incentive to leverage their position. This increases their likelihood of default. Centralized clearing by a CCP would reduce this opacity by either setting competitive prices or providing transparency of trade positions. Culp (2010) indicates that the CCP structure is time-tested and has sustained various market disruptions and individual institutional defaults. Benefits of using a CCP include a reduction in credit risk and evaluation of exposure, transparency of pricing, evaluation of correlation of exposures, default resolution, and default loss reduction. Novation of a contract using a CCP concentrates risk with the CCP and, to that extent, will contribute to the systemic risk (BIS 2004; Koeppl and Monnet 2008). The CCP has offsetting long and short positions. Hence, they do not have any directional risk. However, they do face counterparty risk (Duffie, Li, and Lubke 2010). With a CCP, bilateral risk is replaced with that of the failure of a market participant in the CCP. This risk is separate from the operational failure of a CCP (Weistroffer 2009). Biais, Heider, and Hoerova (2012), Milne (2012), and Pirrong (2010) indicate that central clearing mutualizes risk but does not eliminate risk. Such mutualization can be detrimental to the market as players possess private information, leading to underpricing of risk. Liu (2010) indicates that central clearing reduces counterparty risk but not default risk. Thus, governance and choice of financially robust market participants are more important than central clearing to the elimination of risk. Pirrong (2009) indicates information asymmetry could lead to a preference for bilateral arrangements over that of a CCP. In bilateral arrangements, parties to a contract can better monitor, and hence price, counterparty credit risk. Thus, the benefit of a CCP does not outweigh its cost. Lewandowska and Mack (2010) show 2.

140 OTC Derivatives Regulation: A Comparison 35 that multilateral arrangements provide comparable netting efficiency to that of CCP clearing. Culp (2010) suggests that members could resist clearing through a CCP if they see that the credit risk mitigation is marginal, the margin requirements are not for risk management, or the pricing is not acceptable. Further, the study states that the imposition of the margin is costly due to opportunity cost. Additionally, marking-tomarket will impose liquidity constraints on dealers. CCP-required standardization may preclude market participants from being able to effectively hedge their risks as the standardized products lead to basis risk and do not exactly offset their risk exposure. Finally, CCP risk managers who perceive themselves at an information disadvantage with respect to its members may impose higher requirements of collateral (Weistroffer 2009). Studies have suggested various methods of organizing a CCP, the optimal number of CCPs, and ways CCPs may cope with losses. Koeppl and Monnet (2008) indicate that CCPs can be structured as mutual ownership or for-profit organizations. To secure itself from default by any of its members, a CCP will require margin and a default fund. A profit-maximizing CCP will require a larger default fund, whereas a mutualized CCP will enforce a higher margin requirement. In stressed market conditions, a profit-maximizing CCP will provide efficient trading, while a user CCP will shut down. The Committee on the Global Financial System (2011) indicates that indirect access of clearing through dealers leads to a concentration of risk at these dealers. Also, it makes the system uncompetitive compared to one in which market participants have direct access to clearing. Indirect clearing can be efficient if end users have portability of their accounts across dealers. A domestic CCP may be helpful in maintaining regulatory oversight; however, multiple CCPs will lead to fragmentation and an increased need for collateral. The Committee further advocates coordination of regulation among global regulators to avoid regulatory arbitrage. Links between multiple CCPs will be advantageous due to multilateral netting possibilities through an expanded number of counterparties. However, these links could provide propagation of shocks and systemic risk. Duffie and Zhu (2011) advocate having a lower number of CCPs as it will reduce counterparty credit risk. Having a separate CCP for each asset will reduce netting benefits across assets. It will also increase collateral needs and counterparty credit risk. Hence, having interoperability agreements will be beneficial. Multiple CCPs will have initial margin and equity requirements for each CCP. There is also a potential for regulatory arbitrage. Finally, trade and positions across multiple CCPs need to be consolidated. A CCP could create a fund by contributions from its members. This fund could be utilized in case of default by a member to settle claims with the surviving counterparties (BIS 2004). The net obligations could be limited to the size of this fund. To mitigate this risk, CCPs could impose initial and variation margins, depending on the size and liquidity of positions. Additionally, they could impose capital requirements to create a fund for mutualizing losses (Duffie et al. 2010). Cecchetti et al. (2009) indicate that a CCP may need access to liquidity from

141 36 Review of Futures Markets the central bank in times of market stress or in the case of reduced liquidity due to a member s default. B. Trade Repositories In addition to central clearing, regulators across jurisdictions have proposed trade repositories. It has been contended by studies such as Wilkins and Woodman (2010) that there was not enough information about the OTC trades before the crisis. Regulators lacked information about the size of trades and the volume of trades linked to a counterparty. Hence, they were not in a position to identify concentration of risk in a contract or an institution. There was no central database where regulators could gather and analyze OTC information. Studies have suggested that a trade repository (TR) would help reduce this opacity. Trade repositories can disseminate trade data to the public and help increase market transparency. They can help OTC market participants ascertain the deal on their trades. A trade repository is an institution that maintains a centralized database that records details about OTC derivatives contracts. The purpose of a trade repository is to increase pre-trade (quotes) and post-trade (information on executed trades) transparency. It is a single place where regulators can access data about the entire OTC market, a single trade, or any institution. The objective of a TR is to provide a centralized location where regulators can access data to monitor the OTC market. Regulators can identify concentrations of risk in a trade or with an institution before such concentration becomes destabilizing for the market. They can perform post-mortems on trades and identify guilty parties or aspects that are suspicious or illegal. Trade repositories can help manage trade life cycle events (Hollanders 2012). Russo (2010) thinks that reporting of OTC trades should be mandatory. Additionally, TRs should give free access to regulators to the information stored in the registry (Wilkins and Woodman 2010). By disseminating trade information to market participants, TRs can improve market transparency and confidence in market participants. This dissemination of information will strengthen OTC markets. Wilkins and Woodman (2010) advocate exchange trading of standardized and liquid OTC derivatives to improve transparency. Market participants can access firm quotes and see trade prices. This information will help level the playing field for both sophisticated and unsophisticated market participants. Electronic trading platforms, by providing indicative quotes, can offer limited pre-trade transparency. Avellaneda and Cont (2010) distinguish between pre-trade and post-trade transparency of OTC derivatives data and between regulatory and public dissemination of data where participants in the interest rate swap market use these instruments to hedge the underlying interest rate risk. Standard interest rate derivatives market trades are usually large, OTC, and institutional. Pre-trade information can be disseminated among dealers using dealer networks such as ICAP, Tradition, BGC, and Tullet Prebon. Quotes from dealer networks could be used to provide aggregate indicators of market variables to the whole market.

142 OTC Derivatives Regulation: A Comparison 37 Post-trade information includes detailed information about trades. Avellaneda and Cont (2010) suggest that electronic trading platforms and clearing facilitites can facilitate processing and transmission of post-trade data to regulators and trade repositories. However, there are impediments to post-trade reporting. Electronic networks have not yet gained traction in OTC markets. Clearing facilities keep trade information confidential and, hence, do not disseminate this information to the market. Exchange trading of derivative contracts can help pre-trade and post-trade transparency. However, corporations using customized variations of tenors and maturity may not be able to use exchanges, unless the exchanges offer a wide range or variety of products. Additionally, Avellaneda and Cont (2010) and Wilkins and Woodman (2010) indicate that when the trade size is large and volume low, market makers may have to hold a position for a longer period of time. In fragmented markets, full transparency is feasible as a single position does not affect the price. However, when the size of the position is greater than average trading volume, full transparency will lead to front running and will dissuade market makers as they may not be able to offload risk (Avellaneda and Cont 2010). Hence, full post-trade disclosure may adversely affect market makers. They may be reluctant to enter a trade and provide a market (Wilkins and Woodman 2010). Additionally, dealers could stop or reduce OTC market participation in favor of standardized exchange contracts. Both these measures will reduce liquidity in the OTC market and may be, in general, detrimental. Tuckman (2010) argues that the objective of ascertaining counterparty credit risk may not be met if the data are anonymized or if there is no reporting of intracompany trade. As such, market stability may be impacted. Knowledge of price and volume data can help market participants decide on the appropriate capital to cushion potential losses and other risk management procedures. Price information can reduce collateral disputes. Public information can help identify counterparty credit risk and help calm markets as the market participants ascertain exposure level to derivatives (Duffie et al. 2010). Avellaneda and Cont (2010) suggest that if post-trade transparency is mandated, then such dissemination should be delayed and capped at a certain threshold. Duffie et al. (2010) indicate that position data should be reported with a delay. This delay will help market participants trade on fundamental information rather than on market information. Additionally, this delay will reduce the price impact of the knowledge of real time position information and help market makers exit or change positions at close to the available market price. This study finds that while mandatory clearing is required in all jurisdictions, there are differences in cleared assets, timing, and exemption of parties. Only Singapore exempts foreign exchange swaps and forwards from clearing. Both the EU and Singapore require immediate clearing for all asset classes. The United States phases in clearing based on asset and counterparties to a transaction. All financial institutions face stricter regulations in the EU, with the United States and Singapore exempting smaller financial institutions. Though in theory all jurisdictions are less stringent on nonfinancial institutions, there could be differences in the levels

143 38 Review of Futures Markets used to decide the size of an institution. There are also differences in organizational requirements for a CCP in these jurisdictions. These differences in requirements for assets, timing, and counterparties could lead to regulatory arbitrage across jurisdictions. Singapore, alone, does not mandate trading of cleared derivatives. This exemption increases the choices available to market participants who trade OTC products. Regulations in all three jurisdictions focus on the collection of data and reporting to the TR to increase post-trade transparency. All jurisdictions require reporting of both cleared and uncleared OTC derivatives in all asset classes. However, there is no consistency in priority given to asset classes in various jurisdictions. In all jurisdictions, the onus of reporting is mostly on large financial institutions. While the United States focuses on complete reporting by both financial and nonfinancial institutions, the EU and Singapore are less stringent on nonfinancial institutions. Also, only the United States has a phased-in approach to reporting depending on the institution s category. This difference in reporting requirements based on asset classes and institutions creates differing costs for reporting entities. As such, there is the potential that these reporting entities will choose more favorable jurisdictions for OTC derivatives, leading to regulatory arbitrage. The rest of the paper is organized as follows. First, I discuss the scope of the regulations governing central clearing, margin requirements on noncentrally cleared derivatives, backloading of existing transactions, trading, and trade repositories in each of the jurisdictions. This discussion is followed by a comparison of those same regulations and, finally, concluding remarks. II. REGULATORY AUTHORITY The US Commodity Futures Trading Commission (CFTC) is charged with the regulation of all OTC derivatives except the OTC derivatives based on exchangetraded securities. The US Securities and Exchange Commission (SEC) is charged with the regulation of OTC derivatives representing exchanged-traded securities The European Securities Market Authority (ESMA) is the EU-wide regulator charged with drafting regulations on OTC derivatives. It is the sole authority that approves OTC products for mandatory central clearing. The Monetary Authority of Singapore (MAS) is the sole authority responsible for regulating OTC derivatives market in Singapore. The United States is the only jurisdiction in this study that has multiple authorities regulating OTC derivatives market. This may lead to delay in legislation on differences in the timing and compliance mandated by the two authorities. III. REGULATORY REQUIREMENTS In the United States, OTC derivative contracts called swaps are regulated and include all asset classes, interest rate, commodity, equity, foreign exchange, and credit default swaps. Two authorities in the United States regulate swaps. Swaps regulated by the SEC are focused on securities and include single security total

144 OTC Derivatives Regulation: A Comparison 39 returns or narrowly based indexed total returns. All other swaps including optionality in a total return swap are regulated by the CFTC. A bilateral mixed swap with a counterparty that is a registered dealer or a major participant with the CFTC and the SEC will be subject to key provisions of the Commodity Exchange Act (CEA) and related CFTC rules and requirements of the federal securities law. For all other mixed swaps, joint permission could be sought to comply with the parallel provisions of either the CEA or the Securities Exchange Act. The European Market Infrastructure Regulation (EMIR) incorporates all derivatives contracts that are traded OTC and not on a regulated market. There are no exclusions for any particular type of derivatives. The Monetary Authority of Singapore incorporates all derivatives contracts. The definition of a derivative contract is very broad and includes forwards, options, and swaps. Of the authorities in these three jurisdictions, all have very comprehensive definitions of derivatives contracts. The US definition, though, is very prescriptive (detailed) and has specific exemptions for insurance, consumer and commercial transactions, and commodity forwards. The EU and Singapore are very broad in their definition and do not have any exceptions. Additionally, complications in the registration with either the SEC or the CFTC are confusing and could be costly. A. Central Clearing 1. United States All swaps, regardless of their asset class, need to be centrally cleared. There is a possibility that the Treasury Secretary may exempt foreign exchange swaps and forwards from central clearing. However, the latest clarification from the CFTC (2012) indicated that even if such an exemption from the swap regulation were to be granted by the Treasury Secretary, the swaps would still be subject to reporting requirements under the CEA. Certain insurance products and commodity forward contracts are not required to be centrally cleared. Additionally, the Federal Energy Regulatory Commission regulates instruments or electricity transactions that the CFTC finds to be in the public interest are exempt from central clearing. End users of derivatives are exempt from central clearing. Additionally, the definition of end user is expanded to include small financial institutions (with assets of $10 billion or less) (CFTC and SEC 2012) to be exempt from the regulation. Cooperatives such as farm credit unions and credit unions are also exempt from clearing requirements. 2. European Union All standardized OTC derivatives that have met predetermined criteria need to be centrally cleared. All firms, financial and nonfinancial, that have substantial OTC derivatives contracts need to use central counterparty clearing houses.

145 40 Review of Futures Markets Nonfinancial firms below a certain clearing threshold are exempt from clearing through a CCP. Any OTC contract that is considered to be a hedge is exempt from clearing and as such does not even count toward the total clearing threshold. The threshold has yet to be set by the ESMA and the European Systemic Risk Board. The European System of Central Banks, public bodies charged with or intervening in the public debt, and the Bank for International Settlements (EUR- Lex 2010) are not subject to clearing. There is a temporary exemption from clearing through the CCP for pension funds. There is also an exemption for intragroup transactions subject to higher bilateral collateralization by the EMIR. 3. Singapore All standardized OTC derivatives need to be centrally cleared. Singapore dollars interest rate swaps and US dollar interest rate swaps, and nondeliverable forwards (NDFs) denominated in certain Asian currencies have been prioritized for mandatory clearing followed by other asset classes in the future. The MAS exempts foreign exchange forwards and swaps from the clearing obligation. However, currency options, NDFs, and currency swaps are not exempt. They identify the Dodd-Frank Act in the United States for such exemptions or nonexemptions. Clearing is required when at least one leg of the OTC contract is booked in Singapore and if either one of the parties is a resident or has a presence in Singapore and has a clearing mandate. B. Requirements of CCPs The CFTC may exempt a foreign CCP from registration if it determines that the CCP is regulated and supervised by an appropriate authority in its home country with regulations comparable to those of the United States. A CCP is required to maintain adequate capital to cover at a minimum a loss by a defaulting member and one year s operations. It is required to have sufficient liquidity arrangements to settle claims in a timely manner. Organizationally, the board needs to have market participants as its members. The CCP should have fitness standards for its board, members of a disciplinary committee should reduce (mitigate) any conflicts of interest, and it should maintain segregation of client funds. The CCP should be able to measure and manage risks. The European Union recognizes a third country CCP if the ESMA is satisfied that the regulations in that third country are equivalent to that of the EU. Further, the CCP should be regulated in that third country and that third country regulator must have cooperation arrangements with the ESMA. The ESMA is responsible for the identification of contracts that need to be centrally cleared (Europa.eu 2012). A competent authority in a member state can authorize a CCP; as such, it will then be recognized and can operate in the entire EU. There are permanent capital requirements for CCPs of 5 million. A CCP is required to maintain sufficient funds to cover losses by a defaulting clearing member

146 OTC Derivatives Regulation: A Comparison 41 in excess of the margin posted and default funds. These funds include insurance arrangements, additional funds by other nondefaulting clearing members, and loss sharing arrangements. Additionally, a CCP should have appropriate liquidity arrangements (EUR-Lex 2010). There are specific organizational and governance requirements for CCPs. These include separation of risk management and operations, remuneration policies to encourage risk management, and frequent and independent audits. Additionally, CCPs must have independent board members and a risk committee chaired by an independent board member. Finally, there are specific guidelines to avoid a conflict of interest and maintain segregation of client funds (EUR-Lex 2010). Singapore has no requirement of clearing through only domestic CCPs. Singapore-based corporations can act as clearing houses if they are approved. Foreign clearing houses can operate in Singapore if they are recognized. There are no specific requirements of the central counterparties in relation to the amount of capital required. The only presumption is that the clearing house needs to have sufficient financial, human, and system resources (MAS 2012). The MAS requires segregation of client funds. C. Margin Requirement for Noncleared OTC Derivatives In the United States, the CFTC (2011) proposes rulemaking for initial margin and variation margin for swap dealers (SD) and major swap participants (MSP) for which there is no prudential regulator on swaps that are not centrally cleared through a derivative clearing organization. The proposal allows for netting of legally enforceable positive and negative marking to market swaps and reduction in margin requirements with off-setting risk characteristics. Only swaps entered after the effective date of the regulation are covered. The forthcoming capital rules will encompass existing swaps. There are no margin requirements on nonfinancial end users. Initial and variation margin requirements would not be required if payments are below the minimum transfer amount of $100,000. SD, MSP, or financial entities can post initial margins in the form of cash; US government or agency securities; senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, or the Federal Agricultural Mortgage Corporation; or any insured obligation of a farm credit system bank. A variation margin has to be posted in cash or US Treasury securities. For nonfinancial entities, there is flexibility about assets that could be used as long as their value can be easily assessed on a periodic basis. Those SD and MSP that have a prudential regulator are required to meet the margin requirements of that regulator. A prudential regulator is the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, or the Federal Housing Finance Agency. These commissions will propose capital requirements and financial condition reporting for SD and MSP at a later date. In the EU, financial and nonfinancial firms that enter into OTC contracts that

147 42 Review of Futures Markets are not centrally cleared through a CCP have to adopt procedures to measure, monitor, and mitigate both operational and credit risk including timely electronic confirmation of contract terms and early dispute resolution. Additionally, the contracts have to be marked to market on a daily basis. Finally, there should be appropriate exchange of segregated collateral or appropriate and proportionate holding of capital. These rules are applicable only to market participants subject to central clearing obligations (Herbert Smith LLP 2012). Singapore recommends financial buffers of capital and margins to mitigate the risk of OTC derivatives that are not centrally cleared. The amount of capital and margin should reflect and be proportionate to the risk of noncentrally cleared OTC contracts. The MAS will be implementing the Basel III requirements of capital for banks and will seek to align capital requirements of other regulated financial institutions with Basel III. The MAS will seek to align margin requirements on noncentrally cleared derivatives in accordance with the recommendations of the working group made up of representatives from the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, and the International Organization of Securities Commissions. D. Trading All centrally cleared swaps in the United States are required to trade on a swap execution facility unless the swap execution facility or exchange does not accept the swaps. In the EU, all cleared OTC derivatives have trading requirements mandated by the Markets in Financial Instruments Directive. The MAS does not require trading of centrally cleared OTC derivatives in Singapore. E. Backloading of Existing OTC Contracts In the United States, the Dodd-Frank Act applies to swaps entered only after the mandatory clearing requirement. However, this exemption is not applicable for reporting. The EU has proposed to require backloading of outstanding contracts with remaining maturities over a certain threshold (MAS 2012). In Singapore, a contract for a product subject to mandatory central clearing and having more than a year left before maturity is backloaded. Table 1 summarizes the regulatory requirements for these three jurisdictions. F. Reporting Requirements 1. United States In the United States, swaps trade repositories are regulated by the CFTC or the SEC. TRs authorized by the CFTC (SEC) deal in swaps regulated by the CFTC (SEC). All traded or bilaterally negotiated swaps have to be reported. These swaps

148 OTC Derivatives Regulation: A Comparison 43 Table 1. Summary of Regulatory Requirements by Jurisdiction. United States European Union Singapore Mandatory clearing Yes Yes Yes Who will clear All financials,all end users, all above $10 billion Assets All assets All assets Domestic CCP only Yes (exception if foreign CCP is in comparable jurisdiction) All financials and nonfinancials above a threshold. Temporary exemption for pension funds Yes (exception if foreign CCP is in comparable jurisdiction and contract with foreign regulator) All financial counterparties above a threshold, at least one leg in Singapore or one of the parties in Singapore All except foreign exchange swaps and forwards Backloading Yes Yes, above a threshold Yes, above a year Interoperability None Yes None Mandatory trading Yes Yes No Margin requirement for non-centrally cleared Yes Yes Yes derivatives Base capital for CCP Yes Yes Yes Organizational requirements Yes Yes Yes Loss Mitigation Capital for loss and one year operation liquidity arrangements Capital liquidity arrangements, default funds, and insurance guarantees No N/A

149 44 Review of Futures Markets have to be between two unrelated parties and any changes to the swap agreement have to be reported. If a swap is executed by a swap execution facility (SEF) or designated contract market (DCM), the SEF or the CCP is required to report swap data to the TR as soon as technologically possible. For an off-facility swap, the hierarchy lies with the SD followed by MSP, followed by a non-sd or non-msp. When the counterparties are within the same category, they have to choose which one of them will report. Both parties can choose to report and there is no condition of nonduplication. The party required to report is ultimately liable for the reported data even if that party contracts reporting to a third party (Young et al. 2012). Any swap (mandatory cleared or nonmandatory) that is cleared before the reporting deadlines for primary data can be reported by the clearing facility. Confirmation data on a cleared swap need to be reported by the clearing facility. For a noncleared swap, confirmation data need to be reported by the counterparty as soon as technologically possible. Any changes to the swap over its lifetime need to be reported by the respective parties listed above. Additionally, the state of the swap needs to be reported daily to the TR (Young et al. 2012). There is a real time public reporting obligation by a TR. Such reporting will not identify the counterparty and should be done when technologically possible. These records must be retained for the life of the swap and for five years after the termination of the swap. A TR needs to be appropriately organized and be able to perform its duties in a fair, equitable, and consistent manner. The TR should have emergency procedures and system safeguards and provide data to regulators. 2. European Union The ESMA has the regulatory power to register a trade repository in Europe. Regulators in individual countries cannot do so. Foreign authorities can deal with the ESMA for exchange of information and bilateral negotiations. Foreign TRs are recognized if regulations in the foreign country are comparable to those of the EU and there is appropriate surveillance in that third country. Additionally, there should be agreement between that country and the EU for exchange of information. Financial counterparties are required to report to a TR and to report to regulatory authorities if a TR is unable to record a contract. A counterparty required to report may delegate such reporting to another counterparty. Reporting should include the parties to the contract, the underlying type of contract, maturity, and the notional value. A nonfinancial counterparty, above the information threshold, is required to report on OTC contracts. Such reporting must be done in one business day from the execution, modification, or clearing of the contract. There should be no duplication. The regulation has proposed robust governance arrangements including organizational structure to ensure continuity, orderly functioning of the TR, quality

150 OTC Derivatives Regulation: A Comparison 45 of management, and adequate policies and procedures. Operational requirements include a secure TR with policies for business continuity and disaster recovery. Data reported to a TR should be confidential even from affiliates or the parent of the TR. A TR will share information with (a) the ESMA; (b) the competent authorities supervising undertaking subject to the reporting obligation under Article 6; (c) the competent authority supervising CCPs accessing the trade repository; and (d) the relevant central banks of the European System of Central Banks. A TR will maintain confidentiality of information and maintain records for at least 10 years after the termination of a contract. A TR will aggregate data based on both class of derivatives and reporting entity. 3. Singapore The MAS does not require reporting to a domestic TR. The MAS has proposed two types of trade repositories approved and recognized overseas trade repositories (ATR and ROTR). Approved TRs are domestic, whereas ROTRs are foreign incorporated TRs. The MAS has not required foreign regulators to indemnify ATRs or ROTRs before obtaining data from them. The MAS has proposed reporting for all asset classes of derivatives. However, it recommends a phased implementation of the reporting requirement with a priority given to asset derivatives from a significant share of the Singapore OTC market interest rate, foreign exchange, and oil derivatives. Oil forms a significant part of the physical market during the Asian time zone, but it does not form a significant part of the Singapore derivatives market. All contracts that are booked or traded in Singapore or denominated in Singapore dollars are required to be reported. All contracts where the underlying entity or market participant is resident or has a presence in Singapore also need to be reported. Any foreign finance entities are not required to report in Singapore. However, if MAS has an interest in an entity, it will seek information from a foreign authority. All financial entities and any nonfinancial entity above a threshold (that takes into account the asset size of the entity) have to report. Additionally, group-wide reporting is required for Singapore incorporated banks. Singapore allows single-sided reporting and third-party reporting. While singlesided reporting is mandatory for financial entities, only one of the nonfinancial entities (among a group) needs to report. Foreign entities are not required to report, and public bodies are excluded from reporting. Transaction-level data, including transaction economics, counterparty, underlying entity information, and operational and event data, need to be reported. The content of the data needs to be reported in both functional and data field approaches. Any changes to the terms of the contract over its life need to be reported. The MAS has proposed a legal entity identifier and standard product classification system, but has not required it. The data need to be reported within one business day of the transaction. The MAS requires backloading of pre-existing contracts.

151 46 Review of Futures Markets Both TRs are required to have safe and efficient operations with appropriate risk management and security. They are required to avoid conflict of interest and maintain confidentiality of user information. They are required to maintain transparent reporting with authorities. The MAS is considering minimum base capital requirements on TRs. A ROTR may comply with comparable regulations in home jurisdictions. Table 2 summarizes the reporting requirements for the three jurisdictions. IV. COMPARISON OF REGULATORY REQUIREMENTS A. Clearing Requirements Clearing exemptions for a certain asset class may not necessarily mean that these assets will not move to central clearing. As mentioned before, noncentrally cleared assets are required to maintain higher collateral. This increased requirement in collateral may lead to prohibitive costs. The EU regulation is stricter for all financial entities as it gives no exemption on the size of the financial entity. Financial entities in Singapore below a certain threshold (below $10 billion in the United States) have an exemption from central clearing. As such, they and those exempted entities in the United States may have reduced costs and a competitive advantage over larger domestic rivals and all EU rivals. The regulations for nonfinancial entities below a certain threshold are comparable in their exemption. While the United States has specified a $10 billion threshold, such has not yet been specified by the EU and Singapore. Any differences among these jurisdictions in the clearing threshold will be beneficial to the entities in respective jurisdictions. The EU is the only jurisdiction that exempts pensions from clearing requirements. The idea is that pensions are mostly fully invested. To subject them to the clearing requirement will be detrimental to the pension funds. However, pensions do deal in derivatives to hedge their interest rate and inflation risk. Leahy and Hurrell (2012) indicate that in many cases pension funds hedge those risks with financial counterparties. A requirement on financial counterparties to hold higher collateral on noncentrally cleared derivatives will require them to hold higher collateral for derivative hedges they enter with pension funds. This increases the cost to financial institutions which, in turn, pass them on to pension funds. An exemption given to any nonfinancial entity below a certain threshold may still be costly for these institutions because, in most cases, the counterparty to these transactions may be a larger financial institution. To the extent that these larger financial institutions have to hold higher collateral, nonfinancial entities will bear a higher cost. This defeats the very purpose of the exemption. The alternative will be that even the exempt nonfinancial institutions will have to centrally clear their products. Only Singapore gives an exemption from central clearing to domestic and foreign

152 OTC Derivatives Regulation: A Comparison 47 central banks and supranational institutions. The EU regulation exempts member state banks from central clearing but is not clear on exemptions for foreign central banks. B. Requirements for CCPs The United States and EU require clearing through a domestic CCP. Clearing through a foreign CCP is acceptable in these jurisdictions if a foreign CCP is under a jurisdiction that has regulations comparable to that of either the United States or the EU. There are concerns that such requirement of equivalence in regulation will result in comparing identical points of regulations rather than the intent of regulations in foreign jurisdictions. The requirement for equivalency in foreign jurisdictions results in central clearing through a domestic CCP rather than foreign CCP. Having multiple CCPs will result in fragmentation of clearing. Singapore is the only jurisdiction that allows central clearing using a foreign CCP without requiring investigation of regulations and agreements with foreign regulators. As such, Singapore has much more flexible regulations with respect to the choice of the CCP. The EU has the most prescriptive regulation on the organization of a CCP and a choice of model for the CCP. The regulation indicates a mutualized CCP where the losses of a clearing member s default are mutualized through a default fund and loss sharing. As mentioned by Koeppl and Monnet (2008), this mutualization may ensure that the impact of default is minimized and may not pose systemic risk. However, liquidity may be affected in the case of default as the CCP focuses on default resolution rather than efficient trading, which is taken care of by the regulation through liquidity arrangements and insurance guarantees. Only Europe allows interoperability of a CCP and, to that extent, reduces risk. Thus, it allows netting across asset classes. As such, there is a reduced need for collateral. Further, multilateral netting across asset classes also reduces risk. C. Backloading of Existing Contracts Backloading of contracts written prior to the regulation requires market participants to clear through CCPs. When these contracts were written, there was no regulation requiring OTC contracts to novate through a CCP. The choice of the counterparty was based on the best value provided rather than the counterparty credit risk and any mandated collateral requirements. Additionally, requiring these contracts to clear through a CCP subjects them to the model of a CCP. Backloading is of particular importance in the case of jurisdiction, such as the EU, that prescribes a CCP model. Each CCP model has specific costs. These costs may not have been considered while writing the original contracts. As such, the original contracts may be uneconomical for market participants subject to new regulations. The US regulation is strict as it requires backloading with no exemption for the size or the duration of the contract. Therefore, market participants will face additional costs in the United States.

153 48 Review of Futures Markets Table 2. Summary of Reporting Requirements. United States European Union Singapore Reporting by TR Real time public reporting Yes No No Time delay to report to SDR Minutes, as soon as technologically possible ++1 day ++1 day Disclosure of identity of counterparty to public No No No Notional amount reporting to public Capped N/A N/A Recordkeeping 5 years until swap terminated, 2 years after termination 10 years N/A Regulation of TR Domestic only No No No Cooperation among regulators required Yes Yes Yes Indemnity required Yes No No Governance of TRs Yes Yes Yes Capital requirement No No No Foreign TR reporting Yes Yes Yes 3 rd party reporting Yes Yes Yes Single-party reporting Yes Yes Yes Double reporting Yes No No

154 OTC Derivatives Regulation: A Comparison 49 Table 2, continued. Summary of Reporting Requirements. United States European Union Singapore Regulated by CFTC or SE C ESMA MAS Reporting for Products Required for cleared derivatives Yes Yes Yes Required for un-cleared derivatives Yes Yes Yes Phased-in reporting by product Phased reporting by entity Interest rate first followed by foreign exchange & commodity SD and MSP first, followed by non-sd & non-msp None Interest rate, foreign exchange, & oil first, followed by others None None Threshold None Yes Yes Backloading None Yes Yes, over 1 year Intragroup trades Not reported Not reported Not reported What swaps need to be reported All All All When reported Upon execution and changes Upon execution and changes Upon execution and changes Confirmed Yes N/A N/A Subsequent changes to the swap Reported Reported Reported Daily value of the swap Yes* N/A N/A

155 50 Review of Futures Markets The EU regulation is most beneficial for transactions below the threshold and does not benefit any specific asset class. The Singapore regulation has the potential to benefit foreign exchange contracts (Global Financial Markets Association 2012) as they are typically short term in nature. As indicated, 99% of these contracts are for less than one year and hence do not need to be renegotiated. D. Margin Requirements for Noncleared OTC Derivatives All jurisdictions require an initial and variation margin. The US regulation has details about netting among legally enforceable offsetting contracts and minimum transfer amount. The United States exempts all nonfinancial end users, while the EU exempts any user not subject to central clearing. Singapore is not clear on this requirement. As all jurisdictions subject financial companies to these regulations, their costs may increase to hold collateral and margins. To the extent that these financial companies are on the other side of the contract with exempt companies, financial companies are still subject to these regulations. It is likely that these additional costs will be passed on to the nonfinancial companies exempt from the regulation. E. Reporting Requirements Reporting requirements are consistent across all three regulatory environments in that they require reporting on all asset classes. However, there is a difference in the timeline for reporting. In Europe, there is no phasing in. Singapore requires interest rate, foreign exchanges, and oil derivatives to be reported, followed by others. Finally, the United States has the most tiered reporting requirement. Interest rate derivatives are to be reported first, followed by the foreign exchange and commodity derivatives. Both cleared and uncleared trades need to be reported in all three jurisdictions. The Singaporean requirement of reporting affects any party or transactions related to Singapore. Singapore is a relatively smaller market; hence, its immediate reporting requirement of foreign exchange and oil derivatives, which are additional to that of the United States of interest rate derivatives, may not affect a significant number of market participants or transactions. The European requirement of immediate reporting of all assets will be a dominating requirement. Phasing-in allowed by the United States will give little flexibility if most of the transactions are cross-border. All countries require financial institutions to report. However, there are significant differences. While Singapore requires only financial institutions above a threshold to report, both the EU and the United States require all financial institutions to report. Nonfinancial entities only above a certain threshold are required to report in both the EU and Singapore. In the United States, while nonfinancial institutions are the last to report, there is no exemption for smaller institutions. The Singapore

156 OTC Derivatives Regulation: A Comparison 51 regulation is more accommodating for smaller (financial and nonfinancial) institutions and will help such institutions keep costs down. Only the US regulation has phased-in reporting, with financial institutions reporting first, followed by nonfinancial institutions. This gives nonfinancial institutions additional time to comply. All three jurisdictions allow third-party reporting and single-sided reporting. However, only the United States allows for double reporting. Double reporting might be beneficial to the trade repository to confirm the accuracy of the data being reported. It would be costly for the trade repository to verify the accuracy of the data if double reporting is not allowed. However, double reporting involves costs associated with consolidation of data and the reporting costs incurred by each counterparty. Time to report information to the trade repository is almost immediate in the United States. Both the EU and Singapore allow one day to report information to the trade repository. All three countries require not only initial reporting but also any subsequent changes to the contract. The Depository Trust and Clearing Corporation (DTCC 2012) believes that for day+1 care should be taken to avoid intraday cutoff. Only the United States requires real time public reporting by the TR. While all countries require that the identity of the counterparties be kept confidential, only the United States requires the notional amount of the swap to be capped while public reporting. Capping of notional amounts will provide an added measure of security in keeping the identity of the counterparty confidential. All three countries have similar governance of TRs. TRs are required to keep data confidential. The MAS proposal indicates that data collected by a TR serve a regulatory purpose. However, it does not specifically prohibit use of that data by affiliates of the TR or the TR itself for commercial use. Such absence of a specific prohibition may allow these private entities to benefit from privileged information (Argus 2012). Only the EU prohibits the TR from sharing data with its parent or a subsidiary. Only Singapore is considering base capital requirement from the TR. Singapore has no requirement for the time to keep records. The United States requires the data to be kept for 5 years and the EU for 10 years after the expiration of the contract. The objective of the OTC regulation is to improve collection and monitoring of the OTC market. As such, the regulators in the three jurisdictions have focused on post-trade transparency. A major portion of this post-trade transparency deals with reporting information to the TR in a timely manner. Market participants in the United States face the most stringent deadline regarding reporting of information to the TR upon execution. All three jurisdictions have comparable information that needs to be reported. In all jurisdictions, the onus of reporting falls primarily on financial institutions. Singapore is more favorable to smaller financial institutions. In the United States, nonfinancial institutions have to report only when there is no financial counterparty.

157 52 Review of Futures Markets Both Singapore and the EU require only nonfinancial institutions above a certain threshold to report. Thus, regulations in Singapore and the EU are more favorable to smaller, nonfinancial institutions. Additionally, a potential for regulatory arbitrage is possible depending on the threshold level used. The bulk of the above regulations focus on reducing reporting and regulatory costs for nonfinancial participants and smaller institutions. The idea is that as these participants do not regularly deal with derivatives, it will be costly for them to report. Even if these participants deal with derivatives, the financial counterparties have the requisite manpower and systems to meet the reporting obligations. Thus, it will be more cost effective to use their existing system for reporting. Single-sided reporting is based on the same concept as stated above. However, only mandating a single counterparty to report while reducing reporting and reconciliation costs may increase inaccuracies in reported data. Improper data will definitely not help the regulators to properly maintain the markets. Though singlesided reporting may reduce costs, there may be situations in which double-sided reporting is preferred. This might be in the case of firms that want to be consistent with reporting and report all their trades. Also, if a party is ultimately responsible for the accuracy of a trade, it may want to report it. Finally, double reporting may be essential for trade repositories as it will be easier to compare and note and/or correct differences (DTCC 2012). To avoid fractioning of data across jurisdictions and TRs, regulators in all three countries approve of reporting to TRs in foreign jurisdictions. They condition this approval on agreements between regulators in foreign countries with domestic regulators and compatibility of regulation. Bilateral negotiations between jurisdictions could take a considerable amount of time. The two regulators in the United States, the CFTC and SEC, had to go through various negotiations and time to propose rules on OTC derivatives. Hence, it is possible that market participants may have to report in various TRs leading to duplication and increased costs. There is also a chance that this will lead to fragmentation of data. Any fragmentation of data will not give regulators a complete picture of a market participant s exposure or about an asset class. Hence, regulators will not be in a position to maintain global concentration of positions by asset on a counterparty. Regulators in all three jurisdictions have erred on maintaining confidentiality. The US regulation is more stringent, not just requiring counterparty confidentiality but also requiring capping of the notional amount in public reporting. This requirement will not help post-trade transparency. However, where markets are more concentrated by few participants, it is wise to maintain trade confidentiality. This will help market makers provide liquidity in the market. V. CONCLUSION This study compares clearing and reporting regulation of OTC derivatives in Singapore, the United States, and the EU on assets, institutions, and the timing of regulation. The United States and the EU require central clearing and trading of all asset classes. Singapore requires only central clearing but not trading of all assets

158 OTC Derivatives Regulation: A Comparison 53 except foreign exchange swaps and forwards. Further, only the United States has phased implementation for reporting; Singapore prioritizes foreign exchange derivatives, interest rate contracts, and oil contracts. As the United States is in the most advanced stages of implementation of OTC regulation, the phasing in will be only a marginal reprieve. Singapore s clearing regulation is less stringent on foreign exchange derivatives but not on reporting. Small nonfinancial companies in Singapore and the EU face no regulation of mandatory clearing and reporting. While smaller financial companies have no clearing requirements in Singapore and the United States, they do face reporting requirements (last to report). Hence, the bulk of the regulation is to minimize costs for nonfinancial companies, in particular, the smaller nonfinancial institutions. Regulatory arbitrage is thus possible only based on the threshold used for clearing and reporting in each of the jurisdictions. The United States is in the most advanced stages of the derivatives regulation. It has both adopted and implemented regulations on clearing and reporting. The EU has agreement among members on the OTC regulation but has not yet implemented the regulation. Finally, Singapore has not yet adopted nor implemented OTC regulation (Financial Stability Board 2012). Thus, it is the time to implement regulation that may lead to a regulatory arbitrage towards the EU and Singapore. The main difference in the three regulatory jurisdictions is the nonrequirement of trading of cleared derivatives in Singapore. This difference has the potential to provide substantial choices in trading venues for market participants. References Acharya, V. V. and Bisin, A., 2010, Counterparty Risk Externality: Centralized versus Over-the-Counter Markets. Available at SSRN: abstract= Argus, 2012, Commentary to the Monetary Authority of Singapore Re: Consultation Paper on Proposed Regulation of OTC Derivatives, March 23. Available at Armstrong, R., 2012, As Dodd-Frank Looms, Asian Banks Look to Cut US Trading Ties. Reuters. Available at Avellaneda, M. and Cont, R., 2010, Transparency in Over-the-Counter Interest Rate Derivatives Markets. Finance Concepts, August. Available at Bank for International Settlements (BIS), 2004, Recommendations for Central Counterparties. Consultative Report, March (BIS, Basel, Switzerland). Bank for International Settlements (BIS), 2012, Semiannual OTC Derivatives Statistics at End-December Available at derstats.htm. Biais, B., Heider, F., and Hoerova, M., 2012, Clearing, Counterparty Risk, and Aggregate Risk. IMF Economic Review, 60,

159 54 Review of Futures Markets Cecchetti, S.G., Gyntelberg, J., and Hollanders, M., 2009, Central Counterparties for Over-the-Counter Derivatives. BIS Quarterly Review, September, Committee on the Global Financial System, 2011, The Macrofinancial Implications of Alternative Configurations for Access to Central Counterparties in OTC Derivatives Markets, November. Available at cgfs46.pdf. Commodity Futures Trading Commission, 2011, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants. Proposed Rule, Federal Register 76 (82), Commodity Futures Trading Commission, 2012, Real-Time Public Reporting of Swap Transaction Data. Final Rule, Federal Register 77, January 29, Commodity Futures Trading Commission and U.S. Securities and Exchange Commission, 2012, Joint Report on International Swap Regulation, January 31. Available at Culp, C.L., 2010, OTC-Cleared Derivatives: Benefits, Costs, and Implications of the Dodd-Frank Wall Stree Reform and Consumer Protections Act. Journal of Applied Finance, 20(2), Depository Trust and Clearing Corportation (DTCC) 2012, Commentary on Proposed Regulations of OTC Derivativees. Consultation Paper, Available at DerivSERV_MAS_response_26_March_2012.pdf. Dømler F., 2012, A Critical Evaluation of the European Credit Default Swap Reform: Its Challenges and Adverse Effects as a Result of Insufficient Assumptions (abstract). Journal of Banking Regulation, March 14. Available at Duffie, D. and Zhu, H., 2011, Does a Central Clearing Counterparty Reduce Counterparty Risk? Review of Asset Pricing Studies, 1(1), Duffie, D., Li, A., and Lubke, T., 2010, Policy Perspectives on OTC Derivatives Market Infrastructure. Federal Reserve Bank of New York Staff Reports, no. 424 (Federal Reserve Bank of New York). EUR-Lex, 2010, Proposal for a Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties and Trade Repositories (52010PC0484). Available at LexUriServ.do?uri=CELEX:52010PC0484:EN:NOT. Europa.eu, 2012, Regulation on Over-the-Counter Derivatives and Market Infrastructures - Frequently Asked Questions, March 29. Available at europa.eu/rapid/pressreleasesaction.do?reference=memo/12/232. Financial Stability Board, 2012, OTC Derivatives Market Reforms, Third Progress Report on Implementation, June 15. Available at Financial Times, 2009, Full G20 Communique, September 25. Available at feabdc0.html#axzz24UMDYJSG.

160 OTC Derivatives Regulation: A Comparison 55 Global Financial Markets Association, 2012, GFMA Submits Comments to the European Securities and Markets Authority on Draft Technical Standards for Regulation of OTC Derivatives, March 19. Available at correspondence/item.aspx?id=282. Herbert Smith LLP., 2012, EMIR: EU Regulation of OTC Derivatives, Central Counterparties and Trade Repositories, March. Available at Hollanders, M., 2012, The Role of Oversight in Collecting Derivatives Data. IFC Bulletin No 35. Proceedings of the Workshop, Data Requirements for Monitoring Derivative Transactions, (Bank for International Settlements, Zhengzhou, China). Koeppl, T.V. and Monnet, C., 2008, Central Counterparties. CFS Working Paper no. 2008/42 (Center for Financial Studies, Frankfurt, Germany). Leahy, S. and Hurrell, S., 2012, New Capital Rules Set to Impact Pension Fund Swap Deals. Building Tomorrow Royal Bank of Scotland, May. Available at new-capital-rules-set-to-impact-pension-fund-swap-deals.pdf. Lewandowska, O. and Mack, B., 2010, Squaring the Circle: Clearing Arrangements in Over-the-Counter Derivatives Markets. Working Paper, February (Center for Financial Studies, Frankfurt, Germany). Liu, Z., 2010, Credit Default Swaps - Default Risk, Counter-Party Risk and Systemic Risk, May 1. Available at SSRN: Milne, A., 2012, OTC Central Counterparty Clearing: Myths and Reality. Journal of Risk Management in Financial Institutions, 5(3), Monetary Authority of Singapore, 2012, Consultation Paper I on Proposed Amendments to the Securities and Futures Act on Regulation of OTC Derivatives. Consultation Paper P Available at Consultation Papers. Pirrong, C., 2009, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks through a Central Counterparty. Unpublished Paper, January 8, University of Houston. Pirrong, C., 2010, Mutualization of Default Risk, Fungibility, and Moral Hazard: The Economics of Default Risk Sharing in Cleared and Bilateral Markets. Unpublished Paper, University of Notre Dame. Russo, D., 2010, OTC Derivatives: Financial Stability Challenges and Responses from Authorities. Financial Stability Review, Banque de France, 14, Tuckman, B., 2010, Amending Safe Harbors to Reduce Systemic Risk in OTC Derivatives Markets. Center for Financial Stability Policy Paper, 22, April. Available at BruceTuckman.pdf. Vause, N., 2010, Counterparty Risk and Contract Volumes in the Credit Default Swap Market. BIS Quarterly Review, December, Weistroffer, C., 2009, Credit Default Swaps. Deutsche Bank Research, 21, December (Deutsche Bank, Frankfurt, Germany).

161 56 Review of Futures Markets Wilkins, C. and Woodman, E., 2010, Strengthening the Infrastructure of Over-the- Counter Derivatives Markets. Financial System Review, Bank of Canada, December, Young, M.D., Donley, M.A., Gilbert, G.M., and Kaplan Reicher, R., 2012, The CFTC s New Swap Reporting and Recordkeeping Requirements. Skadden, Arps, Slate, Meagher & Flom LLP. Available at cftc%e2%80%99s-new-swap-reporting-and-recordkeeping-requirements.

162 Alert Memo APRIL 9, 2013 Navigating Key Dodd-Frank Rules Related to the Use of Swaps by End Users Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd- Frank ) enacted a new regime of substantive regulation of over-the-counter ( OTC ) derivatives under U.S. securities and commodities laws. Over the course of 2013, many key provisions of Dodd-Frank are being implemented by the Commodity Futures Trading Commission (the CFTC ) with respect to swaps. While many of the regime s requirements focus on swap dealers ( SDs ) and major swap participants ( MSPs ), commercial entities that enter into OTC derivatives transactions to hedge or mitigate risk, referred to as end users, will also become subject to a wide range of substantive requirements. In particular, end users will need to: determine whether the derivatives they use are required to be cleared or to be traded on a regulated execution facility and, if so, whether they are eligible for, and have completed the steps necessary for, reliance on the exception available for commercial end users; determine whether they must post collateral to their derivatives counterparties; obtain legal entity identifiers for the purpose of public and regulatory reporting requirements; maintain full, complete and systematic records with respect to their swap transactions; enter into the latest International Swaps and Derivatives Association ( ISDA ) Dodd- Frank Protocols or otherwise amend existing swap agreements; comply with new position limit requirements; and comply with new antifraud and antimanipulation regulations. Under proposed guidance and a final exemptive order, non-u.s. end users will generally not be subject to such requirements with respect to swaps entered into with other non-u.s. counterparties. Appendix A to this memorandum is a table summarizing the requirements applicable to end users as well as relevant compliance time frames. Appendix B is a list of key CFTC rulemakings. Cleary Gottlieb Steen & Hamilton LLP, All rights reserved. This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal advice. Throughout this memorandum, "Cleary Gottlieb" and the "firm" refer to Cleary Gottlieb Steen & Hamilton LLP and its affiliated entities in certain jurisdictions, and the term "offices" includes offices of those affiliated entities.

163 Table of Contents Which Derivatives Are Subject to Dodd-Frank?... 3 Who Is an End User?... 5 What Requirements May Apply to End Users?... 8 Clearing. 8 Trade Execution. 17 Margin Reporting Business Conduct and Swap Documentation Recordkeeping Position Limit. 33 Antifraud and Antimanipulation Will Dodd-Frank Impose Requirements on Swaps Between Non-U.S. Persons?

164 Which Derivatives Are Subject to Dodd-Frank? In General. Dodd-Frank regulates a variety of previously unregulated derivatives, including interest rate swaps ( IRS ); non-spot foreign exchange transactions (unless exempted as described below); currency swaps; physical commodity swaps; total return swaps; and credit default swaps ( CDS ). 1 Dodd- Frank divides this group of previously unregulated derivatives into two categories: swaps (which come under the jurisdiction of the CFTC) and security-based swaps (which come under the jurisdiction of the Securities and Exchange Commission ( SEC )). The SEC has not yet finalized most of its substantive rules. Accordingly, this memorandum does not address the regulation of security-based swaps. What Is a Swap? The term swap is broadly defined and, unless an exclusion applies, includes a wide range of agreements, contracts or transactions linked to an array of underliers such as physical commodities, rates, foreign currencies, broad-based security indices or U.S. government or other exempt securities (other than municipal securities). 2 OTC derivatives based on a single non-exempt security or narrow-based security index are generally security-based swaps. Exemption for Physically-Settled Foreign Exchange Swaps and Forwards. The U.S. Secretary of the Treasury has exempted certain physically-settled foreign exchange swaps and foreign exchange forwards from some Dodd-Frank requirements. The exemption does not apply to products such as non-deliverable foreign exchange forwards, foreign exchange options or currency swaps. 3 Exempt foreign exchange swaps and foreign exchange forwards do remain subject to the regulatory reporting requirements and external business conduct standards discussed later in this memorandum. Excluded Instruments. Some common financial products are excluded from the new framework. These include listed futures, options on listed futures, listed and unlisted options on securities and on broad- and narrow-based security indices, See 77 Fed. Reg. 48,208 (August 13, 2012) ( Product Definitions Final Rule ). For these purposes the term exempt securities means certain securities exempted under Section 3(a)(12) of the Securities Exchange Act of 1934 (the Exchange Act ) but does not include, among other securities, municipal securities. Examples of exempted securities include U.S. Treasuries and securities issued by the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). See 77 Fed. Reg. 69,694 (Nov. 20, 2012) ( Final Treasury Determination ). 3

165 commodity trade options, 4 securities repurchase agreements, depository instruments, security forwards and non-financial commodity forwards intended to be physically settled. The CFTC retains anti-evasion authority with respect to the structuring of certain transactions to evade regulation. 4 The CFTC has exempted from many Dodd-Frank rules trade option transactions that are between either two users of the commodity or between a user of the commodity and an ECP In this context, a user of the commodity is a person that is a producer, processor or commercial user of, or a merchant handling the commodity that is the subject of the trade option transaction, or the products or byproducts thereof, and that is offered or entering into the trade option transaction solely for purposes related to its business. The trade option must also be intended to be physically settled. Such transactions are exempt from many Dodd-Frank requirements, including public reporting and clearing (both discussed below), but only exempt from regulatory reporting (also discussed below) if the end user does not enter into any non-trade option transactions that must otherwise be reported. 4

166 Who Is an End User? In General. Title VII of Dodd-Frank created two new categories of registration for SDs and MSPs. SDs and MSPs are subject to comprehensive, substantive regulation, including capital, margin, documentation, reporting, recordkeeping, and internal and external business conduct requirements. o SDs. An entity is regarded as a swap dealer if it: (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. 5 Dodd-Frank provides a de minimis exception from designation as a swap dealer for a person that enters into less than $8 billion of gross notional value in swaps over the preceding twelve months. 6 Under the CFTC s current cross-border proposed guidance and exemptive order (discussed further below), the calculation of the de minimis threshold excludes swaps with non-u.s. persons and foreign branches of U.S. persons that are registered as swap dealers. o MSPs. Even if an entity is not an SD, it may still become subject to registration with the CFTC if: (i) it maintains a substantial position in any major category of swaps, excluding (I) positions held for hedging or mitigating commercial risk and (II) positions maintained by an employee benefit or governmental plan, as defined under the Employee Retirement Income Security Act of 1974 ( ERISA ), for the primary purpose of hedging or mitigating risks directly associated with the operation of the plan; (ii) its swaps create substantial counterparty exposure ; or (iii) it is a private fund or other financial entity that is highly leveraged, is not subject to capital requirements established by an appropriate Federal 5 6 The CFTC has indicated that it interprets this definition in a manner similar (although not bounded by) the SEC s dealer/broker distinction. See 77 Fed. Reg. 30,596 at 30,607 (May 23, 2012) (the Registered Swap Entity Final Rule ). See Registered Swap Entity Final Rule. A smaller, $25 million notional cap applies in the case of swaps with certain so-called Special Entities. Special entities include any (i) Federal agency; (ii) State, State agency, city, county, municipality, or other political subdivision of a State; (iii) employee benefit plan subject to Title I of ERISA; (iv) governmental plan, as defined in Section 3 of ERISA; (v) endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code of 1986; or (vi) employee benefit plan defined in Section 3 of ERISA, not otherwise defined as a Special Entity, that elects to be a Special Entity by notifying an SD or MSP of its election prior to entering into a swap with such SD or MSP. After the expiration of phase-in period in 2016, the $8 billion cap will decrease to $3 billion unless the CFTC decides to set it at a different level. 5

167 banking agency and maintains a substantial position in a major category of swaps. 7 A substantial position is defined (i) in the case of rate or currency swaps, as $3 billion in negative mark-to-market exposure or $6 billion in negative mark-to-market plus potential future exposure or (ii) in the case of credit, equity or commodity swaps, as $1 billion in negative mark-to-market exposure or $2 billion in negative mark-to-market plus potential future exposure. Substantial counterparty exposure is defined as $5 billion in negative mark-to-market exposure across all swaps or $8 billion in negative mark-to-market plus potential future exposure across all swaps. Under the CFTC s current cross-border exemptive order, the calculation of these thresholds by a non-u.s. person excludes swaps with non-u.s. persons and foreign branches of U.S. persons that are registered as swap dealers. End Users. Title VII of Dodd-Frank also applies to end users that do not qualify as SDs or MSPs. Dodd-Frank divides end users into two broad categories financial and non-financial end users. Financial End Users. An end user is a financial end user if it is a commodity pool, 8 private fund, 9 employee benefit plan, 10 or person that is predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of o Predominantly Engaged in Activities that Are Financial In Nature. According to final rules under Title I of Dodd-Frank, an entity is Id. In general, a commodity pool is any investment trust, syndicate or similar form of enterprise operated for the purpose of trading in derivatives regulated by the CFTC. See CEA 1a(10). A private fund is an issuer that would be an investment company, as defined in the Investment Company Act of 1940, but for sections 3(c)(1) and 3(c)(7) of that Act. See Investment Advisers Act of (a)(29). For purposes of this memorandum, an employee benefit plan means an employee benefit plan or governmental plan as defined in paragraphs (3) and (32) of section 3 of ERISA, respectively. See CEA 2(h)(7)(C)(i)(VII). 6

168 predominantly engaged in activities that are financial in nature 11 if in either of its last two fiscal years: the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature represents 85 percent or more of the consolidated annual gross revenues of the company; or the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature represents 85 percent or more of the consolidated assets of the company. 12 o Accounting for Subsidiaries. Under this standard, an end user may take into account its own gross revenues and/or assets as well as the gross revenues and/or assets of all of its consolidated subsidiaries in determining whether it qualifies as a financial end user. This is true even if the end user is an intermediate holding company Activities that are financial in nature include (1) lending, exchanging, transferring, investing for others or safeguarding money and securities; (2) certain insurance activities; (3) providing financial, investment or economic advisory services, including advising an investment company; (4) securitizing; (5) underwriting, dealing in or making a market in securities; (6) extending credit and servicing loans; (7) activities related to extending credit (e.g., real estate and personal property appraising, arranging commercial real estate financing, collection agency services, credit bureau services); (8) certain of leasing personal or real property; (9) operating nonbank depository institutions; (10) trust company functions; (11) financial and investment advisory activities (including providing information, statistical forecasting and advice with respect to any transaction in swaps); (12) securities and derivatives brokerage, riskless principal and private placement services; (13) investment transactions as principal; (14) management consulting and counseling activities; (15) support services in connection with financial activities; (16) community development activities; (17) issuance and sale of money orders, savings bonds and traveler s checks; (18) processing of financial, banking or economic data; (19) providing administrative and other services to mutual funds; (20) owning shares of a securities exchange; (21) acting as a certification authority for digital signatures and authenticating the identity of a person; (22) providing employment histories to third parties for use in making credit decisions; (23) check cashing and wire transmission services; (24) postage, vehicle registration or public transportation services; (25) real estate title abstracting; (26) operating a travel agency in connection with financial services; (27) organizing, sponsoring and managing a mutual fund; (28) merchant banking; (29) lending, exchanging, transferring, investing for others or safeguarding financial assets other than money or securities; (30) providing any device or other instrumentality for transferring money or other financial assets; and (31) arranging, effecting or facilitating financial transactions for the account of third parties. See 12 C.F.R. Part 242 (Apr. 5, 2013) (Board of Governors of the Federal Reserve System ( Federal Reserve ) rule defining Predominantly Engaged in Financial Activities ). See id. See also Dodd-Frank Act Section 102(a)(6). The CFTC has not formally interpreted the predominantly engaged in financial activities standard, but the preamble to the CFTC s final rule regarding the clearing exception for inter-affiliate swaps (discussed below) suggests that the CFTC will defer to the Federal Reserve on this interpretation. 7

169 What Does It Mean to Clear a Swap? Overview of Clearing. To clear a swap, the counterparties to the swap that is subject to mandatory clearing will, as soon as practicable after execution, submit their respective sides of the swap to a derivatives clearing organization ( DCO ) either through a clearing broker (called a futures commission merchant or FCM ) or directly (if the party is itself a member of the DCO), rather than establishing a bilateral contract with each other. Since most end users are not self-clearing members, to accomplish this, an end user will need to establish a clearing relationship with an FCM and enter into cleared derivatives execution agreements (sometimes referred to as give up agreements) with its counterparties. The two counterparties to a cleared swap are not required to, but may, use the same clearing broker to clear the swap. Margin Requirements. Cleared swaps are subject to margin requirements established by the DCO, including daily exchanges of cash variation (or mark-tomarket) margin and an upfront posting of cash or securities initial margin to cover the DCO s (and FCM s) potential future exposure to the end user in the event of its default. End Users May Choose the DCO. Dodd-Frank provides that the counterparty to a swap transaction that is not an SD or MSP has the sole right to select the DCO for a transaction that is required to be cleared. Swap pricing may be affected by the DCO selected to clear the swap. End Users May Choose to Clear Swap Transactions Not Subject to Mandatory Clearing. An end user is entitled to elect to clear swap transactions that are not subject to mandatory clearing, at a DCO of such end user s choice. Which Swaps Are Subject to Mandatory Clearing? In General. The Commodity Exchange Act ( CEA ) authorizes the CFTC, either upon application by a DCO or upon its own initiative, to require a designated swap or category of swaps to be cleared by a DCO. 13 On November 28, 2012, the CFTC issued its first mandatory clearing determination for certain IRS and CDS. IRS. Very generally, the following IRS are subject to mandatory clearing: o Fixed-to-floating swaps; o Floating-to-floating swaps (also known as basis swaps); 13 See CEA 2(h)(2). 8

170 o Forward rate agreements; and o Overnight indexed swaps. The mandatory clearing determination only applies to the IRS listed above in the following currencies: United States dollar, Euro, Sterling or Yen. CDS. Very generally, the following CDS are subject to mandatory clearing: o Untranched indices covering the CDX.NA.IG and CDX.NA.HY; and o Untranched indices covering the itraxx Europe, itraxx Europe Crossover and itraxx Europe High Volatility. 14 The CFTC plans to make additional clearing determinations in the future. End users should consider establishing policies and procedures to monitor which swaps become subject to mandatory clearing. What Are the Exceptions or Exemptions to Mandatory Clearing? In General. The CFTC has issued final rules detailing (i) a limited exception to the mandatory clearing requirement for a defined category of non-financial end users and (ii) an exemption to the mandatory clearing requirement for transactions between certain affiliated entities. Swap Terminations. In a recent no-action letter, the CFTC staff has clarified that swaps that partially or fully terminate existing uncleared swaps are not required to be cleared. 15 What Are the Criteria for the Non-Financial End-User Exception? Eligibility. The CFTC has issued final rules outlining a limited exception to the mandatory clearing requirement for a defined category of non-financial end users. 16 Both third-party and inter-affiliate trades may qualify for the exception. In order to qualify for the exception for a particular swap transaction: o The Entity Entering into the Swap Must Not Be a Financial Entity. To qualify for the exception, the particular entity entering into the swap must not be an SD, MSP or financial end user (as described above). Notably, even an entity within a corporate group that, on a group-wide See 77 Fed. Reg. 74,284 (Dec. 13, 2012) ( Clearing Requirement Determination ). See CFTC Letter No , Comm. Fut. L. Rep. (CCH) 32,560 (Mar. 20, 2013). See 77 Fed. Reg. 42,560, 42,590 (July 19, 2012) ( End-User Exception Final Rule ). 9

171 basis, engages predominantly in non-financial activities may still be a financial entity depending on the activities of the particular entity in question (and those of its subsidiaries). However, there are certain cases where a financial entity is nevertheless eligible for the exception: End-User Exception for Affiliates Acting as Agents for Non-Financial End Users. The end-user exception provides that an affiliate of a non-financial end user may be permitted to use the exception so long as it acts on behalf of the [non-financial end user] and as an agent. 17 o Covered Affiliates. Financial end users acting on behalf of and as an agent for the non-financial end user may make use of the end-user exception. An SD or MSP, however, even if it acts on behalf of and as an agent for a non-financial end user, may not make use of the end-user exception. o Undefined Scope of Agency Requirement. It is unclear whether the CFTC will interpret the agency requirement narrowly (i.e., the central affiliate may not act as a riskless principal, as is usually the case with centralized hedging programs) or in a de facto manner (i.e., to permit a central affiliate to net the demand of various affiliates and act as principal with external counterparties, while at the same time entering into offsetting back-to-back swaps with those affiliates). To address this ambiguity, the Coalition of Derivatives End Users has requested an exemption from mandatory clearing for centralized treasury units. 18 o Additional Considerations. A financial end user wishing to rely on an affiliate s eligibility to elect the end-user exception may need to enter into an agency agreement to demonstrate that it is acting as an agent for the non-financial end user. Such an agreement may expose the non-financial end user affiliate to certain liabilities as a principal to the swap transaction. In addition, such an agency relationship may affect set-off rights as among the various parties to the swap transactions. In order to avoid unanticipated consequences, end users should take care to analyze any potential agency arrangement from the perspective of common law principles of agency and the applicable state law governing the agreement CEA 2(h)(7)(D). Letter from Coalition of Derivatives End Users to Melissa Jurgens, Secretary, the CFTC, dated Feb. 22, 2013, available at TreasuryUnits4c_ExemptiveReliefRequest.pdf. 10

172 Special Treatment of Certain Financial Entities. For purposes of the end-user exception: o Captive Finance Entities Are Not Financial End Users. A captive finance entity will be a non-financial entity eligible to make use of the end-user exception if (i) its primary business is providing financing, (ii) it uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, (iii) 90 percent or more of such exposures arise from financing that facilitates the purchase or lease of products and (iv) 90 percent or more of such products are manufactured by the entity s parent company or another subsidiary of the parent company. o Small Financial Institutions Are Not Financial End Users. The CFTC has exempted certain small financial institutions from the definition of financial entity. Small financial institutions include those banks, savings associations, farm credit system institutions and credit unions with total assets of $10 billion or less on the last day of such person s most recent fiscal year. o Certain Foreign Entities Are Not Subject to Mandatory Clearing. The CFTC has stated that foreign governments, foreign central banks and international financial institutions are not subject to mandatory clearing. This exclusion does not apply to sovereign wealth funds or similar entities that, based on their activities, would likely be considered financial end users. As a result, sovereign wealth funds must be analyzed like any other non-sovereign entity. o The Swap Must Be Used to Hedge or Mitigate Commercial Risk. The CFTC has defined hedging or mitigating commercial risk to include swaps that are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, excluding any transactions that are in the nature of speculation, investing or trading or that are used to hedge another swap, unless that other swap is itself used to hedge or mitigate commercial risk. The CFTC has indicated that commercial risk does not refer only to the risk of the end user itself. For example, the parent entity in a corporate group that is itself eligible for the end-user exception may make use of the exception when it enters into a swap for the purpose of hedging the aggregate commercial risk of affiliates within the corporate enterprise. A swap may also be deemed to hedge or mitigate commercial risk if the swap qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815 ( Derivatives and Hedging ) or 11

173 Governmental Accounting Standards Board Statement 53 ( Accounting and Financial Reporting for Derivative Instruments ). o The End User Must Make an Annual Filing with an SDR or the CFTC. In order for a non-financial end user to rely on the end-user exception for a particular swap transaction, one of the parties to the swap must provide either a swap data repository ( SDR ) or the CFTC with information regarding how the end user generally meets its financial obligations associated with entering into an uncleared swap. The CFTC has indicated that this requirement would be satisfied if, on at least an annual basis, the end user provides or causes to be provided certain specified information to an SDR or the CFTC, including whether the entity generally meets its financial obligations associated with its swaps by (i) a written credit support agreement, (ii) pledged or segregated assets, (iii) a written third-party guarantee, (iv) its own available resources or (v) some other means. The SDRs currently registered with the CFTC include the DTCC Data Repository, ICE Trade Vault LLC and the Chicago Mercantile Exchange. If an end user does not make an annual filing, it will need to provide its counterparty with information regarding how it meets its financial obligations each time it enters into a transaction in reliance on the end-user exception. o SEC Filers Must Obtain Certain Board Approvals. If a non-financial end user is or is controlled by an entity required to file disclosures with the SEC under the Exchange Act, such end user cannot make use of the exception unless an appropriate committee of the board of directors of the entity (which could be the board itself) has approved the decision not to clear the swap. If more than one entity in an end user s group enters into swaps, an appropriate committee of the board of directors of each entity must approve the decision to rely on the end-user exception. Annual Committee Resolution Approving Use of End-User Exception. The board of directors of an end user does not need to approve each swap transaction with respect to which the end user elects the clearing exception. Rather, the CFTC has indicated that an annual certification from the relevant committee of an end user s board of directors that it has reviewed and approved the decision to utilize the exception will suffice. Board Approval of a Swap Policy. As a corporate governance matter, the appropriate boardcommittee may approve a swap policy that contains sufficiently detailed parameters to demonstrate that the board committee has exercised appropriate 12

174 oversight of management s authority to clear or not clear certain swaps. For example, the policy could set limits on the types of counterparties or types of swaps that are pre-approved for the exception and require that any transaction outside those parameters be specifically approved by the committee. The committee could also identify factors that are relevant to the decision not to clear a swap, which could include credit risk analysis, the end user s overall hedging policies, the uniqueness of the swap, margin requirements, accounting and tax considerations. Choosing an Appropriate Committee. The CFTC has indicated that a board committee would be appropriate for these purposes if it is specifically authorized to review and approve the end user s decision to enter into swaps. While the CFTC provides SEC filers and their controlled subsidiaries with reasonable discretion to determine the appropriate committee, for most end users, it is expected that the audit committee (or other committee responsible for oversight of treasury activity) would perform this role. o Reporting Obligation for Each Swap Transaction Relying on End- User Exception. For each swap between an end user and an unaffiliated entity in which the end user relies on the exception, the reporting counterparty 19 will be required to provide the following information to an SDR or the CFTC: (1) whether the end-user exception has been elected; (2) which party is the electing counterparty; and (3) whether the electing counterparty has already provided the information discussed above through an annual filing. End Users Rarely Will Be the Reporting Counterparty. If the end user s counterparty is a U.S. or non-u.s. SD or MSP, the obligation to report this election to an SDR or the CFTC will fall upon such SD or MSP counterparty. Where Both Counterparties are Not SDs/MSPs, and Only One Counterparty is a U.S. Person, the U.S. Person is the Reporting Counterparty. If a non-financial end user enters into a swap with a financial entity that is not a U.S. person and not a SD or MSP, then the end user has the reporting obligation, unless otherwise agreed by contract. 19 This memorandum provides a more thorough discussion of reporting obligations in the section entitled Will End Users Be Required to Report Their Swap Transactions?. 13

175 Inter-Affiliate Trades. Under no-action relief issued by the CFTC staff (the Inter-Affiliate Reporting No-Action Letter ), 20 end users need not report the information relating to the end-user exception for swaps with certain affiliates, subject to conditions described in Are End Users Required to Report Inter- Affiliate Transactions? below. If a non-financial end user is or is controlled by an entity required to file disclosures with the SEC under the Exchange Act, the CEA still requires approval of the use of the end-user exception by the end user s board or appropriate committee, and therefore board resolutions may still be required for end users that only trade with affiliates. Reasonable Basis Requirement. If the end user is not the reporting counterparty, then the reporting counterparty must have a reasonable basis to believe that the end user electing the exception is entitled to do so. The CFTC has not provided an explicit standard for having reasonable basis to believe, but has stated that reasonableness depends on the applicable facts and circumstances. The CFTC has clarified, however, that the standard does not require independent investigation by the reporting counterparty of information or documentation provided by an end user. As long as the reporting counterparty has obtained information, documentation or a representation that on its face provides a reasonable basis to conclude that the end user qualifies for the exception, then, absent facts to the contrary, no further investigation would be necessary. What Are the Criteria for the Inter-Affiliate Exemption from Mandatory Clearing and Trading? In General. The CFTC has issued rules that exempt from mandatory clearing swaps between affiliated entities under common majority ownership and whose financial statements are consolidated with each other, 21 whether or not such See No-Action Relief for Swaps Between Affiliated Counterparties That Are Neither Swap Dealers Nor Major Swap Participants from Certain Swap Data Reporting Requirements Under Parts 45, 46, and Regulation 50.50(b) of the Commission s Regulations, CFTC (APR. 5, 2013). See Clearing Exemption for Swaps Between Certain Affiliated Entities, CFTC, (last visited Apr. 2, 2013) (the Inter-Affiliate Exemption Final Rule ). Affiliates are eligible for this exemption if one counterparty directly or indirectly holds a majority ownership interest in the other counterparty or if a common entity directly or indirectly holds a majority ownership interest in each counterparty. 14

176 entities qualify as non-financial end users or use swaps to hedge or mitigate commercial risk. Eligibility Criteria. To be eligible for the exemption, the affiliates must: o document their trading relationship consistent with the swap trading relationship documentation requirements discussed below, or where both counterparties are not SDs/MSPs, document in writing all terms governing the trading relationship between the affiliates; o establish a centralized risk management program with respect to the interaffiliate swaps; o report the election of the exemption to an SDR or the CFTC, along with the board certification and information regarding how the entity meets its financial obligations, as is also required for reliance on the end-user exception (discussed above); and o satisfy the outward-facing swaps conditions, described below. Treatment of Outward-Facing Swaps Condition. In order to qualify for the exemption, both affiliates to the swap transaction must generally, when entering into swaps with unaffiliated counterparties, either: o comply with the mandatory clearing requirement under the CEA; o comply with an exception or exemption from the mandatory clearing requirement under the CEA; o comply with the requirements for clearing swaps under a foreign jurisdiction s clearing requirement that is comparable, and comprehensive but not necessarily identical to the clearing requirement under the CEA, as determined by the CFTC; o comply with an exception or exemption under a foreign jurisdiction s clearing requirement; or o clear such swap through a DCO or a clearing organization that is subject to supervision by appropriate government authorities in the home country of the clearing organization and that has been assessed to be in compliance with certain principles for financial market infrastructures published by the International Organization of Securities Commissions ( IOSCO ). Time-Limited Alternative Compliance Framework. Given that the clearing requirement will take effect in the United States before other jurisdictions, the CFTC recognized that it may be difficult for non-u.s. affiliates to meet the outward-facing swaps condition discussed above as such affiliates home 15

177 jurisdictions may not yet have comprehensive clearing requirements comparable to those in the United States. As a result, the CFTC has provided a time-limited alternative compliance framework that will remain in effect until March 11, o Affiliates Located in the European Union ( EU ), Japan or Singapore. Swaps between a U.S. affiliate and an affiliate located in the EU, Japan or Singapore will be deemed to have met the outward-facing swaps condition if (i) each affiliate pays and collects full variation margin daily on all swaps entered into by the affiliate with unaffiliated counterparties, (ii) each affiliate pays and collects full variation margin daily on all swaps entered into with eligible affiliate counterparties or (iii) the affiliates common majority owner is not a financial entity and neither affiliate is affiliated with an SD or MSP. o Affiliates Not Located in the EU, Japan or Singapore. Swaps between a U.S. affiliate and an affiliate that is not located in the EU, Japan or Singapore will be deemed to have met the outward-facing swaps condition if (i) the aggregate notional value 22 of swaps entered into by the affiliate counterparty located in the United States with affiliate counterparties outside of the United States, the EU, Japan or Singapore that are required to be cleared does not exceed 5% of the aggregate notional value of all swaps that are required to be cleared and (ii) either the affiliate located outside the U.S., EU, Japan and Singapore pays and collects full variation margin daily on all swaps it enters into with unaffiliated counterparties or both affiliates pay and collect full variation margin daily on all their swaps with eligible affiliate counterparties. Generally speaking, because of the additional conditions to the inter-affiliate exemption, and because of the additional reporting obligations (discussed below), an entity eligible for the non-financial end-user exception for a swap with an affiliate may well find reliance on that exception more straightforward. TIMING FOR COMPLIANCE. If an end user does not qualify for either exception/exemption, then mandatory clearing of the swaps designated by the CFTC will go into effect on June 10, 2013 for most financial end users and on September 9, 2013 for non-financial end users. Swaps entered into before those dates are not subject to mandatory clearing if they are reported in accordance with the rules for described below. 22 In each instance, the notional value as measured in U.S. dollar equivalents and calculated for each calendar quarter. 16

178 Are There Restrictions on Trading Imposed on End Users? In General. Unless subject to an exception, end users will be prohibited from entering into OTC swaps directly with their counterparties if either of the following two conditions is true: o Either party is not an eligible contract participant ( ECP ); or o The swap is subject to the mandatory clearing requirement and is made available to trade by a designated contract market ( DCM ) (i.e., a futures exchange) or a swap execution facility ( SEF ). ECP Trading Requirement. o In General. Under the CEA, any swap transaction with a person other than an ECP must be entered into on, or subject to the rules of, a DCM. o Who is an ECP? Generally speaking, for an unregulated corporation, partnership or other entity to qualify as an ECP, its total assets must exceed $10 million or, if it is entering into the swap in connection with its business or to manage risk, $1 million. The term ECP also includes several defined classes of institutions (e.g., banks, insurance companies, registered investment companies, pension plans, governmental entities, broker-dealers and FCMs) and natural persons that meet certain asset and other requirements. 23 o Must All Swap Guarantors be ECPs? The CFTC s position is that any guarantee of a swap is, itself, a swap. As a result, each guarantor of a swap must be an ECP in order to avoid the prohibition on entering into OTC swaps discussed above. 24 While this requirement may not be particularly onerous for most swap guarantors, it may present an issue in the secured financing context, where multiple affiliates (including those with minimal assets) may guarantee secured obligations that include not just loan obligations but obligations under related IRS or other swaps. If a non-ecp guarantees a swap, the non-ecp guarantor could face enforcement action, the guarantee may be unenforceable (depending on applicable state law) and the SD counterparty, if any, could face For certain purposes, ECPs also include financial institutions, insurance companies, commodity pools, governmental entities, broker-dealers, FCMs, floor brokers and floor traders acting as a broker or performing an equivalent agency function on behalf of another ECP. In addition, ECPs also include such entities, along with investment advisers, commodity trading advisors and similarly regulated foreign persons, who are acting as investment manager or fiduciary for another ECP and who are authorized by that person to commit that person to the relevant transaction. See CFTC Interpretative Letter No , Comm. Fut. L. Rep. (CCH) 32,408 (Oct. 12, 2012). 17

179 enforcement action for failure to verify the ECP status of the guarantor. 25 On February 15, 2013 the Loan Syndications and Trading Association issued a market advisory describing how parties can draft their secured loan agreements to ensure that non-ecps do not guarantee any swap obligations. 26 An ECP may also provide a keepwell to confer ECP status on an entity that would otherwise be a non-ecp guarantor. Trading Requirement for Cleared Swaps. o In General. Swaps subject to the mandatory clearing requirement will be required to be traded on a DCM or SEF unless the swap is not made available to trade by a DCM or SEF. o When Is a Swap Made Available to Trade? The CFTC has indicated that the mere listing of a swap for trading is not sufficient. 27 Instead, it has proposed a number of factors, including, but not limited to, the presence of willing buyers and sellers, the frequency or size of transactions, the trading volume, the bid/ask spread, the usual number of resting firm bids or indicative bids and offers and whether a SEF or DCM supports trading in the swap. 28 A CFTC proposal would allow a SEF or DCM to determine whether a swap is made available to trade and to submit such determination to the CFTC for approval or certification. The CFTC has also proposed that, if one SEF makes a swap available to trade, all economically equivalent swaps would be deemed available to trade. o What is a SEF? Dodd-Frank defines a SEF to include any 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. SEFs are required to register with the CFTC and are subject to several core principles and other requirements. In addition, the CFTC has proposed to interpret the SEF definitions and core principles to restrict the execution modalities permitted to qualify (e.g., how bids and See How Does Dodd-Frank Change the Way Swap Transactions Are Documented below. See Updated Market Advisory: Swap Regulations Implications for Loan Documentation, The Loan Syndications and Trading Association (Feb. 15, 2013). As noted in the advisory, whether the ECP requirement also applies to a pledgor pledging collateral to secure an affiliate s swap is uncertain. See 76 Fed. Reg. 1214, 1222 (Jan. 7, 2011) ( SEF Proposal ) (describing frequency of transactions and open interest as potential considerations for determining whether a swap is available to trade). 76 Fed. Reg. 77,728 (Dec. 14, 2011) ( Available to Trade Proposal ). 18

180 offers may or must be disseminated by a qualifying platform and rules governing order interaction) and to impose certain other requirements on the types of functionalities that a SEF must offer. 29 These limitations can be expected to make it more difficult for an end user to execute a large or complex swap over a SEF without suffering adverse price effects from exposing its trading interest to a larger number of other market participants. o Are There Any Exceptions to the Trading Requirement for Cleared Swaps? Block Trades. The CFTC has proposed to permit a block-sized swap transaction to be executed off of a SEF through any means of interstate commerce. As proposed, however, only the largest trades estimated to be the top 5-6% in notional amount for IRS and CDS would qualify as block trades. Swaps Exempt/Excepted from Mandatory Clearing. In addition, swaps excepted or exempted from mandatory clearing are not covered. TIMING FOR COMPLIANCE. The ECP trading requirement is already in effect. The requirement that all swap guarantors be ECPs applies to swaps and guarantees of swaps entered into after October 12, The trading requirement for cleared swaps will become effective after the finalization of CFTC rules governing SEFs and the CFTC proposal regarding when a swap is available to trade. 29 The CFTC has proposed that order book or request for quote ( RFQ ) platforms may qualify as SEFs, but systems operated by a single dealer and inter-dealer brokerage platforms would not. A SEF (even an RFQ SEF) would be required to operate an all-to-all display functionality. A SEF participant would be required to send an RFQ to at least five recipients, and any resting orders would need to be integrated with responses to RFQs. 19

181 Must End Users Post Collateral with Respect to Their Uncleared Swaps? In General. Dodd-Frank requires SDs and MSPs to collect collateral as initial and variation margin for certain uncleared swaps. Margin requirements for uncleared swaps will generally be higher than the margin required to be posted to a DCO in respect of cleared swaps. Who Sets Margin Requirements? o Very generally, the U.S. federal banking regulators (called the Prudential Regulators ) 30 are responsible for setting margin requirements for SDs and MSPs that are banks and the CFTC is responsible for setting margin requirements for SDs and MSPs that are not banks. The CFTC and the Prudential Regulators have proposed margin requirements, but they are not yet finalized. 31 o In an effort to achieve harmonization across jurisdictions and regulators, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions ( BCBS-IOSCO ) has issued two Consultations on margin requirements for swaps that are not centrally cleared. 32 Margin Requirements for Non-Financial End Users. o Proposed Prudential Regulator Rules. The proposal of the Prudential Regulators would allow SDs and MSPs to set an unmargined threshold for non-financial end users. Under the Prudential Regulators proposal bank SDs and MSPs would be required to collect from non-financial end user counterparties any difference between the initial margin amount specified in the rules and the unmargined threshold. o Proposed CFTC Rules. The CFTC s proposed rules include a full exception from the proposed margin requirements for non-financial end users, although credit support documentation would still be required to be executed The Prudential Regulators are the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit Administration and the Federal Housing Finance Agency. See CGSH Alert Memos, Prudential Regulators Propose Swap Margin and Capital Requirements (Apr. 14, 2011) and CFTC Proposes Uncleared Swap Margin Requirements (Apr. 27, 2011). See Margin requirements for non-centrally-cleared derivatives, BCBS-IOSCO (July 2012); Margin requirements for non-centrally cleared derivatives (Second Consultative Document), BCBS-IOSCO (Feb. 2013). 20

182 Margin Requirements for Financial End Users. Both the Prudential Regulators and the CFTC would effectively divide financial end users into high risk financial end users and low risk financial end users. 33 For both categories of financial end users, margin would not be required to be transferred below a de minimis minimum transfer amount of $100,000. In addition, if a financial end user qualifies as a low risk counterparty, rather than a high risk counterparty, margin would not be required to be transferred until it exceeds the thresholds proposed to be set either based on a fixed dollar threshold (between $15 million and $45 million) or a percentage of the SD s or MSP s capital (between 0.1% and 0.5%). Margin Requirements for Certain Foreign Governmental Entities. The Prudential Regulators and CFTC s proposals would not exempt sovereigns or central banks from the requirement to post and collect margin. However, the recent consultative document on margin requirements published by the BCBS- IOSCO, in which the Prudential Regulators and CFTC were involved, would not require such entities to post margin. How Can End Users Protect the Margin They Post to their Dealer Counterparties? Dodd-Frank requires SDs and MSPs to notify counterparties, such as end users, of their right to require that any initial margin that such counterparties post to guarantee uncleared swaps be segregated at an independent custodian. The counterparty will be permitted, but is not required, to elect segregation. Foreign Exchange. Current proposals would not impose margin requirements on foreign exchange swaps and forwards eligible for the Department of the Treasury exemption for such transactions. 34 TIMING FOR COMPLIANCE. Final rules implementing these margin requirements are still pending A financial end user would be considered high risk unless (1) it does not have significant swap exposure (a level designed to equal half the level of uncollateralized outward exposure that would require registration as an MSP under the substantial counterparty exposure prong of the MSP definition), (2) it predominantly uses swaps to hedge or mitigate the risks of its business activities, including balance sheet or interest rate risk, and (3) it is subject to capital requirements established by a prudential regulator or state insurance regulator. See 76 Fed. Reg. 27,564 (May 11, 2011) ( Prudential Regulator Capital and Margin Proposal ) and 76 Fed. Reg. 23,732 (Apr. 28, 2011) ( CFTC Margin Proposal ). Notably, under these proposals, sovereigns and sovereign financial institutions, such as non-u.s. central banks, would be treated as high-risk financial end users. See Final Treasury Determination, 77 Fed. Reg. 69,694, 69,695 (Nov. 20, 2012). 21

183 Must End Users Report Their Swap Transactions? In General. The CEA requires that all swap transactions that were in existence as of July 21, 2010 (the date Dodd-Frank was enacted) or entered into after that date be reported to an SDR or, if no SDR accepts the relevant swap data, the CFTC. This requirement applies to end users, although the CFTC has issued noaction relief regarding certain inter-affiliate swaps. Public Reporting. The CEA requires that swap transaction and pricing data be reported to the public in real-time as soon as technologically practicable, subject to certain delays for block trades as described below. 35 The parties identities are not made public. Regulatory Reporting. The CEA also requires that all relevant information about every swap transaction be reported to an SDR or the CFTC for the entire life of the transaction. 36 For each swap transaction, the reporting party must report (i) creation data comprised of the primary economic terms of the swap transaction and all of the terms of the swap in the legal confirmation and (ii) continuation data documenting all of the lifecycle events of the swap transaction (e.g., a daily snapshot of all primary economic terms data, including any changes that have occurred since the previous snapshot) and the valuation of the swap transaction. Such data is maintained for regulatory purposes and will not be made public. Historical Reporting. The CEA requires that the responsible party report certain information regarding all swaps that were effective as of July 21, 2010, even if they have already expired. For such swaps that expired prior to April 25, 2011, the reporting party must report information in their possession as of specified dates relating to the swaps to an SDR in whatever method the party selects. For swaps still effective as of April 25, 2011, the reporting party must electronically report minimum primary economic terms data and information that identifies each counterparty. Such data is maintained for regulatory purposes and will not be made public. 37 Reporting Delays for Block Trades. The CFTC has provided for certain delays in real-time public dissemination of swap transaction data for block trades. Under proposed rules, block trade thresholds and reporting delays differ depending on the asset class (or sub-asset class swap category), method of See 77 Fed. Reg. 1182, 1243 (Jan. 9, 2012) ( Real-Time Public Reporting Final Rule ). See 77 Fed. Reg (Jan. 13, 2012) ( Regulatory Reporting and Recordkeeping Final Rule ). See 77 Fed. Reg. 35,200 (June 12, 2012) ( Reporting of Unexpired Pre-Enactment Swaps Final Rule ). 22

184 execution and status of the parties. If a swap exceeds the applicable block trade threshold, the public reporting of data on that swap will be delayed for at least 30 minutes and, in some cases, significantly longer. 38 Pending finalization of block trade thresholds, all swaps are eligible for these delays. Who Is Responsible for Reporting Swap Transaction Data? End Users Are Not Usually Responsible for Reporting. In general, end users will not be responsible for such reporting with respect to most of their swap transactions. o In a transaction in which one of the parties is an SD or MSP and the other is not, the SD or MSP is responsible for satisfying the reporting obligation (even if the SD or MSP is a non-u.s. person). o In a transaction in which one of the parties is a financial end user and the other is a non-financial end user, the financial end user is responsible for satisfying the reporting obligation (unless the financial end user is a non- U.S. person). o In a transaction in which both parties are non-financial end users, the counterparties are to agree as a term of the transaction as to which counterparty is the reporting party (unless the financial end user is a non- U.S. person). End Users Are Responsible for Reporting Transactions with Certain Non- U.S. Counterparties. The CFTC has stated that, in the case of a swap between a U.S. and a non-u.s. person, in which neither party is an SD or MSP, the U.S. person is responsible for reporting, regardless of the statuses of the parties. Foreign financial institutions that have not registered as SDs may agree by contract to report swaps on behalf of their U.S. end user counterparties, although a U.S. end user will ultimately be responsible for ensuring that the swaps are reported. Are End Users Required to Report Inter-Affiliate Transactions? No-Action Relief from Reporting End-User Inter-Affiliate Transactions. On April 5, 2013, the CFTC staff issued no-action relief to end users for regulatory reporting obligations with respect to certain inter-affiliate swaps (including historical swap reporting and reporting relating to the end-user exception). Public reporting requirements, which apply to all trades that are arms length, are not the subject of the Inter-Affiliate Reporting No-Action Letter. The noaction relief is not time-limited. 38 See 77 Fed. Reg. 15,460 (Mar. 15, 2012) ( Block Trade Proposal ). 23

185 Conditions to the Inter-Affiliate Reporting No-Action Letter. Each aspect of the relief only applies to bilateral, uncleared OTC swaps where neither counterparty is an SD, MSP or an affiliate of either. The relief will likely apply to most inter-affiliate swaps between end users. The relief includes the following conditions: o 100% Commonly Owned Affiliates New Swaps. The no-action relief from regulatory reporting and end-user exception reporting applies to swaps between a counterparty that 100% owns the other counterparty or between counterparties that are 100% commonly owned (directly or indirectly) by a party that reports its financial statements on a consolidated basis. o Majority Commonly Owned Affiliates New Swaps. For swaps between a counterparty that owns a majority interest in the other counterparty or between counterparties that are majority commonly owned (directly or indirectly) by a party that reports its financial statements on a consolidated basis, the no-action relief would allow a party to only report the information required under the regulatory reporting rule and the end-user exception rule on a quarterly basis (no more than 30 days after the entity s fiscal quarter, beginning with the quarter ending June 30, 2013), as long as public reporting requirements do not apply to the individual swaps. (As noted above, public reporting does not apply to trades that are not arms length. ) o All Affiliates Historical Swaps. The no-action relief from historical reporting applies to any swaps between affiliates, whether 100% or majority owned or commonly owned. Recordkeeping Obligations Still Apply. Any end user subject to this relief must still retain records of all swaps as required by the regulatory reporting and historical reporting rules. If an End User Is Not a Reporting Party, Does It Have Any Reporting Obligations? End Users Must Obtain a Legal Entity Identifier. Even in those situations where end users are not responsible for reporting swap data to the relevant data repository, the CFTC requires that each counterparty to a swap be identified in all recordkeeping and all swap data reporting by means of a single legal entity identifier. As a result, end users must obtain a legal entity identifier for each legal entity entering into derivatives transactions Legal entity identifiers may be obtained online at 24

186 End Users May Need to Provide Consent. In addition to obtaining a legal entity identifier, an end user may be required, under applicable non-u.s. laws, to consent to having its data reported to the relevant SDR by its SD or MSP counterparty. TIMING FOR COMPLIANCE. o Reporting requirements for SDs and MSPs are already in effect. o Under no-action relief issued by the CFTC staff (the End-User Reporting No-Action Letter ), 40 public and regulatory reporting requirements for non-financial end users, in those instances in which the end user is the reporting party, are currently scheduled to become effective with respect to IRS and CDS on July 1, 2013, 41 and with respect to equity swaps, foreign exchange swaps and commodity swaps, on August 19, Historical reporting requirements for non-financial end users are scheduled to become effective October 31, o Under the End-User Reporting No-Action Letter, public and regulatory reporting requirements for financial end users, in those instances in which the financial end user is the reporting party, are currently scheduled to become effective with respect to IRS and CDS on April 10, 2013, and with respect to equity swaps, foreign exchange swaps and commodity swaps, on May 29, Historical reporting requirements for financial end users are scheduled to become effective September 30, See Time-Limited No-Action Relief for Swap Counterparties that are not Swap Dealers or Major Swap Participants, from Certain Swap Data Reporting Requirements of Parts 43, 45 and 46 of the Commission s Regulations, CFTC (APR. 9, 2013). Non-financial end users must report by August 1, 2013 any data relating to IRS and CDS from the period between April 10, 2013 and July 1, Non-financial end users must report by September 19, 2013 any data relating to equity swaps, foreign exchange swaps and commodity swaps from the period between April 10, 2013 and August 19, Financial end users must report by June 29, 2013 any data relating to equity swaps, foreign exchange swaps and commodity swaps from the period between April 10, 2013 and May 29,

187 How Does Dodd-Frank Change the Way Swap Transactions Are Documented? In General. Under Dodd-Frank, SDs and MSPs entering into swap transactions are subject to a host of regulations, some of which require them to make and receive certain representations and agreements from their counterparties and receive certain information about their counterparties. SDs and MSPs Are Subject to External Business Conduct Standards that May Have an Impact on End Users. Dodd-Frank provided the CFTC with mandatory and discretionary rulemaking authority to impose business conduct standards on SDs and MSPs. 44 Although these standards relate to the conduct of SDs and MSPs, certain of the requirements may impose indirect obligations on end users or require the satisfaction of certain pre-execution requirements. o End Users Will Be Asked to Make Certain Representations to SD and MSP Counterparties. Know Your Counterparty. SDs are required to have policies and procedures reasonably designed to obtain and retain a record of essential facts concerning a known counterparty to a swap transaction. As such, SDs may ask end users for (i) facts required to comply with applicable law and to ensure compliance with the SD s internal credit and operational risk management policies; and (ii) information regarding the authority of any person acting for the counterparty. True Name and Owner. SDs and MSPs are required to obtain and retain a record of the true name and address of the counterparty, guarantors, underlying principals and any persons exercising control with respect to the positions of such counterparty. Eligibility Verification. Before entering into a swap transaction, an SD or MSP must (i) verify that its counterparty is an ECP and (ii) determine whether its counterparty is a Special Entity or eligible to elect to be treated as a Special Entity. Suitability. The CFTC requires that an SD have a reasonable basis to believe that any swap or trading strategy involving swaps that it recommends to a counterparty is suitable for such counterparty. Thus, recommendations trigger a duty by SDs to undertake reasonable diligence to understand the risks and 44 See 77 Fed. Reg (Feb. 17, 2012) ( External Business Conduct Standards Final Rule ). 26

188 rewards of a swap and to have a reasonable basis to believe the swap is suitable to the counterparty s needs. o SD Safe Harbor. For an end user that is not a Special Entity, suitability requirements are met in circumstances where (i) the end user or its representative represents it is exercising independent judgment and (ii) the SD represents it is not evaluating the suitability of any recommendation. o Impact on End Users. In order to rely on the safe harbor, an SD may request that an end user or its representative represent that it is exercising independent judgment and is capable of evaluating the swap transaction. o Additional Obligations Involving Special Entities. Additional obligations apply to SDs or MSPs transacting with Special Entities. For more information, please refer to our April 12, 2012 Alert Memorandum entitled CFTC Adopts External Business Conduct Standards. 45 o SDs and MSPs Must Provide End Users with Certain Information. Scenario Analysis. For swaps not subject to Dodd-Frank s mandatory SEF trading requirement, an SD must offer to provide a scenario analysis to end users, and must provide the analysis if the end user requests it. The SD is required to design the scenario analysis in consultation with the end user and must also disclose all material assumptions and calculation methodologies used to perform the analysis (although it is not required to disclose any confidential, proprietary information about any model used to prepare the analysis). Clearing. If a swap is subject to mandatory clearing, an SD or MSP will be required to notify an end user counterparty of its right to select the DCO. If the swap is not subject to mandatory clearing, the SD or MSP will be required to notify such counterparty of its right to elect to require the swap to be cleared and to select the DCO. Certain Disclosures. SDs and MSPs will need to update documentation to provide end users with information about the following: 45 Available at: 27

189 o material risks; o material contract characteristics of the swap transaction; o material incentives and conflicts of interest; and o notification that an end user counterparty has the right to receive the DCO s daily mark for a cleared swap. TIMING FOR COMPLIANCE. The CFTC has extended the date by which SDs/MSPs must comply with most of the External Business Conduct Standards until May 1, Swap Trading Relationship Documentation. CFTC rules require that SDs and MSPs, but not end users, comply with certain swap trading relationship documentation requirements. These rules require that SDs and MSPs establish policies and procedures reasonably designed to ensure that they execute written (electronic or otherwise) swap trading relationship documentation with their counterparties that includes, among other items, all terms governing the swap trading relationship and all credit support arrangements. 47 o Requirement for Financial End Users to Agree to a Valuation Process. For swap transactions with financial end users, the financial end user and its SD or MSP counterparty must have written documentation in place in which the parties agree on the process for determining the value of each swap. Non-financial end users do not have a similar requirement, although they may request such documentation. o Documentation of Any Exception to or Exemption from Mandatory Clearing and Trading. Swap documentation must state whether an end user is relying on an exception or exemption from mandatory clearing and trading for a particular transaction. Portfolio Reconciliation. If an end user enters into swap transactions with an SD or MSP, such SD or MSP may request that an end user perform portfolio reconciliation on either a quarterly or annual basis (depending on the level of swap activity with the counterparty). Portfolio reconciliation is the process by which the counterparties to a swap (i) exchange the terms of all swaps between them, (ii) exchange valuations (i.e., the current market value or net present value) of each swap between them as of the close of business on the immediately preceding business day, and (iii) resolve any discrepancies in material terms (including the swaps primary economic terms) and valuations See 78 Fed. Reg. 17 (Jan. 2, 2013) ( Extension of Compliance Dates ). See 77 Fed. Reg. 55,904, 55, (Sept. 11, 2012) ( Swap Documentation Final Rule ). 28

190 Portfolio Compression. SDs and MSPs are required to establish written policies and procedures for portfolio compression with end users. Thus, although end users are not required to engage in portfolio compression, SDs and MSPs may ask end users to engage in compression from time to time. Portfolio compression is the process by which an SD or MSP and one or more counterparties wholly terminate or change the notional value of some or all of the swaps being considered in the compression process and, depending on the methodology being employed, replace the terminated swaps with other swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated swaps being considered in the compression process. Swap Confirmation. The CFTC enacted rules requiring that SDs and MSPs send post-trade acknowledgments to swap counterparties as well as execute posttrade confirmations for each swap transaction into which they enter (other than those cleared with a DCO or traded on a DCM or SEF). In general, end users will not be responsible for confirming swap transactions. That said, in order to satisfy its own obligations, an SD or MSP may request that an end user take certain actions, such as signing an acknowledgment of the legally binding terms of a swap transaction. Request for Draft Acknowledgment. An end user may request a pre-trade draft acknowledgment from an SD or MSP prior to entering into a swap transaction. TIMING FOR COMPLIANCE. The Swap Confirmation and Portfolio Compression rules are already in effect. Compliance with the Swap Trading Relationship Documentation and Portfolio Reconciliation rules has been delayed until July 1, How Does the Market Plan to Implement Such Changes in Required Documentation? ISDA s Dodd-Frank Protocols. ISDA has completed two new protocols in order to provide standardized agreements, representations and information necessary to make the parties who subscribe to them compliant with Dodd- Frank. 49 o The August 2012 DF Protocol. The August 2012 DF Protocol is intended to help parties to swap transactions comply with certain of the requirements under Dodd-Frank, including the External Business Conduct Standards. The framework is meant to supplement new or See Extension of Compliance Dates. Information on the Protocols may be found on ISDA s website at: 29

191 existing swap agreements (documented via an ISDA master agreement or other long-form confirmation) with SDs and MSPs in order to bring them into compliance with the initial set of rules finalized by the CFTC. 50 o The March 2013 DF Protocol. The March 2013 DF Protocol is intended to bring new or existing swap agreements into compliance with additional rules finalized by the CFTC since the August 2012 DF Protocol, including the Swap Trading Relationship Documentation, Portfolio Reconciliation, Portfolio Compression and Swap Confirmation rules. 51 o Ongoing Process. As the CFTC continues to finalize its rulemaking process, parties to swap transactions will need to update their documentation to remain in compliance with applicable regulations. Impact on End Users. The CFTC rules covered by the ISDA Dodd-Frank Protocols do not directly apply to end users. Rather, Dodd-Frank imposes certain obligations on SDs and MSPs. In order to continue to deal in swaps with SDs and MSPs once compliance with Dodd-Frank s swap regulatory rules are required, end users will either need to enter into the Dodd-Frank Protocol, amend their ISDA master agreements with such SDs and MSPs, or otherwise enter into separate agreements or supplements to provide individualized representations and disclosures. SD or MSP counterparties may not be able to continue to transact with end users who do not sign on to the August Dodd-Frank Protocol or execute alternative bilateral documentation by May 1, Adhering to the Dodd-Frank Protocols. In order to take advantage of the Dodd-Frank Protocols, end users must submit an adherence letter to ISDA in which the end user agrees to certain of the terms that comprise the Dodd-Frank Protocols. Submission of the adherence letter will not, however, amend existing agreements with SD or MSP counterparties. In order to amend existing agreements, each end user must complete a questionnaire that includes representations about the legal status of the end user. The end user can choose which counterparties will receive its completed questionnaire. When an end user s questionnaire is matched to its SD or MSP counterparty, the existing swap transaction is amended to conform to the those requirements of the Title VII regime covered by the Protocol. Limited Flexibility of the Dodd-Frank Protocols. The Dodd-Frank Protocols are not negotiable. If either party to a swap does not wish to enter into a protocol, then the parties must enter into a bilateral agreement to bring the swap Parties may access information about August 2012 DF Protocol at: Parties may access information about March 2013 DF Protocol at: 30

192 agreements into compliance with the applicable CFTC regulations. There is, however, some flexibility built into the Dodd-Frank Protocols in that parties to each Protocol need only adopt those optional schedules applicable to their particular swap transaction. End users should consult with both their SD or MSP counterparties and counsel in order to determine the parameters of any amendments. TIMING FOR COMPLIANCE. There is currently no cut-off date for adherence to the Dodd-Frank Protocols. That said, many of the rules that give rise to the need for the August 2012 DF Protocol and the March 2013 DF Protocol become effective on or before May 1, 2013 and July 1, 2013, respectively. 31

193 Does Dodd-Frank Impose New Recordkeeping Obligations? General Recordkeeping Requirements for End Users. CFTC rules require end users that conduct swaps to keep full, complete, and systematic records, together with all pertinent data and memoranda with respect to each of their swaps for a period of five years following termination of the swap. Records can be kept in either paper or electronic form, as long as the records are retrievable upon request by the CFTC within five business days. CFTC Large Swap Trader Reporting. Dodd-Frank enacted and the CFTC implemented certain large swap trader reporting requirements applicable to persons that enter into swaps linked to specified physical commodity futures contracts. While the relevant CFTC rules impose these reporting requirements on DCOs, clearing members and SDs, certain end users that own or control 50 or more gross all-months-combined futures equivalent positions in the relevant types of physical commodity swaps are required to keep records related to those swaps and must produce them upon request by the CFTC. 52 TIMING FOR COMPLIANCE. Requirements for the retention of swap data records are already in effect.. 52 See 76 Fed. Reg. 43,851 (July 22, 2011). 32

194 Does Dodd-Frank Impose New Rules With Respect to Position Limits? In General. Dodd-Frank allows the CFTC to set aggregate position limits on futures and options on physical commodities and economically equivalent swaps. It also narrowed the definition for bona fide hedging transactions exempted from position limits. 53 As a result, the CFTC adopted rules that would have applied maximum aggregate position limits across twenty-eight designated listed physical commodity futures contracts and economically equivalent swaps. Position Limit Rules Currently Invalid. On September 28, 2012, the District Court for the District of Columbia enjoined and vacated the CFTC rules regarding position limits. The CFTC has approved an appeal of the District Court s decision. It remains possible that the CFTC will propose new position limit rules. TIMING FOR COMPLIANCE. Not yet applicable. 53 CEA 4a(a). 33

195 How Will Dodd-Frank s New Antifraud and Antimanipulation Rules Affect End Users? In General. End users, even those making use of certain exceptions or exemptions discussed in this memorandum, are subject to the CFTC s antifraud and antimanipulation provisions. New CFTC Rules Prohibiting Fraudulent Activity. With respect to swaps, Dodd-Frank amended the CEA to prohibit fraudulent activity, including material misstatements and omissions in connection with futures contracts, options on futures contracts and swaps. The CFTC s rules harmonize the scope of liability for deceitful behavior and CFTC enforcement under the CEA with fraud liability and SEC enforcement under Section 10(b) of the Exchange Act. New CFTC Rules Prohibiting Manipulation. Dodd-Frank amended the CEA, and the CFTC has adopted rules, to provide that no person is permitted to engage in any manipulative or deceptive behavior related to any swap, commodity or futures contract or to attempt to manipulate the price of any swap, commodity or futures contract. 54 Do the CFTC Rules Impose New Disclosure Obligations? In its adopting release, the CFTC noted that its new rules do not impose any new disclosure obligations on market participants. That said, market participants could violate the rules due to a breach of other disclosure requirements in the CEA or associated CFTC rules, or by trading on material non-public information (i) in breach of a pre-existing duty (established by law, agreement, or understanding) or (ii) that was obtained through fraud or deception. The application of this guidance to the non-securities derivatives markets, where market participants often trade on the basis of non-public information for hedging purposes, remains unclear. TIMING FOR COMPLIANCE. These rules are already in effect. 54 CFTC Regulations ; see also 76 Fed. Reg. 41,398 (July 14, 2011) ( Antifraud Final Rule ). In applying the rule prohibiting price manipulation, the CFTC noted that it will use a four-part test, specifically, that: (i) the accused had the ability to influence market prices, (ii) the accused intended to create a price or price trend that does not reflect legitimate forces of supply and demand, (iii) artificial prices existed and (iv) the accused caused the artificial prices. See Antifraud Final Rule, 76 Fed. Reg. 41,398, 41,407 (July 14, 2011). 34

196 Will Dodd-Frank Impose Requirements on Swaps Between Non-U.S. Persons? In General. The CFTC has issued a release regarding the cross-border application of its rules in the form of proposed interpretive guidance in June 2012 (the Proposed Guidance ). 55 In addition, on December 21, 2012, the CFTC issued an exemptive order that would delay the effectiveness of certain provisions of Dodd-Frank until July 2013 (the Exemptive Order ). 56 The Exemptive Order and the Proposed Guidance would define which entities qualify as U.S. persons and are therefore generally subject to rules under Dodd-Frank. In addition, the Proposed Guidance would define the circumstances under which non-u.s. persons would be required to register with the CFTC as SDs or MSPs (as well as which of the rules applicable to SDs and/or MSPs would apply). Who Is a U.S. Person? Under the Proposed Guidance and Exemptive Order, whether CFTC rules apply to an end user largely depends on whether either it or its counterparty is a U.S. person. Under the Exemptive Order, a U.S. person includes: (i) (ii) (iii) (iv) (v) any natural person who is a resident of the United States; any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund, or any form of enterprise similar to any of the foregoing, in each case that either (A) is organized or incorporated under the laws of the United States ( legal entity ) or (B) for all such entities other than funds or collective investment vehicles, has its principal place of business in the United States; any individual account (discretionary or not) where the beneficial owner is a U.S. person; a pension plan for the employees, officers, or principals of a legal entity with its principal place of business in the United States; and an estate or trust, the income of which is subject to United States income tax regardless of source. The Proposed Guidance included a broader U.S. person definition, particularly with respect to the coverage of funds organized outside the U.S. The CFTC continues to consider what final definition to adopt See 77 Fed. Reg. 41,214 (July 12, 2012). See also CGSH Alert Memo, CFTC Proposes Guidance on Cross-Border Application of Title VII of the Dodd-Frank Act (July 3, 2012). See 78 Fed. Reg. 858 (Jan. 7, 2013). 35

197 Requirements Applicable to Non-U.S. Persons. o Under the Exemptive Order, non-u.s. persons are only subject to requirements with respect to swaps with U.S. persons. However, under the Proposed Guidance, swaps with non-u.s. persons whose obligations are guaranteed by a U.S. person and non-u.s. persons who are deemed conduits of a U.S. person would also be subject to Dodd-Frank under certain circumstances. A non-u.s. person would be considered to operate as a conduit for swaps in which (i) the non-u.s. person is majorityowned, directly or indirectly, by a U.S. person; (ii) the non-u.s. person regularly enters into swaps with one or more U.S. affiliates or subsidiaries of the U.S. person; and (iii) the financials of the non-u.s. person are included in the consolidated financial statements of the U.S. person. o Therefore, a non-u.s. end user would generally be subject to clearing, trade execution, business conduct, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, regulatory reporting, trade confirmation, margin and swap data recordkeeping only in the case of swaps with U.S. persons. 57 o Although the CFTC has proposed to treat foreign branches of U.S. persons as U.S. persons, the CFTC has temporarily exempted swaps entered into by non-u.s. persons and foreign branches of U.S. swap dealers from compliance with certain requirements, such as clearing and trading, margin and segregation for uncleared swaps, swap trading relationship documentation, portfolio reconciliation and compression, public reporting, trade confirmation, daily trading records and external business conduct standards. 58 o Other requirements, such as antifraud and antimanipulation rules and position limits, would apply to all of a non-u.s. person s swaps, including swaps with non-u.s. person counterparties. * * * The Prudential Regulators proposal regarding margin for uncleared swaps is similar to the CFTC s Proposed Guidance. The Prudential Regulators margin collection requirements would not apply to a transaction between a non-u.s. domiciled counterparty (other than a branch or office of a U.S. person or a counterparty whose obligations are guaranteed by a U.S. affiliate) and a foreign registered swap dealer or major swap participant. However, for these purposes, a foreign registered swap dealer or major swap participant would not include a branch or office of a U.S. person or an entity controlled by a U.S. person. Depending on the territorial scope of CFTC registration requirements, the proposed margin rules could result in a significant expansion in the extraterritorial application of U.S. law that could intensify the competitive disparities faced by U.S.-domiciled bank holding companies operating outside the United States. See Exemptive Order, 78 Fed. Reg. 858, at

198 Please call any of your regular contacts at the firm or any of the partners and counsel listed under Derivatives in the Practices section of our website ( if you have any questions. CLEARY GOTTLIEB STEEN & HAMILTON LLP 37

199 Appendix A: Summary of Dodd-Frank Requirements Applicable to Non-Financial End Users Requirement Summary description Are non-financial end users generally required to comply with the requirement? Registration as SD/MSP Mandatory Clearing Mandatory Trade Execution ECP Trading Requirement Margin for Uncleared Swaps Real-Time Public Reporting Regulatory Reporting Recordkeeping Certain parties will need to register with the CFTC, triggering a host of regulations CFTC will require that certain designated derivatives be cleared through a DCO CFTC will require that certain designated derivatives be traded on a DCM or SEF In general, only ECPs can enter into OTC swaps or guarantee such swaps Counterparties will generally need to post margin to SDs and MSPs The reporting party must make report trade information in real-time to SDRs or the CFTC The reporting party must make report trade information in real-time to SDRs or the CFTC Counterparties must retain records and documents related to trades No, if activity does not exceed relevant thresholds No, if swap is for hedging or mitigating commercial risk by non-financial end users No, if swap is for hedging or mitigating commercial risk by non-financial end users Compliance date? December 31, 2012 September 9, 2013 for non-financial end users for swaps not excepted. June 10, 2013 for financial end users for swaps not excepted. Rules have only been finalized with respect to certain IRS and CDS Rules have not been finalized Applies to end users who are not U.S. persons (under the Exemptive Order)? Yes, in calculating thresholds, must include transactions where a counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes Already in effect Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Requirement is relaxed for end users Yes, although SD and MSP counterparties will generally be responsible Yes, although SD and MSP counterparties will generally be responsible Rules have not been finalized Already in effect Already in effect Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes, if counterparty is U.S. person (including the non- U.S. branch of a U.S. SD) Yes Already in effect Yes, if counterparty is U.S. person (including the non- U.S. branch of a U.S. SD) 38

200 Requirement Summary description Are non-financial end users generally required to comply with the requirement? Swap Documentation External Business Conduct Standards Position Limits Antifraud and antimanipulati on Trades must be documented pursuant to CFTC rules SD and MSP counterparties will respect that end users provide certain representations CFTC s rule regarding position limits has been vacated CFTC rules prohibit fraud and manipulation involving swaps The requirements imposed on end users are limited The requirements imposed on end users are limited Compliance date? Swap confirmation and portfolio compression rules are already in effect. Swap trading relationship documentation and portfolio reconciliation rules are delayed until at least July 1, 2013 May 1, 2013 (for most standards) Applies to end users who are not U.S. persons (under the Exemptive Order)? Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Yes, if counterparty is U.S. person other than the non-u.s. branch of a U.S. SD Unclear Unclear Yes, if ultimately adopted Yes Already in effect Yes 39

201 Appendix B: Key CFTC Rulemakings Affecting End Users In General o Product Definitions Final Rule, 77 Fed. Reg. 48,208 (August 13, 2012) o Final Treasury Determination, 77 Fed. Reg. 69,694 (Nov. 20, 2012) o Registered Swap Entity Final Rule, 77 Fed. Reg. 30,596 (May 23, 2012) Clearing o Mandatory Clearing Requirement for Certain Interest Rate Swaps and Credit Default Swaps Proposal, 77 Fed. Reg. 47,170 (Aug. 7, 2012) o Clearing Requirement Determination, 77 Fed. Reg. 74,284 (Dec. 13, 2012) o End-User Exception Final Rule, 77 Fed. Reg. 42,560 (July 19, 2012) o Inter-Affiliate Exemption Final Rule, ralregister pdf (last visited Apr. 2, 2013) Trade Execution o SEF Proposal, 76 Fed. Reg (Jan. 7, 2011) o Available to Trade Proposal, 76 Fed. Reg. 77,728 (Dec. 14, 2011) Margin o Prudential Regulator Capital and Margin Proposal, 76 Fed. Reg. 27,564 (May 11, 2011) o CFTC Margin Proposal, 76 Fed. Reg. 23,732 (Apr. 28, 2011) Reporting o Real-Time Public Reporting Final Rule, 77 Fed. Reg. 1182, 1243 (Jan. 9, 2012) o Regulatory Reporting and Recordkeeping Final Rule, 77 Fed. Reg (Jan. 13, 2012) o Reporting of Unexpired Pre-Enactment Swaps Final Rule, 77 Fed. Reg. 35,200 (June 12, 2012) o Block Trade Proposal, 77 Fed. Reg. 15,460 (Mar. 15, 2012) Documentation & Business Conduct o Swap Documentation Final Rule, 77 Fed. Reg. 55,904, (Sept. 11, 2012) o External Business Conduct Standards Final Rule, 77 Fed. Reg (Feb. 17, 2012) o Internal Business Conduct Standards Final Rule, 77 Fed. Reg. 20,128 (Apr. 3, 2012) o Extension of Compliance Dates, 78 Fed. Reg. 17 (Jan. 2, 2013) Recordkeeping o Regulatory Reporting and Recordkeeping Final Rule, 77 Fed. Reg (Jan. 13, 2012) Antimanipulation o Antifraud Final Rule, 76 Fed. Reg. 41,398 (July 14, 2011) 40

202 Cross-Border Application o Cross-Border Proposed Guidance, 77 Fed. Reg. 41,214 (Jul. 12, 2012) o Final Exemptive Order Regarding Compliance with Certain Cross- Border Swap Regulations, 78 Fed. Reg. 858 (Jan. 7, 2013) o Further Proposed Guidance Regarding Compliance with Certain Cross- Border Swap Regulations, 78 Fed. Reg. 909 (Jan. 7, 2013) 41

203 Swaps: Dodd-Frank Memories Amid repeated Dodd-Frank extensions, swaps end-users may need an aide-mémoire , by Gordon E. Goodman Things are seldom what they seem, Skim milk masquerades as cream; Highlows pass as patent leathers; Jackdaws strut in peacock's feathers. -- "HMS Pinafore," Gilbert & Sullivan, 1878 At this point in the process of implementing the changes that were required by the Dodd-Frank Wall Street Reform and Consumer Protection Act -- with respect to recordkeeping, reporting and governance -- almost everything was supposed to have been completed by now. A final piece of the puzzle was to have occurred during April 2013, when real-time and general reporting was to have begun. However, as with many of the early Dodd-Frank schedules, the reporting deadline was extended through a "no-action" letter issued by the Commodity Futures Trading Commission (CFTC) during early April. The CFTC's repeated extensions may have lulled the risk community into a sense that perhaps it would all go away. This is not the case. So, for risk managers who may have forgotten the many changes required by Dodd Frank (and in particular for the non-swap dealers, non-major swap participants, non-financial entities and end-users), the following is a refreshed to-do list, an aide-mémoire. This article is intended to cover many of the issues and questions confronted by "end-users." End-user is the generic term that I will use in this article when talking about the "nons" generally, but please note that though speculative traders and end-users are both "nons," they have quite different requirements under Dodd-Frank with respect to mandatory clearing. Each end-user should consider its own circumstances in designing an appropriate compliance program, because this article does not cover every minute detail. End-User Qualification To begin, in order to qualify as an end-user (Category 3), a company must be neither a swap dealer nor a major swap participant (Category 1). Nor can the company be a "financial entity" (Category 2). In a subsequent article, I will provide more detail on financial entities (one of the less discussed terms in Dodd-Frank), but for present purposes, they are persons predominantly engaged in activities that are financial in nature, as defined by the Federal Reserve under the Bank Holding Company Act. With respect to the first part of the end-user requirement (i.e., being neither a swap dealer nor an MSP), this can only be determined by running the "de minimis" tests that determine whether a company is a swap dealer and the various MSP tests that determine whether a company is a major swap participant.

204 In particular, end-users should make sure that they are not dealing in significant quantities of swaps with "special entities" (primarily government organizations) under Dodd-Frank. At a minimum, end-users should stay well under the de minimis thresholds that apply to swap trades with special entities. The $8 billion threshold that generally applies under the de minimis test drops to $800 million for special entities that engage in utility operations and to just $25 million for non-utility special entities (all calculated on gross notional amounts). One additional point for foreign companies to keep in mind is that the definition of a "financial entity" is based on the percentage of their assets and income that are derived from financial activities (sometimes called the "85/85" test). This calculation can be significantly influenced by how derivatives are treated within the company's financial statements -- U.S. Generally Accepted Accounting Principles present derivatives on a net basis while the European International Financial Reporting Standards present derivatives on a gross basis. End-User Next Steps Assuming a company qualifies for the end-user exemption from mandatory clearing (see above), companies that are subject to SEC reporting obligations (generally, U.S. public companies) must then adopt annual board resolutions to make this election. These resolutions can be adopted by the board itself or by a suitable committee of the board -- e.g., the audit committee or the finance committee. Though there is no statement within Dodd-Frank about companies that are not subject to SEC reporting obligations, it is a best risk practice for all companies that claim end-user status to adopt these same board resolutions. Swap dealers will probably be asking for proof of end-user status to all of their customers under Dodd-Frank's "know your counterparty" (KYC) rules that apply to swap dealers, so companies claiming end-user status should adopt appropriate board resolutions. Under CFTC rules, the annual board resolution must be filed with a swap data repository (SDR). For non-reporting end-users (i.e., end-users whose counterparties will do the swap reporting), this may be an issue if they do not have an existing relationship with an SDR. Based on recent discussions, at least one of the SDRs is working on providing a filing mechanism for the nonreporting end-users at this time. Keep in mind that the purpose of filing a board resolution with an SDR is to claim an exemption from the mandatory clearing requirement, but to date there have been few swap categories listed by the CFTC that are actually subject to mandatory clearing. In particular, the CFTC has yet to include any of the energy commodity swaps in the list of swaps subject to mandatory clearing -- so the timing for adoption of a board resolution has been extended (originally, this was due to be in place by September 2013). Hedging As part of this board resolution, a company claiming end-user exemption from mandatory clearing must represent that it uses swaps to hedge or mitigate commercial risk arising from its underlying physical business -- e.g., oil and gas production or gasoline refining. An important

205 point to consider is that the board resolution itself is necessary, but not sufficient, to receive an exemption from mandatory clearing. The transactions themselves must be used for hedging purposes. What this means is that even after making an election and filing the annual board resolution with an SDR, a company can still only be exempted from mandatory clearing if its swaps are really being used for hedging purposes. Assume for a moment that a company uses swaps for two purposes within its business: to hedge its physical oil and gas production and to engage in some limited speculative trading activity. In effect, it is an end-user when it is hedging its physical transactions, but it is a trader when it engages in speculative activity (for which the exemption from mandatory clearing is not available). A company like this should still proceed to pass an appropriate board resolution claiming exemption from mandatory clearing, but only for those transactions that are being used as hedges (and not for its speculative trading activity). Remember that end-users and speculative traders are both "nons," but they have different results under Dodd-Frank with respect to the mandatory clearing exemption rules. Another point to consider is that qualifying swaps are also excluded from certain parts of the de minimis and MSP tests. In order to qualify as a hedge, swaps must come under one of the following standards: the "mitigation of commercial risk" standard (the Dodd-Frank standard), the "bona fide hedge" standard (the Commodities Exchange Act standard) or the accounting hedge standards set by FASB. De Minimis and MSP Tests Going forward, the de minimis and MSP tests described previously have to be run on a regular basis. A company that passes these tests today (and therefore can initially qualify for end-user status) may fail these same tests next year or the year after. So building a robust mechanism for running these tests as part of a company's base risk system is an important consideration. The de minimis calculations are run on a trailing 12-month basis in relation to the gross notional amount of a company's dealing swaps, while MSP tests are run on a quarterly basis looking at current and expected future exposures (MTMs) of the company's swaps (but only looking at the negative MTM values). The de minimis tests currently have three thresholds: an $8 billion threshold for all entities, an $800 million threshold for utility special entities and a $25 million threshold for non-utility special entities. The CFTC has indicated that these thresholds will apply during a "phase-in" period that will last about five years. At the end of the phase-in period, the CFTC may reduce its de minimis thresholds to lower levels. The MSP tests are more complicated than the de minimis tests, but they have been set at levels that should only capture the very largest swap market participants. The details of the MSP tests will be studied in more detail in a subsequent article.

206 It is logical to anticipate that if any company expects to fail the MSP test for a quarterly period, it would probably file an election to become a swap dealer, since the MSP status carries most of the burdens with few of the benefits associated with swap dealer status. Meeting Financial Obligations In the board resolution electing end-user exemption from mandatory clearing, a company must indicate how it will meet its financial obligations. For companies that have historically set the margin thresholds in their ISDA credit support annex (CSA) at relatively high levels in order to avoid the need for daily exchanges of margin, they may want to reconsider the best levels to set under Dodd-Frank. One of the surprising issues to consider is that unused thresholds within CSAs (i.e., the difference between a company's actual exposure and its collateral threshold levels) are considered to be a form of credit facility that can get included in some of the MSP test calculations. (The MSP tests can also be calculated under an alternative methodology that excludes these unused thresholds, but this alternative methodology has some of its own issues, which will be discussed further in a subsequent article.) There are five methods set by the CFTC for meeting financial obligations within a board resolution under Dodd-Frank: (1) a written credit support agreement (this could be the CSA attached to the ISDA); (2) pledged or segregated assets (including posting or receiving margin pursuant to a credit support agreement or otherwise); (3) a written third-party guarantee; (4) the electing counterparty's available financial resources (this is an alternative to the CSA route); or (5) means other than those described. Who Has the Reporting Obligation? In general, if a transaction is concluded on an exchange, no further reporting is required. For off-exchange (OTC) transactions, one of the two parties to a swap must report the transaction to an SDR. If a Category 3 entity (i.e., an end-user) does a swap transaction with a Category 1 entity (swap dealers and MSPs) or a Category 2 entity (a financial entity), then the Category 1 or Category 2 counterparty has the reporting obligation (and not the end-user). The question arises: what happens when two end-users do a swap with each other? The answer is that if one of the end-users is a "U.S. entity" (as that term is defined under Dodd- Frank) and the other is not a U.S. entity, then the end-user that is a U.S. entity has the reporting obligation. A second question naturally arises: what happens when both are U.S. entities or both are not U.S. entities? The answer is that the parties have to agree on who will do the reporting. The main point to keep in mind is that for all swaps, someone has to do the reporting to the SDR. There is no free lunch.

207 When is the Reporting Required? Originally, all swaps were subject to reporting requirements that were to have begun on 4/10/13. This included "pre-enactment" swaps (swaps that were in effect on 7/21/10, when Dodd-Frank was enacted) and "transition" swaps (swaps that were executed after 7/21/10 but before 4/10/13). This original schedule was revised for non-financial counterparties (i.e., end-users) under a "noaction" letter issued by the CFTC during early April 2013 (Letter No ). The revised Dodd-Frank reporting schedule for end-users is now as follows (please note that the Dodd-Frank standard for reporting transaction data is generally in "real time," but this term is defined differently for different types of swap participants): Credit/interest rate swaps entered into after 7/21/13: subject to Dodd-Frank standards Credit/interest rate swaps entered into from 4/10/13 to 7/21/13: 8/1/13 Equity/FX/ commodity swaps entered into after 8/19/13: subject to Dodd-Frank standards Equity/FX/ commodity swaps entered into from 4/10/13 to 8/19/13: 9/19/13 All historical swaps that were in existence from 7/21/10 to 4/10/13: 10/31/13 Dodd-Frank Recordkeeping for End-Users End-users must keep full, complete and systematic records of all their swap transactions. The recordkeeping requirements apply to pre-enactment, transition and post-4/10/13 records. Records should be kept in electronic format unless they were originally created in paper format and have been maintained as such. Records must be kept for five years from the termination date of the swap, with the exception of audio records, which must be kept for one year from termination date. Please note that these same recordkeeping requirements apply to certain related physical transactions. Specifically, these are the physical transactions that are the hedged items for which hedge treatment is being claimed with respect to an end-user's hedging swaps. Final Issues and Parting Thoughts End-users should obtain legal entity identifiers (LEIs or CICIs) for each corporate entity that trades in swaps. End-users should also consider possible adherence to the August 2012 ISDA protocol. Though this article has discussed many of the more common issues that have arisen for endusers trying to comply with the new Dodd-Frank requirements, inevitably there will be some important issues that have not been covered. There will also inevitably be additional "no-action" letters and further changes in the Dodd-Frank regulatory structure before all is said and done. For this reason, this article is intended only as the first in a series of similar articles dealing with additional specific Dodd-Frank issues.

208 Dodd-Frank s Impact on Financial Entities, Financial Activities and Treasury Affiliates Swaps compliance requirements are complex , by Gordon E. Goodman The compliance requirements for the Dodd-Frank Act (DFA) are complex. On one end of the spectrum, we have DFA "end users" that are not subject to the act's mandatory clearing rules, but are subject to certain reporting and record-keeping requirements. On the opposite end, there are swap dealers, major swap participants and "financial entities" -- three categories of companies that are subject to mandatory clearing, along with much more rigorous reporting and record-keeping requirements. The financial entities category is perhaps the most intriguing, partly because it is the least discussed of the types of companies under the DFA that cannot seek exceptions from the mandatory clearing requirement. Mandatory clearing is the obligation to clear swaps at a regulated entity (like an exchange or derivatives clearing organization (DCO)) and post full collateral. Financial entities also have the obligation to report swaps to swap data repositories (SDRs) when they are trading with end-users and other non-financial entities. In the DFA, a "financial entity" is described by Congress as any company that is " predominantly engaged in activities that are financial in nature, as defined in the Bank Holding Company Act of 1956." The DFA, in turn, requires the Board of Governors of the Federal Reserve System (the Board) to establish the requirements for determining whether a company is "predominantly engaged in financial activities." Given the broadness of the Board's definition of "financial activities," the financial entities category may actually include more companies than the two more widely-discussed DFA categories of swap dealers and major swap participants. Moreover, for many purposes, being labeled a "financial entity" under the DFA may be burdensome -- especially for companies that do not particularly consider themselves to be "financial" companies. Surprisingly, a significant number of subsidiary companies that centrally execute financial instruments for large diversified corporations may be considered financial entities under the DFA, but they may also qualify for an exception under the CFTC's recent noaction letter on "treasury affiliates." What is a Financial Entity? Under the DFA, just like swap dealers and major swap participants, financial entities (most of them, at least) are excluded from making an election that is otherwise available to end-users to be exempt from the DFA's mandatory clearing requirements.

209 The broader term "financial company" within the DFA includes not only financial entities but also bank holding companies and certain non-bank financial companies that are supervised by the Board. Very large (or significant) non-bank financial companies can also be determined to be systemically important under the DFA. As a result, they can become subject to additional regulation, like the Orderly Liquidation Act (OLA). What are Financial Activities? In its final rule on the definition of "Predominantly Engaged in Financial Activities," issued in April 2013, the Board determined that certain investing and trading activities should be considered activities that are financial in nature under the Bank Holding Company Act. Since the Board's definition of financial activities also covers activities that are not regulated under the DFA (e.g., trading in forward contracts), it is not yet clear how these two sets of related regulations (i.e., the Board's rules on financial activities and the CFTC's rules on the exception from clearing) will be interpreted. For example, should trading in forward contracts be included or excluded from the "predominantly engaged" tests that are described below? The DFA provides that a company will be considered to be predominantly engaged in financial activities if more than 85% of its annual gross revenues or if more than 85% of its consolidated assets are financial in nature. For companies that do not have a centralized subsidiary used for their corporate hedging activities, the two 85% tests may not be a problem, but a review should be conducted for all corporations that trade in swaps. What are Captive Finance Companies and Treasury Affiliates? In its so-called final rule for the "End-User Exception to the Clearing Requirement for Swaps," the DFA provides a potential exception for captive finance companies that have been deemed financial entities. That rule states that a financial entity does not include any company whose "primary business is providing financing." In order to qualify for this fairly limited exception for captive finance companies, a company must use derivatives for the purpose of hedging its underlying commercial risks related to interest rate or foreign exchange exposures. In addition, 90% or more of these risks must arise from financing that facilitates the purchase or lease of products manufactured by the parent company or a subsidiary of the parent company. More importantly for many diversified companies, in June 2013, the CFTC's Division of Clearing and Risk issued a no-action relief letter for certain treasury affiliates. If not for this letter, these affiliates might have been categorized as financial entities, and would therefore have been ineligible for an exception from the mandatory clearing requirement.

210 The no-action letter basically expands the existing exception within DFA that originally only covered treasury affiliates that act as agents for related subsidiaries. It includes treasury affiliates that act as principals when executing swaps for related subsidiaries. In order to claim the exception from mandatory clearing for treasury affiliates, a company must comply with all the requirements described in the no-action letter and also make the necessary filings with an SDR (similar to the annual filings that are required of end-users). A final exception to consider for certain cooperatives is one that the CFTC announced in August The CFTC, in its "Final Rule on the Clearing Exemption for Certain Swaps Entered Into by Cooperatives," determined that a cooperative whose members were all end-users would not be deemed a financial entity only because of the swaps that it executed for its member companies (even when acting as a principal). Closing Thoughts The definition of financial entities is the least well understood of the three categories of companies (swap dealers, major swap participants and financial entities) that are the most heavily regulated under the DFA. But for the CFTC's recent no-action letter on treasury affiliates, many diversified companies with centralized subsidiaries that execute financial instruments would have been subject to the DFA restrictions placed on financial entities. Companies should carefully review their use of swaps to determine whether they will be considered financial entities, as well as whether they may qualify for the treasury affiliate exception. Gordon E. Goodman is currently a consultant with the Alliance Risk Group. He previously held senior positions at both E.I. DuPont de Nemours & Co., where he served as president of its DuPont Power Marketing subsidiary, and at Occidental Petroleum Corporation, where he served as the trading control officer for its Occidental Energy Marketing subsidiary. He was the founding chairman of the American Petroleum Institute's (API's) Risk Control Committee, and he also served on the API's General Committee on Finance. He was a member of the Financial Accounting Standards Board's (FASB's) Valuation Resource Group (VRG) and earlier was a member of its Energy Trading Working Group (ETWG). He is currently on GARP's Energy Oversight Committee, which administers the Energy Risk Professional (ERP) certificate. His prior contributions to GARP's "Risk Review," "Risk Professional," and "Risk News & Resources" publications have included the following articles: "Dodd Frank Memories" (2013); "The Liquidity Risk Sweepstakes" (2012); "The Ethics of Business" (2012); "How to Value Guarantees" (2008); and "Credit Risk: Will the Bubble Burst?" (2007).