OTC derivatives. The challenge of deriving clear benefits. An in-depth look at regulatory changes and their impact on institutional investors

OTC derivatives The challenge of deriving clear benefits An in-depth look at regulatory changes and their impact on institutional investors A research publication from BNP Paribas

Managing editor Franck Lambert, Head of marketing, BNP Paribas Securities Services Contributing editors Florence Fontan, Head of European affairs, BNP Paribas Securities Services David Beatrix, Business development - market and financing services, BNP Paribas Securities Services Mark Armstrong, Legal European regulatory affairs, BNP Paribas Corporate and Investment Banking Nicolas Mehta, Head of OTC derivatives documentation, policy and development, BNP Paribas Corporate and Investment Banking Additional contribution Jeremie Pellet, Head of regulatory affairs, BNP Paribas Corporate and Investment Banking Florent Benhamou, Market risk products, BNP Paribas Securities Services Cyril Ettori, Head of market and counterparty risk analysis, BNP Paribas Securities Services Eric Roussel, Head of product management, trade and market solutions, BNP Paribas Securities Services Special thanks Jonathan Duff, Communications manager, BNP Paribas Securities Services Mark Hillman, Head of marketing and communications, BNP Paribas Securities Services

Table of contents

06 08 10 14 16 18 Executive summary Part 1: Overview of the regulatory initiatives affecting OTC derivatives 1.1 Dodd-Frank Act and EMIR: similar but different 1.2 Ucits and Solvency II: increasing requirements on the valuation of OTC derivatives Part 2: The impact of regulations on investment managers operations, financing needs and counterparty risk exposure 2.1 Operational aspects of the introduction of cleared OTC derivatives Navigating the documentation provisions Connecting to SEFs, affirmation platforms and trade repositories Renewing your approach to OTC derivatives valuation Adapting your collateral management set-up Choosing a clearing broker 30 2.2 New funding challenges The rise of collateral requirements Analysing your options for collateral optimisation and transformation 37 2.3 A new paradigm for counterparty risk The implications of CCP models Upgrading the approach to counterparty risk measurement 42 44 48 52 Next steps About BNP Paribas Glossary Contacts

Executive Summary

Over the years, over-the-counter (OTC) derivatives have given institutional and corporate investors a flexible tool for hedging a large range of risks. The swap market has grown very large. Then the 2008 financial crisis occurred and critics accused the OTC derivatives markets of triggering and amplifying the crisis due to the swap market s sheer size. Since the 2008 crisis, regulators have proposed a number of initiatives aimed at making the market safer. Chief among such initiatives are the Dodd-Frank Act in the US and the European Market Infrastructures Regulation (EMIR) in Europe. The two are similar in the way they treat OTC derivatives, particularly as they seek to mitigate systemic risk and boost transparency. However, there are a number of important differences that cannot be overlooked, raising the thorny issue of transatlantic regulatory arbitrage. In parallel, other regulations such as Europe s undertakings for collective investment in transferable securities (Ucits) directive and Solvency II frameworks are forcing institutional investors to be more risk-conscious when using OTC derivatives. At the heart of their requirements is the valuation challenge of complex instruments, with a clear objective to promote independent, sophisticated and more frequent pricing. Electronic execution and clearing are surely coming, in conjunction with a requirement to mark derivatives to market on a daily basis. In short, the barrage of regulatory initiatives will change the entire OTC derivatives industry dramatically and institutional investors will need to look closely at the impact of these initiatives on three areas: 1 2 3 Operations: first, diverging documentation requirements on both sides of the Atlantic will present legal challenges. Beyond that, frontand back- office teams will have to change the way they handle cleared OTC derivatives (interface/connectivity with execution and affirmation platforms among other things). At the same time, they must upgrade existing internal procedures and systems to meet more stringent requirements for un-cleared OTC derivatives. Middleoffice teams may struggle to adapt their reporting capabilities and valuation techniques for both cleared and un-cleared OTC derivatives, often referred to as portfolio bifurcation. This forces the issue for a hybrid yet state-of-the-art collateral management set-up. As a result of these operational changes, many institutional investors will look to outsourcing as a way to mitigate complexity. Funding: collateral requirements will become more complex and will ultimately rise due to new rules for collateral eligibility at CCPs and the co-existence of cleared and un-cleared OTC derivatives. This already worries investors, particularly in times of tight liquidity. Executing brokers and clearers will increasingly be judged on their skill in working with custodians to make the best use of collateral. Counterparty-risk measurement: centrally cleared OTC derivatives markets are deemed to be safer during times of adverse market conditions. However, investors will have to learn how to do business with a more diverse array of counterparties: dealers, clearers and central counterparties (CCPs), and to consider the best option to safeguard their collateral. Increasingly detailed regulatory provisions will challenge asset managers, especially in Europe, to measure counterparty risk at fund level. 7

Part 1: Overview of the regulatory initiatives affecting OTC derivatives 9

Part 1: Overview of the regulatory initiatives affecting OTC derivatives 1.1 Dodd-Frank Act and EMIR: similar but different From Pittsburgh to Washington and Brussels A little more than a year after the collapse of Lehman Brothers, the G20 countries met in Pittsburgh in September 2009. They passed a resolution stating: all standardised OTC derivatives contracts should be traded on the exchanges or via electronic trading platforms, where appropriate, and cleared through CCPs by end of 2012 at the latest. Principally, the resolution sought to allay systemic risk in the market for OTC derivatives, and to make transparent (pre- and post-trade) transactions that were widely perceived as opaque. It sparked a lively debate on both sides of the Atlantic about how best to overhaul and regulate the OTC derivatives markets. The US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) on 15 July 2010, which was signed into law by President Obama on 21 July, 2010. The implementation of the Dodd-Frank Act s derivatives reforms (contained in Title VII), initially due to take effect on 16 July 2011, has been delayed by the US regulators until later in 2012. Title VII of the Dodd-Frank Act creates a new regulatory framework for participants and products in OTC derivatives markets. It requires most derivative products to be traded on execution platforms, cleared through CCPs according to strict rules governing capital, margin, reporting, record keeping and business conduct, or collateralized on a bilateral basis, and reported to Swap Data Repositories. On 15 September 2010, the European Commission published its formal legislative proposal for regulation on OTC derivatives, central counterparties and trade repositories: European Market Infrastructures Regulation (EMIR). Like the Dodd-Frank Act, the proposed European Union (EU) Regulation aims to fulfil the commitments given at the G20 Pittsburgh summit: all standardised OTC derivatives should be cleared through CCPs by the end of 2012 at the latest. Moreover, EMIR contains additional provisions related to the confirmation process, collateral mechanisms, independent valuation and reporting of OTC transactions to trade repositories. The proposed EU Regulation is still in draft form and is subject to amendment during the EU legislative process. Political agreement on the final text is expected sometime in Q4 2011. Both the proposed EU Regulation and the Dodd-Frank Act envisage that there will be extensive regulatory standards that will significantly affect how the two regimes operate. In the EU, the European Securities and Markets Authority (ESMA) will have the important job of developing most of these standards and rules (to be finalised by the end of June 2012, albeit this seems like a moving target). In the US, the job falls mostly to the Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). 10 Objectives and spirit The Dodd-Frank Act and EMIR share the same approach when it comes to regulation of the OTC derivatives markets. Both seek above all to

mitigate systemic risk and increase transparency. However, there are significant differences between the two, and those differences are growing as EMIR passes through the legislative process in Brussels. The thorny issue of transatlantic regulatory arbitrage is ever present. The Dodd-Frank Act tackles some things that EMIR does not, but some of these will be addressed in a separate review by the EU s markets in financial instruments directive (MiFID). Notably, draft MiFIR (ie, the proposed amendments to MiFID will take the form of a directive and a regulation) will cover pre- and posttrade transparency requirements for OTC derivatives transactions and the non-equity markets, and the mandatory trading of OTC derivatives on organised trading facilities (OTFs) or derivatives trading venues (DTVs). A draft legislative proposal on the latter is expected from the European Commission in late October 2011. Both the draft EU Regulation and the Dodd-Frank Act aim to impose mandatory clearing and reporting obligations on a broadly defined class of OTC derivatives (with notable differences for some classes of derivatives). Both, however, allow regulators like ESMA in the EU and CFTC in the US to decide which derivatives are eligible and when the clearing obligation applies. The draft EU Regulation is potentially less burdensome for certain end-users for example, pension funds albeit that this is still a moving target in terms of the clearing obligation. Under the Dodd-Frank Act, the clearing obligation applies to everyone trading an eligible contract, although non-financial entities may escape them when entering into certain hedging transactions. In the EU, the clearing obligation applies to all financial counterparties. Non-financial counterparties only become subject to the clearing obligation when their positions exceed a specified clearing threshold yet to be defined by ESMA and certain hedges will be excluded. The Dodd-Frank Act imposes margin requirements on dealers and major swap participants entering into un-cleared transactions. At the counterparty s request, the initial margin (Independent Amount) must be segregated with an independent third party custodian. The latest compromise draft of the European Regulation discussed at Member State level requires financial counterparties to prove that they can measure, monitor and mitigate operational and credit risk (non-financial counterparties are exempt except when the clearing threshold is breached). Derivatives contracts entered into once the Regulation is in force must show that collateral has been accurately and appropriately exchanged. There is no mandatory requirement to segregate collateral in accounts, only a requirement to distinguish such collateral if a request is made by one of the parties prior to contract execution. However, the extent of segregation is not clear. Neither is there any distinction made between initial and variation margin. There are also questions as to whether segregation is at CCP level and at clearing-member level. The latest draft Regulation also considers permitting competent EU authorities to exempt intra-group transactions from the collateral requirements (such transactions are defined in the draft). Both the Dodd-Frank Act and the proposed EU Regulation envisage subjecting dealers to rules for registration and business conduct. The US regime also extends registration, conduct of business and margin/capital rules to major swap participants. 11

Part 1: Overview of the regulatory initiatives affecting OTC derivatives Both the Dodd-Frank Act and the proposed EU Regulation seek to allow cross-border clearing by permitting the recognition or exemption of non-domestic CCPs. It remains unclear, however, how these provisions will operate in practice. The Dodd-Frank Act requires compliance with all US rules providing trade repository services across borders (including indemnification). The proposed EU Regulation currently requires recognition of non- EU repositories by ESMA, provided certain conditions are met. Among these conditions is an international agreement with the third country and co-operation arrangements. We do not know yet what obligations EMIR and Dodd-Frank Act will impose when the parties to a transaction are on different sides of the Atlantic. The Dodd-Frank Act requires the execution of OTC derivatives contracts subject to the clearing obligation on a swap execution facility (SEF) or on a futures or securities exchange. The SEF or exchange will have to make the derivative available to trade, with post-trade transparency in real time for cleared derivatives and to position limits. In the EU, as noted previously, these issues are being addressed separately as part of the MiFID review. Until the European Commission publishes its legislative proposal later in 2011, it is premature to state to what extent the EU will mirror the relevant Dodd-Frank requirements. The EU proposals currently have no equivalent to the US push out rule restricting the derivatives activities of banks. They also do not have an equivalent to the Volcker rule that restricts banks from carrying out proprietary trading. Dodd-Frank Act and European Market Infrastructures Regulation: different speeds IIn Europe, EMIR is still under negotiation at the European Parliament. It is expected to be finalised before the end of 2011. EMIR is a European regulation, not a directive. This means it will pass directly into national law without a period of national transposition by each EU member state. Despite this fast-track approach, however, EMIR is not expected to come into force before the end of 2012 at the earliest as the European Commission, with the support of ESMA and other European regulators, needs to adopt almost 30 technical standards. In mid June 2011, the CFTC and SEC took actions that will likely defer most of the Dodd-Frank Act requirements regulating swaps and security-based swaps. Temporary relief will give market participants until the first quarter of 2012 to comply the initial date was to have been July 2011. To date, the SEC and CFTC have issued very few final rules, including how they even define the term swap. CFTC temporary exempt relief 14 June Initial deadline for rule making 16 July Title VII Rulemaking deadline 1st Quarter Rules effective date 4th Quarter US (Dodd-Frank) Dodd-Frank Act signed 21 July Rule making by CFTC and SEC 2010 2011 2012 31st Dec G20 Deadline Europe (EMIR) European Comission Prorposal 15 September Creation of ESMA 1 January European Parliament ECON vote on EMIR 24 May EP vote on EMIR 4th Quarter ESMA publishes technical standards May MiFID review 4th Quarter EMIR enforcement 31 December Council agreement on EMIR 20 June 12

Acts and regulations: transatlantic differences Scope Clearing obligation Non-cleared trades Reporting Timeline EU: EMIR Broad range of OTC derivatives but limited to derivatives on specific underlyings (MiFID Annex I, Section C) Out of scope/exempt: Spot foreign exchange (FX) transactions, commercial forward FX transactions, some kinds of physically settled commodity transactions Mandatory clearing of eligible derivative contracts for trades entered into between financial counterparties and third country entities (including those which would be exempted if EU entities) Two ways to determine clearing eligibility: (a) Bottomup : CCP request and (b) Top-down : ESMA in consultation with the ESRB (incentivise EU CCPs to clear; use of non-eu CCPs) Criteria: (1) systemic risk reduction (2) liquidity of contracts (3) availability of pricing information (4) ability of the CCP to handle contract volumes (5) level of client protection provided by the CCP EMSA to define details in secondary legislation by 30 June 2012 Bilateral trading of non-cleared trades possible, provided general risk management measures are in place (eg mitigation of operational and credit risk, including requirements for electronic confirmation, portfolio reconciliation, daily mark to market of outstanding contracts, segregated exchange of collateral or appropriate holding of capital) Capital requirements directive (CRD) IV likely to impose higher capital charges for non-cleared trades and 1-3% risk weighting for CCP exposures Financial counterparties and non-financial counterparties that exceed an information threshold are subject to the reporting obligation of OTC derivatives contracts to Trade Repositories, no later than the working day following the execution, clearing, or modification of the contract Possibility for a counterparty to report OTC derivatives contracts on behalf of another counterparty When a trade repository is registered by ESMA for reporting a particular type of OTC derivative, all those derivatives previously entered into shall be reported to that repository within 120 days Draft Regulation in the co-decision procedure and under review by the European Parliament and Member States For the Regulation to come into effect, both Parliament and member states need to jointly negotiate and agree a single text (expected for end 2011) ESMA to draft technical standards by 30 June 2012 Technical standards need to be adopted by the Commission to be legally effective Regulation has direct effect (unlike a directive) and requires no implementing legislation would enter into force 20 days after official publication (anticipated end of 2012 but could be earlier if politically expedient) CCPs that have an existing national authorisation would have two years to obtain authorisation Other provisions do not take effect until implementing regulatory standards are adopted (eg information and clearing thresholds for non-financial counterparties) EMIR generally unclear on the non-application of the new requirements to existing trades ( grandfathering provision) US: Dodd-Frank Applies to a broad range of OTC derivatives including any agreement, contract or transaction that is, or in the future becomes, commonly known to trade as a swap Out of scope/exempt: Spot FX transactions, some types of physically settled commodity transactions and certain physically settled forward transactions in securities Possibility for the Treasury secretary to exclude FX swaps and forwards from the clearing obligation (but not the reporting obligation) Clearing obligation applies to anyone who enters into a derivative subject to the clearing obligation; applies to trades between US and non-us counterparties In general, the rules do not apply to derivatives trades that do not have a direct impact/connection with US commerce (eg Foreign CCP, Foreign counterparty probably excluded) Mandatory clearing of swaps determined by the CFTC (for swaps ) and SEC (for security based swaps ) as eligible provided a central clearing house exists Criteria: differ from the EU; for example, the US regulators are required to take into account the effect on competition, including clearing costs CFTC can also restrict trading in non-cleared contracts and stay the application of the clearing obligation Stricter oversight of swap dealers and major swap participants, including registration with the CFTC, BCR, position limits and stricter capital and margin requirements Customised trades may trade OTC, but must be reported to a trade repository and likely to be subject to higher capital and margin charges Transactions between financial and non-financial counterparties not exempt from the margin requirements, but regulators have indicated that these provisions should not apply to end-users Secondary rule-making will define capital and margin requirements Each swap, either cleared or uncleared, shall be reported to a registered Swap Data Repository as soon as technologically practicable after time of trade execution (appropriate delay will apply for block trades ) Responsibility of reporting uncleared swaps to SDR will depend on a hierarchy of counterparty types Uncleared derivatives existing at enactment generally must be reported to a registered trade repository or the relevant regulator, under rules that must be adopted by October 2011, within 30 days of the final rules or other time period specified in the rules CFTC/SEC to draft secondary regulations pursuant to statutorily prescribed deadlines General effective date is 360 days after date of enactment (21 July 2010), but rulemaking is likely to extend beyond this period Most rules will provide opportunity for public comments for 30 days (some rules 45-60 days) 13

Part 1: Overview of the regulatory initiatives affecting OTC derivatives 1.2 Ucits and Solvency II: increasing requirements on OTC derivatives valuation Beyond EMIR and Dodd-Frank, the industry has witnessed mounting regulatory pressure for more independent, sophisticated and frequent valuation. Which investors are most affected? Which jurisdictions have the most detailed provisions? Asset management Since January 2009 (Ucits III 4th amendment), European asset managers are required to use independent valuation sources for all positions. The financial crisis of 2008 prompted some countries to move ahead on their own without waiting for the European Regulation to evolve. In France, the Autorité des Marchés Financiers (AMF) published its own instructions as early as 9th December 2008. Asset managers must now have internal pricing capabilities for valuing the term financial instruments (comprising OTC derivatives) they hold in their portfolios. The Ucits IV directive, entered into force on 1 July 2011, allows managers to invest in OTC derivatives, provided that the OTC derivatives are subject to reliable and verifiable valuation on a daily basis (Article 50 of the Ucits IV directive). Ucits IV also requires them to be able to monitor at any time the risk of the positions and their contribution to the overall risk profile of the portfolio (Article 51). In July 2010 the Committee of European Securities Regulators (CESR) published its own guidelines. These cover risk management and the calculation of global exposure and counterparty risk for Ucits (CESR/10-788). They will change current market practices dramatically. The OTC derivatives exposure must now be computed on the basis of a commitment approach much more sophisticated than computing mark-to-market exposure. Moreover, even when a commitment approach does not apply, the guidelines generally call for more advanced models of counterparty risk. The use of OTC derivatives has spread widely since Ucits III included them among eligible securities. The trend has even led the European commission to create the term sophisticated Ucits to designate these funds with innovative investment strategies. As a result, the above requirements for independent, sophisticated and more frequent pricing of OTC derivatives are having an impact on very large areas of the investment community. Since its third version, Ucits has become Europe s flagship investment vehicle, spreading globally as a brand. So the question of how to value OTC derivatives interests more than just European asset managers. Asset managers in Asia or hedge funds trying to use Ucits vehicles to attract institutional investors are directly concerned. 14

Insurance Insurance companies operating in Europe face slightly different issues regarding OTC derivatives. The Solvency II legislation places risk management at the heart of their operations. It imposes an approach based on cash flow, requiring consistent valuation of assets and liabilities and computation of stresstested values to obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR). Insurance companies traditionally tend to focus rather on the modelling of their liabilities rather than their assets. The former are complex and very specific, while the latter can be evaluated at relatively low cost by external parties. The new regulations will change this dramatically. Insurance portfolios typically contain OTC derivatives such as interest rate or credit default swaps and inflation-linked instruments and to hedge the guaranteed minimum returns in variable annuity products. The new consistency requirement between assets and liabilities will compel insurance companies to develop complex data warehouses and look-through reporting. They will need to improve their data cleansing processes in conjunction with asset valuation processes. That is why we believe insurance companies will further rely on their asset management departments to value their fund assets. For valuations of their direct holdings in OTC, however, they will tend to rely more on external providers. Solvency II in a nutshell The European directive Solvency II must be applied from the 1 January 2014, by all insurance companies based in Europe. It has the first objective to place risk management at the heart of all insurance companies, imposing a cash-flow based approach, and harmonising insurance sector practices. The second objective is to protect policyholders through robust and comprehensive risk management practice. The directive is composed of three pillars: Pillar I, quantitative requirement on capital computation, has the most important impact in terms of OTC valuation and reporting capabilities. It aims to make the market consistent in terms of valuation of assets and liabilities and the computation of their stressed values to obtain the Solvency Capital Requirement (SCR) and Minimum Capital requirement (MCR) Pillar II, supervisor review, aims at better organisation of- and more operational and governance controls over- investment management Pillar III, disclosures: a comprehensive reporting approach to the regulator, the company board and the investors Solvency II requirements also impact asset managers, in particular because Pillar I imposes on insurance companies look-through reporting capabilities to analyse their underlying portfolio of funds. This results in increasing pressure on asset managers to bring further transparency to their allocation. Regulatory provision for OTC derivatives valuation is not new but it is now reaching a critical point. This is particularly true in Europe, which is adding layers of provisions and requirements at both the European and national levels. While EU legislation seems to be taking the lead, the impact is already worldwide, especially for asset managers. Indeed, whether the need arises from having to respect Ucits requirements or to help their insurance clients comply with Solvency II, the pressure is on asset managers to fully understand the details and intricacies of the new legislation. 15

Part 2: The impact on investment managers operations, financing needs and risk exposure 17

Part 2: The impact on investment managers operations, financing needs and risk policies 2.1 Operational aspects of the introduction of cleared OTC derivatives Navigating the documentation provisions Differing approaches in the EU and the US have fostered the adoption of different clearing of OTC derivatives. What is the impact on documentation and how should investors approach it? Europe The EU approach is in essence a principal model. Today, the bilateral agreement adopted between two counterparties dealing OTC derivatives is typically the master agreement published by the International Swaps and Derivatives Association (ISDA). It is composed of several components: Master agreement: defines the general terms and conditions that will guide the relationship (obligations, events of default, governing law) Schedule: adapts the Master Agreement to specific needs of the parties and sets out any particular terms the parties agree will apply to transactions between them Conformation: sets out the term of a specific transaction Credit support annex/deed: relates to the financial collateral that will be exchanged between the parties (eligibility, frequency, haircuts, thresholds.)* The new reforms will add to these documentation requirements. Clients will now have to sign one or more clearing agreements that bring into effect an additional agreement such as an ISDA master agreement with a collateral annex for cleared transactions. Transactions will continue at present to be entered into directly between the client and the clearing member (or executing broker, under a give-up relationship). Once the clearing broker has entered into or accepted the transaction with the client, an equivalent transaction must also be registered in the client account of the clearing member at the clearing house. Of course, all this comes on top of the master agreement with the executing broker. This is backed up with security interest in favour of the client over the receivable on that client s account with the clearing house. This is designed to mitigate client s credit risk to the clearing member under the cleared ISDA agreement and cleared credit support annex (CSA). It does not, however, extend to any exposure under the existing non-clearing ISDA and CSA, or indeed to any other relationship between the client and the clearing member. Cleared transactions also require the following documents to be put in place: *Note that this is not put in place for all counterparties. Master give-up and back-loading agreement between the executing broker and clearing member 18

Designation notice given by the clearing member to the executing broker relating to the specific client in question Compensation agreement which addresses what would happen between the executing broker and the client, should the clearing member not accept the transaction in question within the stated time frame. Clearing fees and other auxiliary matters (as relevant) are set out in a side letter. United States The US model, on the other hand, is an extension of the futures model: a futures commission merchant (FCM), acting as agent and guarantor of the client s margin and other obligations to the clearing house, faces the CCP. The documentation would be a customer account agreement (developed from the form used for existing listed derivative transactions) with an addendum addressing specific issues in relation to cleared OTC derivatives. These might include termination and close-out mechanisms, and any porting arrangements. Since these are likely to be standard for all CCPs, one agreement should suffice (though there may also need to be CCP-specific appendices). Clearing fees and interest rates on cash margin are set out in a separate side letter. In addition, there is an Execution Agreement (similar to a give-up documentation suite) which can be either bilateral (client and executing broker) or, subject to CMC rulemaking in this regard, trilateral (client and executing broker and FCM). The tables below set out the proposed documentation and documentary approaches for clearing OTC derivatives with CCPs in US and Europe, respectively: US approach to legal framework Contract label Purpose Signing parties Execution or Client Executing Clearer CCP or Clearing? Broker FCM (Customer Clearing X X Account Agreement) FIA Addendum Clearing X X Business Terms Side Letter (or Schedule 2) Clearing X X FIA Give-Up Agreement Execution/ X X (X) Clearing (Focus on LCH.Clearnet SwapClear IRS, ICE Clear Credit and CME IRS) 19

Part 2: The impact on investment managers operations, financing needs and risk policies European approach to legal framework Contract label Purpose Signing parties Execution or Client Executing Clearer CCP or Clearing? Broker ISDA (including CSA) Execution X X CCP s Clearing agreement, Clearing X X including a cleared CSA & cleared ISDA Clearing deed of Clearing X X X assignment Clearing compensation Execution X X agreement Give up agreement Execution/ X X Clearing Designation Notice Execution/ X X Clearing (Focus on LCH.Clearnet Ltd SwapClear IRS) It seems fair to say that the clearing industry could benefit from further standardisation of documentation. Connecting to SEFs, affirmation platforms and trade repositories Adopting central clearing for eligible OTC trades will be a burden for all institutional investors. While most participants expect to make their operations more efficient in the coming years, looming regulatory deadlines will exert significant pressure sooner or later. Which operating model will be needed? How similar will OTC clearing processes look to the familiar futures commission merchant (FCM) model or the general clearing member (GCM) model? It will take time before OTC trades can be as completely automated as listed derivatives are. We anticipate the process for automating OTC clearing will move forward in fits and starts in the early days. With listed derivatives, in contrast, machines can currently execute and control trades, run risk calculations, accept, reject or reconcile trades without the need for human hands. The diagram below illustrates the existing set-up for Chicago Mercantile Exchange (IRS & CDS contracts) and the target for SwapClear (IRS contracts.) Note that institutional investors will be required to interact with swap execution facilities and affirmation platforms. 20

1 2 3 4 5 Step 1: Execution and choice of CCP The block trade is executed on a SEF (Swap Execution Facility) by both parties (the Executing Broker and the Client), including the choice of the CCP The block trade is transferred to an Affirmation Platform Step 2: Affirmation, allocation and choice of futures commission merchant (FCM) The Executing Broker (EB) alleges the block trade (and selects an FCM if not self-cleared) The Client affirms the block trade, allocates the trade to Unique Client ID (e.g.funds) and selects one or several FCM(s) The trade is submitted for clearing to the CCP Step 3: Clearing Consent A Clearing Consent Request is sent by the CCP to the clearing members (Client FCM and EB FCM) The clearing members give their Clearing Consents Give-up Step 4: Intraday Clearing The CCP runs its risk filters After risk filters are passed, the novation and confirmation of the trade occur simultaneously and a clearing notification is sent to Client FCM, EB FCM and the Affirmation Platform Transaction is allocated in FCM Position Accounts (PA) held by the CCP (for Clients: 1 PA per Unique Client ID = legal entity) Step 5: Post-trade processing Netting Reporting: the trade is integrated by the CCP into the appropriate Trade Repository Reconcilliation Margining and payments Executing broker Front Office Middle Office Risk EB (selfcleared) or FCM (EB) Give up Swap Execution Facility 1 Execution choice of CCP Affirmation Platform 2 Affirmation Allocation choice of FCM 3 Clearing consent CCP 4 Novation Clearing 5 Post-trade processing Trade Repository Give up Client Front Office Trade Support Risk FCM (Client) Notes: On SwapClear, allocation will potentially be possible post clearing (TBC) On CME, Clearing Consent can be automated through a Risk Filter engine parameterised by the clearing member Execution platforms While the exact definition and mandatory obligations of SEFs are still being worked out, the Dodd-Frank Act mandates that all clearable swaps be executed on SEFs. MiFID 2 will likely include a similar provision for Europe. We expect it to set out an obligation to deal on organized trading facilities (OTFs). Existing platforms like Bloomberg, Tradeweb, and Market Axess are all seeking have the SEF label. They need it to comply with US regulations and to attract liquidity on their systems. Affirmation and confirmation platforms Most sell-side firms are already connected to electronic affirmation platforms (mainly ICE Link for CDS and Markitwire on IRS), which are used to match the economic terms of a transaction immediately after execution. They are used extensively for swaps, although use can vary widely between contracts, and ease the electronic confirmation given the existing STP functionalities between the affirmation and confirmation platforms. Yet the use of electronic affirmation is still optional, and small/ medium sized asset managers do not commonly affirm their trades electronically. The vast majority perform only a small number of OTC trades per month, and if they compare the relatively small operational risk with the significant investment cost, they have little incentive to connect to the electronic platforms. 21

Part 2: The impact on investment managers operations, financing needs and risk policies Tomorrow, in a world where eligible OTC contracts will have to be executed on organised trading facilities and cleared through a CCP, electronic trade matching and automation in general will not be an option anymore. Asset managers will have to communicate electronically with their counterparts whether it is by connecting to execution platforms when they exist or to affirmation platforms. Execution platforms are still developing and as we have seen the exact regulatory framework is not yet finalised. It is hence early days to know the exact remit of both execution platforms and affirmation platforms. We can however expect affirmation platforms to expand further in the field of non-cleared trades. In any case, following the encouragement by both regulators and ISDA, the industry is moving towards more Straight Through Processing (STP) and electronic affirmation. For bilateral trades (non-cleared OTC) the EMIR proposal explicitly states that where available trade confirmation should be made via electronic means. Institutional investors will have to adapt despite the complexity of setting-up and maintaining connections to those platforms. Connection to Swap Data Repositories/Trade Repositories Swap Data Repositories (in the US)/Trade Repositories (in the EU) have been pushed by regulators on both sides of the Atlantic. New rules being drafted will govern the content of such databases, along with how fast and how frequently participants report their positions to regulators. We predict that industry pressure to delay the reforms will push these requirements into 2012 for the US and 2013 for the EU. Nevertheless buy-side entities will have to wait until these rules are finalized to see their positions reported to the various repositories. In the US, the Dodd-Frank Act states that cleared swaps other than large notional swaps (ie block trades) must be reported as soon as technologically practicable after the time of trade execution. While the definition of the entity responsible for reporting cleared swaps is still under debate, the responsibility for the reporting of non-cleared swaps to the Swap Data Repositories falls on the counterparty which has the highest rank in a hierarchy of counterparty types*. This should solve part of the reporting issues for financial and non-financial entities. If this rule stands, a buy-side party s positions will be reported to the trade repository (TR) by its dealer for bilateral trades. On cleared trades, we anticipate that the reporting of cleared trades will be performed by the clearers on behalf of their final clients. *Section 729 of Dodd-Frank Act sets a hierarchy of counterparty types for reporting obligation purposes, in which SDs [Swap Dealers] outrank MSPs [Major Swap Participants], who outrank non-sd/ MSP counterparties, which would solve part of the reporting issues for financial and non-financial entities (as per the Dodd-Frank definition). In Europe, all OTC derivatives transactions will also have to be reported to a trade repository no later than the business day following execution, clearing or modification. A counterparty may delegate this reporting to its clearing broker, the CCP or an external agent. We expect a number of institutional investors to make use of these options. At the moment, industry initiatives for trade repositories stand at different stages depending on the asset class: 22

Fixed income products and especially credit derivatives have historically been the asset classes moving fastest towards electronification. The trend gained momentum in the past decade as operational risk grew in tandem with the booming market. Today almost all credit derivative trades are confirmed electronically in the DTCC from both the sell and buy sides. DTCC even built a Global Repository for OTC Credit Derivatives within its Trade Information Warehouse. This was achieved by adding copper records to the existing gold records (legally binding transactions confirmed electronically). The copper records are single-sided, non-legally binding transactions, and comprise more bespoke contract submissions that are not eligible for electronic confirmation. On interest rates, TriOptima s Interest Rate Trade Reporting Repository (IRTRR) has been active since early 2010. Major sell-side dealers submit their positions to the repository. After March, 2011, however, the ISDA launched a new request for proposal (RFP) for an Interest Rate Repository that would match the CFTCs new list of operating standards. DTCC was selected in early May 2011. What will TriOptima IRTRR become when DTCC starts operating? Good question, since participants will not relish maintaining links with two repositories for the same asset class. For equity derivatives, DTCC s Equity Derivatives Reporting Repository was launched in August 2010. For commodity derivatives, in June 2011 DTCC (in a jointventure with EFETnet) won the bid (issued by the ISDA) to establish a Commodity Derivatives Trade Repository For foreign exchange derivatives, a request for proposal (RFP) issued jointly by ISDA and AFME will aim at setting up a Forex Derivatives Repository. Iberclear and Clearstream also announced in December 2010 the creation of REGIS-TR with Iberia and Telefonica as pilot clients. While DTCC is in a good position to setup a global trade repository across all asset classes, there is a strong possibility that each regulator will request the creation of trade repositories for its respective geographical zone. Yet it remains unclear how EMIR and DFA will respond. The monitoring of systemic risk is one of the top regulatory priorities, but there is no guarantee that regulators will choose to monitor it in the same way. As a result it could be difficult for a given trade repository to comply with both frameworks. The frequency of reporting is also set to increase. Under the CFTC s proposed rules, all swaps must be reported in real time to the Swap Data Repository except block trades, which are subject to a 15-minute delay in reporting. Can internal organisations, procedures, and systems respond adequately given this constraint? We do not yet know. More disquieting still is the question of how much such speedy actions will cost. Level 1 measures for EMIR are not yet approved so the frequency requirement is still up in the air. The draft proposal, however, already requires both cleared and non-cleared trades to be reported. It adds that ESMA will be responsible for recommending in detail how to avoid double reporting this is to be part of its 23

Part 2: The impact on investment managers operations, financing needs and risk policies proposition for level 2 measures. This is a similar objective to the one pursued by CFTC with its hierarchy of counterparty types. Lastly, how to report daily valuations to those trade repositories raises new questions. Currently only static data are reported by participants. Over time, we expect regulators to require additional information so as to better measure the exposure between participants. Connection to SEFs, adoption of affirmation and confirmation platforms, management of reporting to trade repositories the sell side may be familiar with CCP clearing and its procedures, but institutional investors are not. They have much less experience in CCP-related operational processes. They are about to face a new reality. Entering the complex clearing world will require institutional investors to turn towards expert operational partners, be it their clearer or their middle-office service provider. Renewing your approach to OTC derivatives valuation Converging regulations are pushing institutional investors to value their assets, in particular OTC derivatives, in an independent, more sophisticated and more frequent manner. Are asset managers and corporates prepared to meet this challenge and what issues should they be considering? Most institutional investors have developed internal valuation resources for simple OTC derivatives. IRS, CDS or plain vanilla options still represent the vast majority of the traded exposure and the characteristics of these instruments are relatively standard. The valuation model is straightforward to implement and market data is easy to get from data providers like Bloomberg, Markit, Reuters and others. These internal solutions, however, often do not follow the processing of trades all the way through. Nor are they adapted to the latest regulations. Moreover, insufficient market data regarding, say liquidity, can complicate the valuation of even simple products. This happened frequently during the 2008 crisis. CCPs prices will help but not enough In the era of reform now dawning, CCPs will provide valuations of cleared OTC Derivatives on a next day basis. This will not remove the need for independent, third-party valuation, however, even for cleared OTCs. Indeed, possible discrepancies between different CCP algorithms may require price reconciliation. These price discrepancies will probably recur frequently and require quick resolution. Let s take the example of pricing for Interest Rate Swaps. Here the timing of the reference data snapshot may vary from one CCP to another, so discrepancies will arise. In this case, internal valuation could solve the problem by harmonising all prices on a single curve. Discrepancies can also arise naturally from a hedging strategy comprising cleared and non-cleared products. In this case 24

different methodologies and market data for cleared and noncleared trades could render the entire strategy less efficient. Non-cleared OTC derivatives and structured products will compel buy-side institutions to develop a robust valuation process, suited to the complexity and the transparency requirements for the instruments in question. Asset managers will have to take into account several alternative pricing sources, including counterparties, in-house valuations and independent third parties, so as to ensure the robust pricing approach required by regulators. Vendors can help as long as they are transparent Institutions should beware the temptation to hold down in-house pricing costs by relying exclusively on external vendor prices to challenge their counterparties. Here they must avoid the blackbox effect. This means that vendors should report their own price computations transparently and disclose the market data used for the valuation, together with the mathematical sensitivities associated with the price. The vendor should also allow for the counterparty to challenge the price whenever necessary, with the former enlisting experts to explain the gap between two prices. In-house is possible but not straightforward Those who decide to perform valuations in-house must pay particular attention to the technical challenges posed by complex OTC derivatives. Independent valuation requires specific expertise in data management and generates related costs. Scarce or nonobservable data such as correlations, volatility surfaces or exotic currency prices can be complicated to obtain. Sometimes, the sell side itself may be the only source. It is closer to the market where the price formation occurs. At the same time, over-reliance on sell-side data can compromise the independence of buy-side OTC prices. Additional data sources are required, which is why buy-side companies ask for an external valuation service. In-house OTC valuation resources must also be fast. Ucits IV, EMIR and other upcoming regulations will require daily computation. Production, controls and reporting must all operate efficiently for an in-house system to work with the required frequency. The efficiency of OTC valuation relies on team expertise but also on the performance of a system capable of embracing powerful booking and trade management capacities together with the latest generation of pricing engines. Front-to-back STP platforms such as Murex, Simcorp or Calypso provide those functionalities and can synchronise with risk and collateral management modules. But the substantial investments required to implement such systems can encourage partnering with an expert provider, who will help to meet the regulatory requirement efficiently. 25

Part 2: The impact on investment managers operations, financing needs and risk policies Institutional investors to embrace more sophisticated pricing methodologies The more precise the pricing of the contract is, the more optimised the call for collateral will be. As a result, we expect increasing demand for second generation improvements in the pricing process. Such sophisticated pricing methodologies are already widely used by sell-side firms and it is now a matter of time before institutional investors adopt them. One of the main ways to achieve the expected level of accuracy is to factor counterparty risk properly. Counterparty risk has to be taken into account to evaluate the collateral-driven margin calls. In practice, this means the Credit Value Adjustment (CVA) has to be computed at the portfolio level and the incremental CVA must be reflected in the pricing of each transaction. The CVA computation relies on an advanced probabilistic approach and finely calibrated credit market data. The CVA also has to be computed on a pre-trade basis, which is quite a challenge for almost all buy-side companies. Moreover the credit crunch in 2008 highlighted the need for valuation methodologies to account for the nature of collateral (if any) that applies to OTC transactions dealt under a Credit Support Annex (or equivalent collateral agreement). Thus discounting methodologies that take into account overnight interest rate swaps (OIS) spreads are increasingly popular and are progressively replacing the LIBORbased methodologies. Central counterparties themselves are moving to OIS discounting methodologies in their swap-clearing activities. Regulation and evolving market practices will require a profound rethink of the valuation processes and systems for pricing OTC derivatives. Pricing from CCPs will help but will not suffice. Sourcing alternative prices and adopting the sell-side pricing methodologies is the way forward. Yet, given the complex nature of the instruments, those who buy and sell OTC derivatives are probably better off delegating those increasingly complicated tasks to external partners. Adapting your collateral management set-up From a collateral management perspective, the introduction of central clearing will give rise to portfolio bifurcation. Once cleared, OTC trades will refer to clearing agreements, while bilateral OTC trades will continue to refer to ISDA Credit Support Annexes (or local jurisdiction collateral agreements). What will be the impact on collateral management operations and which areas should be looked at? Although the volume of bilateral trades will decrease in favour of cleared trades, portfolio bifurcation will nonetheless imply a duplication of the processes. The existing bilateral process will remain in place, but a second path will be needed to route the cleared trades to the adequate clearing agreement. 26