Derivatives Regulation

Joshua Cohn Partner +1 212 506 2539 [email protected] Mark Compton Partner +44 20 3130 3388 [email protected]

Jerome J. Roche Partner +1 202 263 3773 [email protected] 3 June 2015

Overview of Title VII of Dodd-Frank

• Registration requirements for: – Swap Dealers (SD) and Security-Based Swap Dealers (SBSD) – Major Swap Participants (MSP) and Major Security-Based Swap Participants (MSBSP)

• Substantive regulation of swaps activities, including: – Mandatory clearing and trade execution requirements – Margin requirements for uncleared swaps – Recordkeeping and data reporting requirements – Internal and external business conduct standards – Large trader reporting and position limits

• Authority for implementing swaps regulation allocated to CFTC (swaps), SEC (security-based swaps), and both together (mixed swaps) 2

US Product Definitions

• What is a swap? – A "swap" is broadly defined to include any transaction involving, on an executory basis, the exchange of payments based on the value of commodities, securities or other financial instruments

• What is a security-based swap? – A "security-based swap" is defined to include any swap based on a narrowbased security index or on a single security (excluding a US government security, but including non-US government securities) or a loan

• What is a mixed swap? – A "mixed swap" is defined as a subset of SBS that also are based on the value of one or more interest or other rates, commodities, or other financial instruments, or economic interests or contingencies

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US Intermediary Definitions

• A SD or SBSD is a person who engages in any of the following activities – Holding oneself out as a dealer in swaps or security-based swap (SBS) – Making a market in swaps or SBS – Regularly entering into swaps or SBS as an ordinary course of business for one’s own account – Engaging in any activity causing oneself to be commonly known in the trade as a dealer or marketmaker in swaps or SBS

• MSP/MSBSP is a non-SD/non-SBSD that meets any of the following criteria: – Maintains a "substantial position" in swaps or SBS for any of the major swap or SBS categories, not including positions held for hedging or mitigating commercial risk – Outstanding swaps or SBS create "substantial counterparty exposure" that could have serious adverse effects on the financial stability of the US banking system or financial markets – A financial entity that is highly leveraged, not subject to US bank capital requirements, and maintains a "substantial position" in any category of swaps or SBS

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Key Statutory Provisions For Extraterritorial Application of Title VII • For CFTC, Dodd-Frank section 722(d) provides: – "The provisions of [the CEA]relating to swaps that were enacted by [Title VII of the DFA] shall not apply to activities outside the United States unless those activities— ‘‘(1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or ‘‘(2) contravene such rules or regulations as the Commission may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act . . . "

• For SEC, Dodd-Frank section 772(b) provides: – "No provision of [the Securities Exchange Act of 1934] that was added by [DFA Title VII], or any rule or regulation thereunder, shall apply to any person insofar as such person transacts a business in security- based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate to prevent the evasion of any provision [added by DFA Title VII]."

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CFTC Cross-Border Guidance

• On July 12, 2013, the CFTC issued final interpretive guidance and an exemptive order regarding the crossborder application of the swaps provisions of DFA Title VII – Based on proposed interpretive guidance and exemptive orders issued in July and December 2012 – Defines US person status and effect of status on registration requirement – Establishes requirements applicable to certain cross-border swaps – Describes process to determine comparability of other nation swap requirements for purposes of substituted compliance 6

Swap Dealer De Minimis Calculation under CFTC Cross-Border Guidance • A US person or a guaranteed or conduit affiliate must include all dealing swaps • A non-US person not guaranteed by, or an affiliate conduit of, a US person must (subject to exceptions) include all dealing swaps with: •

US persons (other than foreign branches of SDs); and

•

Counterparties that are guaranteed affiliates of a US person, unless the counterparty is a SD, a SD affiliate engaged in de minimis dealing, or is guaranteed by a non-financial entity

• A non-US person not guaranteed by, or an affiliate conduit of, a US person may exclude swaps entered into anonymously on a DCM, SEF or FBOT and cleared • A person (US or non-US) must aggregate relevant dealing swaps of all commonly controlled affiliates (US and non-US), except those of any affiliates that are registered SDs

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Substantive Swap Regulation under CFTC CrossBorder Guidance • In determining how Title VII will apply extraterritorially under the July 2013 Interpretive Guidance and Policy Statement, the CFTC has divided substantive swaps regulations conceptually into (i) "Entity-Level Requirements" and (ii) "Transaction-Level Requirements." • Entity-Level Requirements (ELR) – First Category: capital adequacy; chief compliance officer; risk management; swap data recordkeeping (other than complaints and marketing/sales materials) – Second Category: SDR reporting; recordkeeping for complaints and marketing/sales materials; "large trader" reporting of physical commodity swaps

• Transaction-Level Requirements (TLR) – Category A: clearing and swap processing; margining and segregation for uncleared swaps; trade execution; swap trading relationship documentation; portfolio reconciliation and compression; real-time public reporting; trade confirmation; daily trading records – Category B: external business conduct standards 8

Substituted Compliance under CFTC Cross-Border Guidance • In the case of certain parties and certain rules compliance with another country’s rules may satisfy CFTC in lieu of its own – Parties –Generally swap dealers and MSPs – Rules – Entity-Level (1st and 2nd) and Category A Transaction-Level – Under the exemptive order, the CFTC’s temporary relief for the EU, Australia, Canada, Hong Kong, Japan, and Switzerland ("Six Jurisdictions") expired in December 2013

• Noted areas of concern: – Data repository direct access – Privacy laws – Clearing and trading venue recognition 9

CFTC’s Comparability Determinations

• In December 2013 the CFTC issued: – Limited ELR determinations for the EU, Australia, Canada, Hong Kong, Japan, and Switzerland; and – Very limited TLR determinations for the EU and Japan

• CFTC did not issue reporting rules determinations, but issued limited no-action relief for certain requirements: – CCO annual reports; – SDR reporting (NAL 13-75); and – Periodic risk exposure reports 10

November 2013 CFTC Staff Advisory

• On November 14, 2013, CFTC staff issued an advisory (No. 1369) that interpreted the cross-border guidance to require compliance with the TLRs if persons located in the US are regularly arranging, negotiating, or executing swaps for a nonUS SD when entering into swaps with non-US persons. – NALs 13-71, 14-01, 14-74, 14-140 delay the effectiveness of the November advisory until September 30, 2015

• Effectively would require full compliance with TLRs (no substituted compliance)

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Further CFTC Guidance

• On November 15, 2013, CFTC staff issued a guidance letter that interpreted the cross-border guidance and SEF rules to require multilateral trading facilities (MTFs) to register as SEFs or DCMs if they provide the ability to trade or execute swaps to US persons or US-located persons. • Effectively would require SEF registration for many non-US Multilateral Trading Facilities (MTFs) • On February 12, 2014, NAL 14-16 provided relief to qualifying EU MTFs – NAL 14-16 superseded on April 9, 2014 by NAL 14-46 – MTFs or participants must comply with real-time reporting and SDR reporting requirements

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What Next for CFTC Cross-Border Guidance?

• In December 2013, trade associations sued the CFTC seeking to have the cross-border guidance and related pronouncements invalidated, however, the case was substantially dismissed in September 2014 – Remand for the cost-benefit analysis of certain rules pending

• In January 2014 the CFTC issued a request for comment on the applicability of CFTC regulations to swaps of non-US swap dealers and non-US counterparties involving persons or agents in the US • In April 2014, then-acting Chairman Wetjen was reported in the press to have said he did not believe the November advisory was the right decision (at least as to non-availability of substituted compliance) • Neither the CFTC Commission, nor the staff, has yet taken further action in advance of the September 30, 2015 deadline 13

SEC Cross-Border Rulemaking

• On May 1, 2013, the SEC released its proposed rules and interpretive guidance regarding the cross-border application of the security-based swaps provisions of DFA Title VII – Also the SEC re-opened for public comment all other then-proposed SBS rules – Public comment period ended in August 2013

• SEC has subsequently implemented US and cross-border rules for – Definition of US person (different than CFTC) – De minimis calculation for non-US SBSDs and threshold calculations for non-US MSBSPs – SDR registration requirements, duties, and core principles – SBS reporting and dissemination requirements

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SEC Cross-Border US Person Definition

• The SEC defines a US person as: – A natural person resident in the US; – A partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the US or having its principal place of business in the US; – An account (whether discretionary or non-discretionary) of a US person; or – An estate of a decedent who was a resident of the US at the time of death

• Similar to CFTC’s guidance with respect to reasonable reliance on representations, but different with respect to look-through and IGOs 15

SBS Dealer De Minimis Calculation for SBSDs

• The SEC has not yet finalized SBSD registration rules; once done, however, they will apply cross-border in the following ways • A US person must include all dealing SBS, including that of a non-US branch • A non-US person who is not a conduit affiliate of a US person must (subject to exceptions) include all dealing SBS with: • US persons (other than foreign branches of SBSDs); and • Non-US persons if the SBS is guaranteed by a US affiliate of the “counting” counterparty, unless the SBS is executed anonymously and cleared

• A conduit affiliate of a US person must include all dealing SBS • A person (US or non-US) must aggregate relevant dealing SBS of all commonly controlled affiliates (US and non-US), except those of any affiliates that are registered SBSDs 16

SEC SDR Registration Rules

• SDRs will be required to register with the SEC and will be subject to examination by the SEC • SDRs will need to comply with certain principles regarding: – Governance arrangements, – Treatment of market participants, and – Dissemination of SBS data

• Compliance will be required in March 2016 – SEC’s proposed amendments to Reg SBSR would set the effective date for the SDR reporting and public dissemination rules as 6 months and 9 months after the date the first SDR accepts SBS in a particular asset class 17

Reg SBSR: SDR Reporting and Dissemination

• SEC’s rulemaking defines regulatory reporting and public dissemination requirements – The reporting rules require primary and secondary trade information be reported to an SDR • But defer to SDRs for the setting of reportable data elements and reporting formats • Final rules were accompanied by a proposal to define additional provisions of the reporting regime

– The rules establish part of the SBS reporting hierarchy, but are subject to further definition for cleared and platform-executed SBS in the proposal – Generally, all SBS other than historical SBS, clearing transactions, allocation transactions ,and certain cross-border transactions are required to be publicly disseminated 18

Still to come in the United States

• Margin for uncleared swaps – No regulators have finalized their rules – Banking regulators re-proposed their rules in September 2014 – CFTC re-proposal in October 2015

• Re-proposed position limits – Necessity and fundamental premise remain in question – Most recent comment period expired March 30, 2015

• Adoption of further SEC SBS rules and cross-border application • Review of reporting rules 19

EMIR Parties: Who does EMIR apply to?

EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract, even when that entity is trading with non-EU firms. Parties

Criteria

Financial counterparties (“FC”)

Firms, institutions and undertakings authorised or managed pursuant to MiFID, the Capital Requirements Directive, the Direct Insurance Directive, the Life Assurance Directive, the Reinsurance Directive, the UCITS IV Directive, the Institutions for Occupational Retirement Provision Directive and the AIFM Directive.

Qualifying non-financial counterparties (“NFC+”)

Undertakings established in the EU other than, Central Counterparties (“CCPs”) and Financial Counterparties, which exceed certain thresholds for derivatives activity (“the Clearing Threshold”), as measured over a 30 day period.

Non-financial counterparties (“NFC”)

Undertakings established in the EU other than, CCPs and Financial Counterparties, which do not exceed the Clearing Threshold.

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EMIR: What does it require?

FC

• Clearing obligation • Risk mitigation techniques • Reporting obligation

NFC+

• Clearing obligation • Risk mitigation techniques (save in relation to the increased capital requirements and the reporting of unconfirmed trades) • Reporting obligation

NFC

• Certain risk mitigation techniques (timely confirmation, portfolio reconciliation and compression, dispute resolution) • Reporting obligation 21

EMIR: Risk Mitigation • Parties must have procedures in place to measure, monitor and manage risk of contracts for all uncleared OTC derivatives contracts (Article 11) • Techniques include: • • • •

Timely confirmation Portfolio reconciliation Portfolio compression Dispute resolution procedures

• Additional obligations only for FC and NFC+: • Daily mark-to-market valuations (or mark-to-model where not available and subject to conditions) • Procedures for timely, accurate and appropriately segregated exchange of collateral for contracts entered into on or after 16 August 2012 22

EMIR: Risk Mitigation –Timely Confirmation Phase-in of Requirements: Both Parties FC / NFC+ CDS and IRS

One Party is an NFC-

To 28/2/14

From 28/2/14

To 31/8/13

1/9/13 31/8/14

From 1/9/14

T+2

T+1

T+5

T+3

T+2

To All other 31/8/13 types T+3

1/9/13 31/8/14

From 1/9/14

To 31/8/13

1/9/13 31/8/14

From 1/9/14

T+2

T+1

T+7

T+4

T+2

• Where trades are concluded after 4pm or with a counterparty in a time zone which does not allow the timeframe to be adhered to, an additional business day is permitted 23

Risk Mitigation – Portfolio Reconciliation

Ongoing compliance requirements:

Both Parties are FC / NFC+

One Party is NFC -

• ≥ 500 OTC derivatives contracts outstanding: each business day

• >100 OTC derivative contracts outstanding: once per quarter

• 51-499 OTC derivative contracts outstanding: once per week

• ≤ 100 OTC derivative contracts outstanding: once per year

• ≤ 50 OTC derivative contracts outstanding: once per quarter

* Where trades are concluded with an NFC-, it is likely that the lower standard will apply. 24

EMIR: Risk Mitigation – Portfolio Compression

Compliance start date: 15 September 2013 Applies to FCs, NFCs+ and NFCs with over 500 uncleared OTC derivative contracts outstanding to a single counterparty Obligation: 1. to have procedures in place to analyse the possibility of compression twice a year; and 2. To be able to provide a reasonable and valid explanation to the relevant competent authority if conclude portfolio compression not appropriate

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EMIR Risk Mitigation – Dispute Resolution Compliance start date: 15 September 2013 Ongoing compliance requirements: • FCs must report to the competent authority any disputes for an amount in excess of €15m and outstanding for at least 15 business days relating to: • an OTC derivative contract; • valuation of an OTC contract; or • exchange of collateral. FCs, NFCs+ and NFCs, when concluding OTC derivative contracts, must agree detailed procedures and processes in relation to: • the identification, recording and monitoring of disputes relating to the recognition or valuation of the contract and exchange of collateral • the resolution of disputes in a timely manner with a specific process for disputes outstanding for more than five business days 26

EMIR: Reporting requirements

• Product scope • All OTC derivatives • All listed derivatives (exchange traded derivatives)

• Reporting responsibility • Both counterparties must ensure that trades are reported without duplication • Each counterparty may independently report the trade • One counterparty may delegate reporting of the trade to their counterparty • A third party can submit data on behalf of one or both counterparties to a trade • In the context of an ETD, one transaction could involve up to six reports (one from the counterparty, two from its broker (a MiFID investment firm), two from a clearing member and one from the CCP)

• Data to report • Counterparty data – the details relating to the parties to the trade • Common data – the economic details relating to the derivative contract • Post trade lifecycle events

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EMIR: Reporting start dates for all derivatives • Reporting start date – 12 February 2014 • Reporting obligation applies to: • Contracts entered into before 16 August 2012 which remain outstanding on that date • Contracts entered into on or after 16 August 2012 • Contracts entered into after 16 August 2012 and are outstanding on reporting start date must be reported on or before 12 February 2014 • Back-reporting: • Contracts entered into before 16 August 2012 and are still outstanding on 12 February 2014 must be reported within 90 days of the reporting start date (ie, 13 May 2014) • Contracts outstanding on or after 16 August 2012 but not outstanding on or after the reporting start date must be reported within 3 years of the reporting start date (ie, 12 February 2017)

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EMIR: Exposure & Collateral data  From 11 August 2014, FC and NFC+ had to report exposures and details of any collateral on a daily basis  Collateral  Valuation of collateral posted is to be reported as part of the Counterparty Data  Distinction recognised between collateral posted on a transaction basis and on a portfolio basis  Valuation  Valuations based on mark to market or mark to model to be reported as part of Counterparty data  Contracts that are cleared by a CCP, mark to market valuations reported shall be those provided by the CCP 29

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EMIR: Margin Requirements

• 14 April 2014: ESAs published consultation paper on requirement to exchange margin on non-centrally cleared OTC derivatives looking at: – minimum amount of initial and variation margin to be posted and collected and the methodologies by which that minimum amount would be calculated; – the eligibility of collateral to be used for margins; – operational processes; and – risk-management procedures. • Consultation period ended on 14 July 2014 • Expected to come into force December 2015

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The extraterritorial effect of EMIR

1. EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract. 2. It applies to EU firms even when trading with non-EU firms. 3. It has extraterritorial effect in some circumstances: a)

The clearing obligation applies to contracts entered into by a EU FC / NFC+ and a third country entity that would be a FC or NFC+ in the EU.

b)

The clearing obligation and risk mitigation requirements apply to contracts between third country entities that would be a EU FC or NFC+ in specified circumstances. 31

EMIR and Extraterritoriality

Clearing obligation – Article 4(a)(iv)(v) Risk mitigation – Article 11(12)

• EU + non-EU – applies if non-EU would be subject to clearing if in EU • Non-EU + non-EU – applies if (1) entity would be subject to obligations if established in EU and (2) if “contract has direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent evasion of provisions of” EMIR

• Non-EU + non-EU – applies if (1) entity would be subject to obligations if established in EU and (2) if “contract has direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent evasion of provisions of” EMIR

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EMIR and Extraterritoriality: Equivalence

• But EMIR is only extraterritorial if neither counterparty to the OTC derivative contract is established in a third country whose legal, supervisory and enforcement regime has been declared equivalent to EMIR. • When one counterparty is established in an equivalent third country, there shall be deemed compliance with the clearing obligation, the reporting obligation, the rules on NFCs+ and the risk mitigation requirements for uncleared trades set out in EMIR. 33

EMIR: What is equivalence?

Mechanism to: 1. avoid duplicative or conflicting rules on clearing, reporting and risk mitigation requirements caused by extraterritorial effect; 2. permit non-EU CCPs to provide clearing services to clearing members which are established in the EU; and 3. enable EU counterparties to satisfy their reporting obligation under EMIR by reporting to a third country trade repository. 34

EMIR and Extraterritoriality: decisions

Recognition

Recognition of non-EU CCPs – Article 25

• Non-EU CCPs are prohibited from providing clearing services to entities in EU unless recognised by ESMA. • Non-EU CCPs must have applied to ESMA for recognition by 15 September 2013 • Commission must declare equivalence of CCP’s jurisdiction

Recognition of non-EU TRs – Article 77

• Non-EU TRs must apply to ESMA for recognition • Commission must declare equivalence of CCP’s jurisdiction

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EMIR: Clearing

OTC derivatives contracts must be cleared by a CCP if : •

ESMA has determined they are subject to a mandatory clearing obligation;

•

the contract is between any combination of FC and NFC+ (or a qualifying third country entity); and

•

(subject to the transitional periods and depending on the types of counterparties) they are entered into or novated either: –

on or after the date the clearing obligation takes effect; or

–

after the publication of the relevant set of final rules in the Official Journal.

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EMIR: Clearing

• Clearing obligation itself not yet in force. Will not take effect until: – CCPs have been authorised – or recognised if in a third country – to clear under the new EMIR regime; and – the Commission has adopted a recommendation from ESMA regarding what class of derivatives should be cleared.

• Within 6 months of receiving notification that a CCP has been authorised or of recognising a CCP, ESMA shall provide advice to the Commission on whether the classes of derivatives it clears should be subject to the clearing obligation. 37

Clearing: What does EMIR require?

• ESMA must provide advice on: – the class of OTC derivatives contracts which should be subject to the mandatory clearing obligation; – the dates from which the obligation takes effect, including any phase-in and the class of counterparty to whom the obligation shall apply; and – the minimum remaining maturity of the OTC derivatives contracts which are subject to the front-loading obligation.

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Clearing: What does EMIR require?

• In determining the class of OTC derivatives contracts which should be subject to the mandatory clearing obligation, ESMA shall take into consideration: – the degree of standardisation of the contractual terms and operational processes of the relevant class of OTC derivatives; – the volume and liquidity of the relevant class of OTC derivatives; – the availability of fair, reliable and generally accepted pricing information in the relevant class of OTC derivatives.

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Questions?

Joshua Cohn Partner +1 212 506 2539 [email protected] Mark Compton Partner +44 20 3130 3388 [email protected] Jerome J. Roche Partner +1 202 263 3773 [email protected]

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