An overview of the impact of the Dodd-Frank Act on interest rate derivatives for market participants that are neither swap dealers nor major swap participants. Summarizes swap clearing and trade reporting requirements.

1. Interest Rate
Derivatives under
Dodd-Frank
Implications for market participants other than
swap dealers and major swap participants
Margaret Scullin
mscullin@fisherbroyles.com
404-530-9372
November 2013

2. Outline
• Overview of Derivatives Regulation
• Central Clearing
• Clearing Certainty
• Portability
• Protection of Customer Collateral
• Uncleared Swaps
• End User Exception
• Margin Requirements
• Documentation
• Trade Reporting

3. The Dodd-Frank Act is passed in
the wake of the financial crisis
Size and scope of law
unprecedented for
financial legislation
• 849 pages
• 1,601 sections
• 398 rulemakings
required
• Title VII (§§701-774)
regulates derivatives

4. Why derivatives regulation?
Concern over size and lack of transparency of derivatives
market, most memorably expressed by Warren Buffett:
“I view derivatives as time bombs, both for the parties that
deal in them and the economic system.”
“In my view, derivatives are financial weapons of mass
destruction, carrying dangers that, while now latent, are
potentially lethal.”
Berkshire Hathaway 2002 Annual Report
(emphasis added)

5. Why else? The Bailout of AIG.
American International
Group, Inc. (AIG)
CDS
Buyer
CDS
Buyer
AIG Financial
Products Corp.
CDS
Buyer
CDS
Buyer

6. Objectives of Dodd-Frank
Derivatives Regulation
Require
central
clearing
Reduce
counterparty
credit risk
Require trade
reporting
Increase
transparency

7. Clearing – changing the way
derivatives are transacted
Historically, derivatives were entered into privately, or
over-the-counter (OTC), between two parties
Party A
Party B

8. Cleared Environment
Introducing the derivatives clearing organization (DCO) as central
counterparty
In theory, it looks like this:
DCO
Party A
Party B

9. Cleared Environment
In reality, it looks more like this:
DCO
Party A’s FCM
Party A
Party B’s FCM
Party B

10. Pros & Cons of Central Clearing
Pros
Cons
• If trade accepted for
clearing, original
counterparties have no
credit exposure to each
other
• Portability – can
transfer positions and
related margin from
one FCM to another
• Instead, counterparties
have credit exposure to
their FCMs and DCOs
• Increased collateral
(initial margin +
variation margin)
• Added transaction costs
(FCM/DCO fees)

11. Wanted: Clearing Certainty
• Parties want certainty, prior to executing a trade, that their
FCM and DCO will accept that trade.
• Where clearing is mandatory and no exemption applies, if a
trade is not accepted for clearing, it must be terminated.
The parties may incur losses due to the terminated trade.
• FIA-ISDA Cleared Derivatives Execution Agreement is a
breakage agreement whereby parties specify how trades
failing to clear will be treated and allocate breakage costs.
• CFTC guidance prohibits mandatory breakage agreements
as a condition of access to swap execution facilities.

12. Improvements Expected
• The current system, of post-execution checks coupled with
breakage agreements, is an interim solution.
• An industry working group is investigating solutions for
pre-execution certainty.
• Considering three possible models:
• Push – FCMs “push” individual customer credit limits to the
various Swap Execution Facilities (SEFs) on which cleared
derivatives trades are executed; would be fast but inflexible
• Ping – messaging between SEFs and FCMs and/or SEFs and
DCOs; would be more flexible but slower than push model
• Hub – third party service, would work with either push or ping
method, and would eliminate the need for FCMs to subdivide
credit limits across SEFs

13. Portability
• Ability to transfer trades and related collateral from one
FCM to another, without having to close out and re-book
• Customer can move trades to another FCM that is
financially stronger or that offers better commercial terms
(i.e., lower excess margin requirements)
• More flexible than OTC model, which requires consent from
the counterparty to transfer a trade

14. Portability: Pre-FCM Default
• Customer has right to transfer its trades from an FCM at
any time, as long as customer is not currently in default to
that FCM (CFTC Rule 39.15(d))
• Customer must have another FCM that is willing to accept
the transferred trades
• Transfer rule expected to apply would require transfer
requests to be completed within 5 business days, unless
more time is needed for due diligence (NFA Rule 2-27)
• Timing of transfer could be impacted by:
• Need to execute clearing documentation with transferee FCM
• Partial transfers could result in need to post additional margin
to transferor FCM on remaining positions

15. Portability: Post-FCM Default
• DCO will try to transfer non-defaulting customers’
positions to a solvent FCM
• In the event of an FCM bankruptcy, the trustee and
bankruptcy court will determine whether and when
customer positions can be transferred
• Any shortfall in customer funds at the FCM is likely to prevent
or limit transfers
• Under the Bankruptcy Code, any losses must be shared pro
rata among customers (because cleared swaps are
“commodity contracts” under the Bankruptcy Code)
• Trustees of defaulted FCMs have always sought permission of
Bankruptcy Court to transfer customer funds

16. Protection of Cleared Swaps
Customer Collateral
• Critical issue, especially given volume of transactions that
will be required to be centrally cleared
• Existing futures model was considered inadequate because
of “fellow customer risk”: risk that nondefaulting
customers’ collateral can be taken to satisfy a shortfall
created by another customer’s default, which causes the
FCM to default to the DCO (a “double default”)
• CFTC considered various models and adopted Legal
Segregation with Operational Commingling (LSOC)

17. LSOC
Benefits
• Eliminates fellow
customer risk in the
event of a double
default
• DCOs (and trustees)
will have information
about individual
customers’ positions
and collateral
Limitations
• Customer collateral at
risk if FCM defaults to a
DCO for any reason other
than customer default(s),
such as investment losses
or misuse of customer
collateral
• Bankruptcy Code still
requires pro rata
distribution of collateral
liquidated by DCO in
event of FCM bankruptcy

18. FCM Bankruptcies: Ripped from
the Headlines…
October 31, 2011
July 10, 2012

19. What Went Wrong?
MF Global
PFGBest
• Proprietary trading
activities led to increased
capital requirements and
demands for collateral
• “Excess” funds were
“borrowed” intra-day
from customer accounts
• Credit rating downgrade
worsened liquidity crisis
• $1.6 billion shortfall in
customer funds
• Fraud began in 1993
• Bank statements falsified
• CEO set up fake P.O. box
to intercept regulatory
documents
• Customer funds were
misappropriated; used to
cushion capital, pay
regulatory fines, etc.
• $215 million shortfall in
customer funds

20. CFTC Response
• Amendments to CFTC Rule 1.25, limiting permitted
investments for customer funds (removing corporate debt,
foreign sovereign debt and repurchase transactions with
affiliates from list of permitted investments)
• Rule 1.25 will now apply to Rule 30.7 accounts (for
customers trading on foreign exchanges) instead of only
Rule 4d accounts (for customers trading on domestic
exchanges)
• FCMs must post collateral to clearinghouses on a gross,
rather than net, basis
• Final DCM rules include minimum requirements for
financial surveillance of FCMs by SROs
• LSOC

21. CFTC Response (continued)
• FCMs can no longer use the “alternative method” for
calculating the total amount of customer funds required to
be kept in Rule 30.7 accounts (and the “regulatory excess”)
• “Corzine Rule”: no withdrawals of >25% of excess funds
without written management approval and prior
notification to regulator
• Daily segregated account reports and identification of
customer funds depositories
• CFTC must be granted direct online (read-only) access to
FCMs’ depository accounts
• Enhanced standards for auditing of FCMs

22. Other Protections for FCM
Customers?
MF Global Trustee Giddens, some legislators and customer
groups have argued for an insurance mechanism
• FDIC and SIPC protect bank depositors and securities
holders; why not similar protection for futures customers?
• Canadian Investor Protection Program – MF Global
Canadian customers were made whole

23. Uncleared Swaps: Exceptions to
Mandatory Clearing
The Dodd-Frank Act requires all swaps to be cleared, except:
• Swaps entered into before the effective date of the clearing
rules (“pre-enactment swaps”)
• Certain foreign exchange swaps
• Swaps entered into by non-financial entity end-users as
hedges of commercial risk (the “end user exception”)
• If specifically exempted by the CFTC:
• Exception to definition of “financial entity” allows “small
banks” (total assets <$10 billion) to avail of end user exception
• Cooperatives
• Eligible treasury affiliates

24. Evidencing End User Exception
• Swap counterparties that elect the end user exception must
retain evidence of their eligibility and basis for the
exception
• Public companies electing the exception must obtain board
approval of the decision to enter into uncleared swaps

25. Margin Requirements
• Cleared Swaps – subject to initial and variation margin
required by the derivatives clearing organization, as well as
any excess margin requirements imposed by FCM under
clearing agreement between customer and FCM
• Uncleared Swaps – CFTC reopened the comment period on
proposed rule, with view to international harmonization;
general aim is to impose requirements sufficiently high to
incentivize clearing, with some exceptions:
• Non-financial end users using swaps for hedging would not be
required to post margin
• Financial end users subject to capital requirements set by a
prudential regulator and using swaps for hedging could have
modest unsecured thresholds

26. Amending ISDA Master
Agreements
• ISDA Master Agreements with swap dealers and major
swap participants must be amended to comply with CFTC
rules (ex: Business Conduct Standards; Swap Data
Recordkeeping and Reporting Requirements)
• ISDA has launched protocol (the ISDA August 2012 and
March 2013 DF Protocols) to facilitate amendments
• Structured differently from past protocols
• Because compliance requirements vary depending on legal
status of each party (ECP, SD, MSP, special entity), structured to
allow participants to privately and selectively share
information about their legal status with other participants
through the exchange of questionnaires
• $500 adherence fee

27. Trade Reporting: Scope
Trade reporting requirements apply to all interest rate,
currency, equity, credit and other commodity swaps,
whether:
• cleared or uncleared
• executed on a swap execution facility (SEF), designated
contract market (DCM) or exchange or entered into
bilaterally over-the counter (OTC)

28. Trade Reporting: Who?
If trade is executed on a trading facility, the SEF or DCM will report it.
If an off-facility trade is accepted for clearing before the reporting
deadline, the DCO will report it.
If neither party is a swap dealer or major swap participant and only
one party is a US person, the US person reports.
Otherwise, the parties must determine who is the “reporting party”:
If yes, swap dealer
reports.
Is only one party a
swap dealer?
If no, is only one
party a major
swap participant?
If yes, major swap
participant
reports.
If no, is only one
party a financial
entity?
If yes, financial
entity reports.
If no, parties agree
who reports.

29. Trade Reporting: Where?
Trades must be reported to a registered swap data repository
(SDR) or, if no SDR is available to accept the data, to the CFTC
(for swaps other than security-based swaps)

30. Trade Reporting: What?
• Creation Data – primary economic terms (PET) data and
confirmation data
• Continuation Data – all changes to the PET data and all
valuation data
• Additional reporting requirements apply for each trade
entered into in reliance on an exception to mandatory
clearing
• Reporting required on a trade-by-trade basis by reporting party
• Reporting party’s obligations are reduced if the electing party has
filed an annual report with an SDR providing details of its
eligibility to elect the exception

31. Trade Reporting: When?
• PET data: as soon as technologically practicable, but
no later than –
• cleared swaps: initially 4 hours, reducing to 1
• uncleared swaps: initially 48 business hours, reducing to 24
• Confirmation data: initially 48 business hours,
reducing to 24
• Valuation data: quarterly
• Other continuation data: initially 2 business days,
reducing to 1

32. Trade Reporting: How?
Reporting parties must use facilities, methods, or data
standards permitted or required by the SDR
Three identifiers will be used:
• Unique Swap Identifier (USI) – ID’s transaction
• Legal Entity Identifier (LEI) – ID’s counterparty
• Unique Product Identifier (UPI) – ID’s transaction type

33. Non-SD/MSP Reporting Obligations
Cleared Swaps
Uncleared Swaps
• If on SEF or DCM, no
reporting requirements
• If off-facility and
cleared before
reporting deadline, no
reporting requirements
• If off-facility and
cleared after reporting
deadline, report PET
data only
• If on SEF or DCM,
report only valuation
data and other
continuation data
• If off-facility, report all
data (PET, confirmation,
valuation, and other
continuation data)