OTC Derivatives: Dodd Frank Act

Rajeev Jha
Capgemini US LLC
4/5/2011
 Table of Contents

1. Executive Summary ................................................................................................................................. 3

2. Derivatives .............................................................................................................................................. 4
2.1. OTC Derivatives .................................................................................................................................. 4
2.1.1. OTC Derivatives – Trade Flow ......................................................................................................... 4
2.1.1.1. Trade Flow – Details ........................................................................................................................ 5
2.2. Exchange Traded Derivatives ............................................................................................................... 6
2.2.1. Exchange Traded Derivatives – Trade Flow ....................................................................................... 7
2.2.1.1. Trade Flow - Details ........................................................................................................................ 8
3. Dodd Frank Act – Title VII....................................................................................................................... 9
3.1. Provisions of Title VII.......................................................................................................................... 9
3.1.1. Market Participants .......................................................................................................................... 9
3.1.2. Roles of Supervisors ...................................................................................................................... 10
3.1.3. Derivatives Market Structure .......................................................................................................... 11
3.1.4. Clearing ........................................................................................................................................ 12
3.1.5. Trading ......................................................................................................................................... 12
3.1.6. Capital & Margining Requirements ................................................................................................. 13
3.1.7. Reporting & Recordkeeping ........................................................................................................... 13
3.1.8. CFTC / SEC Rulemaking Process ................................................................................................... 14
3.2. OTC Derivatives Trading - Under DFA Guidelines .............................................................................. 15
3.2.1. OTC Derivatives – DFA Proposed Trade Flow................................................................................. 15
3.2.1.1. Trade Flow – Details ...................................................................................................................... 16
4. Evaluation of Proposed DFA Reforms: .................................................................................................... 17
4.1. Market Participants: ........................................................................................................................... 17
4.1.1. Swap Dealers: ............................................................................................................................... 17
4.1.2. Major Swap Participants (MSPs): .................................................................................................... 17
4.1.3. Commercial End Users: .................................................................................................................. 18
4.2. Regulatory Rulemaking: ..................................................................................................................... 18
5. Glossaries: ............................................................................................................................................ 19
1. Executive Summary
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-
Frank Act”) was signed into law by U.S. President Barack Obama. It was designed to make order of
the cascading regulatory chaos that ensued in 2008 when mammoth banks and some unregulated
financial firms collapsed, and public funds were used to save them.

The law touches on nearly every facet of the financial sector. The goals of this legislation are to
achieve following objectives:

Establish a new council of "systemic risk" regulators to monitor growing risks in the financial
system, with the goal of preventing companies from becoming too big to fail and stopping
asset from forming, such as the one that led to the housing crisis.

Create a new consumer protection division within the Federal Reserve charged with writing and
enforcing new rules that target abusive practices in businesses such as mortgage lending
and credit card issuance.

Empower the Federal Reserve to supervise the largest, most complex financial companies to
ensure that the government understands the risks and complexities of firms that could pose a risk
to the broader economy.

Allow the government in extreme cases to seize and liquidate a failing financial company in a
way that protects taxpayers from future bailouts.

Give regulators new powers to oversee the giant derivatives market, increasing transparency by
forcing most contracts to be traded through third-parties instead of only between banks and their
customers. Derivatives, which are complex financial instruments, are often used
to hedge risk. Speculative trading in the contracts led to losses at many banks in the 2008 crisis.

The 2,300-page bill which has 16 Titles is the most extensive overhaul for the U.S. financial
system since the 1930s. The objective of this paper is to analyze the impact of Title VII on OTC
derivatives trading.
2. Derivatives
A derivative is a risk transfer agreement, the value of which is derived from the value of an
underlying asset. The underlying asset could be an interest rate, a physical commodity, a company’s
equity shares, an equity index, a currency, or virtually any other tradable instrument upon which
parties can agree.
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they
are traded in the market. The first is over-the-counter (OTC) derivatives, which are customized,
bilateral agreements that transfer risk from one party to the other. OTC derivatives, which are
sometimes called swap agreements or swaps, are negotiated privately between the two parties and
then booked directly with each other. The second category consists of standardized, exchange-traded
derivatives, which known generically as listed derivatives or futures. In contrast with OTC
derivatives, listed derivatives are executed over a centralized trading venue known as an exchange
and then booked with a central counterparty known as a clearing house.

2.1. OTC Derivatives

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, and exotic options are almost always traded in this way.
These derivatives are not traded on an exchange, so there is no central counter-party. Therefore,
they are subject to counter-party risk, like an ordinary contract, since each counter-parties relies
on the other to perform.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with
respect to disclosure of information between the parties, since the OTC market is made up of
banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts
are difficult because trades can occur in private, without activity being visible on any exchange.
According to the Bank for International Settlements, the total outstanding notional amount is
US$684 trillion (as of June 2008 ). Of this total notional amount, 67% are interest rate contracts,
8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity
contracts and 13% are other types of contracts.

Characteristics of OTC Derivatives are as follows:

• Trades negotiated over-the-counter

• Customized contracts are broken down by trading desk into tradable risks and hedged in
liquid markets
• Traded between dealers as principals
• Dealer is normally counterparty to all trades
• Margin (collateral) often exchanged but subject to negotiation between counterparties

2.1.1. OTC Derivatives – Trade Flow

Following diagram illustrates the most common way that OTC Derivatives are traded and
cleared.
OTC Derivatives – Trade Flow

1 Trading
2

Swap Dealer Counterparty

Agreement
Terms

5 Electronic 4
Confirmation
Clearing Manual
Confirmation
Market Wire 6

Clearing House

Reporting Reporting

Data Repositories

Page 1

2.1.1.1. Trade Flow – Details

The counterparties to the trade enter into a bilateral trade agreement, the details
of which can be conveyed either manually or electronically.

TF# Trade Flow Descriptions

Function
Dealer A dealer is a person or organization who “make a market”
by maintaining bid and offer quotes to other market
participants.
Counterparty Counterparty is a legal and financial term. It means a party
to a contract. Counterparty is usually the entity with whom
one negotiates on a given agreement, and the term can refer
to either party or both, depending on context.
Agreement Terms Agreement Terms specify the delivery and payment terms
of underling assets.
 Manual Manual confirmation is a direct communication between
Confirmation the counterparties' operations departments.

Electronic Electronic confirmations are often routed through a trade

Confirmation processing facility (eg MarkitSERV) where the trade details
are confirmed and the formal clearing of the trade is
conducted.
Clearing House A clearing house is a financial institution that
provides clearing and settlement services for financial and
commodities derivatives and securities transactions. A
clearing house stands between two clearing firms (also
known as member firms or clearing participants) and its
purpose is to reduce the risk of one (or more) clearing firm
failing to honor its trade settlement obligations.
In OTC Derivatives, trade clearing through Clearing
House is an optional process.
Data Repositories Data Repositories retains the trade information of OTC
Derivatives. It is administered by a clearing facility or by
the counterparties themselves depending on how the trade is
cleared.
In OTC Derivatives, the information in Data
Repositories is not available publically.

2.2. Exchange Traded Derivatives

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where
individual’s trade standardized contracts that have been defined by the exchange. According to
BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during
Q4 2008. Some types of derivative instruments also may trade on traditional exchanges. For
instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed
on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Like
other derivatives, these publicly traded derivatives provide investors access to risk/reward and
volatility characteristics that, while related to an underlying commodity, nonetheless are
distinctive.

Characteristics of Exchange Traded Derivatives are as follows:

• Trades executed on organized exchanges

• Trades limited to standardized contracts
• All trades are booked with exchange’s clearinghouse, which is counterparty to all trades
• Mandatory margin requirements
• Initial margin
• Variation margin
• Daily settlement (mark to market) and margin calls
2.2.1. Exchange Traded Derivatives – Trade Flow
In Exchange Traded Derivatives, rather than a bilateral agreement, the counterparties
convey their bids and offers to an exchange where the trade is consummated. Trade
information is then sent to the exchange associated clearinghouse where it is cleared.
Once cleared the clearinghouse stands between the counter parties guaranteeing both
sides of the trade. Because of that fiduciary arrangement, access to a clearinghouse is
restricted to clearing members who have satisfied particular financial requirements.

Following diagram illustrates the most common way that Exchange Traded Derivatives
are traded and cleared.

Exchange Traded Derivatives – Trade Flow

1 2

Dealer Counterparty
3

Clearing
Trading Trading

Exchange 5
Clearing Member

Clearing

Clearing House

Reporting
Data
Repositories

Page 1
2.2.1.1. Trade Flow - Details
TF# Trade Flow Descriptions
Function
Dealer A dealer is a person or organization who “make a market”
by maintaining bid and offer quotes to other market
participants.
Counterparty Counterparty is a legal and financial term. It means a party
to a contract. Counterparty is usually the entity with whom
one negotiates on a given agreement, and the term can refer
to either party or both, depending on context.
Exchange A futures exchange or derivatives exchange is a central
financial exchange where people can trade
standardized futures contracts; that is, a contract to buy
specific quantities of a commodity or financial instrument at
a specified price with delivery set at a specified time in the
future.
Clearing Member Clearing Membership is required for a Counterparty to avail
the facility of a Clearing house. Therefore a non-clearing
house member wishing to trade on an exchange must have
an arrangement with a clearinghouse member to represent
their trades to the clearinghouse.
Clearing House A clearing house is a financial institution that
provides clearing and settlement services for financial and
commodities derivatives and securities transactions. A
clearing house stands between two clearing firms (also
known as member firms or clearing participants) and its
purpose is to reduce the risk of one (or more) clearing firm
failing to honor its trade settlement obligations. A clearing
house reduces the settlement risks by netting offsetting
transactions between multiple counterparties, by
requiring collateral deposits (a.k.a. margin deposits), by
providing independent valuation of trades and collateral, by
monitoring the credit worthiness of the clearing firms, and
in many cases, by providing a guarantee fund that can be
used to cover losses that exceed a defaulting clearing firm's
collateral on deposit.
Data Repositories Data Repositories retains the trade information of Exchange
Traded Derivatives. It is administered by a clearing house.
The information in Data Repositories is available publically.
3. Dodd Frank Act – Title VII
The OTC derivatives market has been largely unregulated, which critics say permitted significant
risks to build within the financial services industry virtually unchecked. In the wake of the financial
crisis in 2008, regulation of derivatives became a primary focus of financial regulatory reform. Title
VII of the Dodd-Frank Act, entitled the Wall Street Transparency and Accountability Act of 2010,
establishes a new framework for regulatory and supervisory oversight of the over-the-counter
(“OTC”) derivatives market, which is estimated at more than $600 trillion.

The new regulatory framework described in Title VII requires achieving following objectives:

• The Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange
Commission (“SEC”) to share regulatory and supervisory authority for OTC derivatives (i.e.,
swaps and security-based swaps, respectively – hereinafter “swaps”) and to participate jointly
in the rule-making process.
• Mandatory clearing for swaps accepted by a clearing entity and designated by the CFTC and
SEC as clearable.
• Mandatory execution of cleared swaps on a regulated exchange or swap execution facility
(“SEF”).
• Mandatory reporting of cleared and non cleared swaps to a trade repository or the CFTC or
SEC.
• Capital and margin requirements with higher requirements to be imposed on un-cleared
swaps.
• Prohibitions on certain swap activities for insured depository institutions.
• Public access to swap transaction volume and pricing data.
• The CFTC and SEC are required to promulgate final rules implementing the provisions of
Title VII within 360 days of enactment.

3.1. Provisions of Title VII

Highlights of the major provisions of Title VII are discussed below.

3.1.1. Market Participants

Virtually all derivatives market participants are impacted by the legislation, though the
degree of impact depends on how an individual firm is classified. Different rules apply to
different market participants: swap dealers, major swap participants and commercial end-
users.

A “Swap Dealer” is defined as any person who

Holds itself out as a dealer in swaps;
Makes a market in swaps;
Regularly engages in the purchase or sale of swaps in the ordinary course of
business;

A “Major Swap Participant” (“MSP”) is defined as anyone that maintains a substantial

net position in swaps (excluding positions held for hedging or mitigating commercial
risk) or whose positions create substantial counterparty exposure that could have serious
adverse effects on the financial stability of the U.S. banking system or financial markets.
As with swap dealers, a person may be designated as an MSP for one or more categories
of swaps without being classified as an MSP for all classes of swaps.
 “Commercial End Users” are businesses that use derivatives to hedge “commercial
risk,” generally risk from producing or consuming commodities. Commercial end-users
would be exempt from the clearing requirement.

The regulators have significant authority to determine if an end-user is an MSP. Entities

that have a significant swap book and are not commercial hedgers, such as hedge funds,
would likely be deemed MSPs. In addition, some large commercial producers, such as
major oil producers, would likely be deemed MSPs.

3.1.2. Roles of Supervisors

Under the new law, the Federal regulatory supervisors have expanded powers over the
derivatives business. The law provides the CFTC and SEC with extensive new authority
and imposes significant requirements on these agencies to regulate the OTC derivatives
market, products and market participants. The regulatory agencies determine which
market participants are subject to the legislation.

Under Title VII, the CFTC has authority over swaps, swap dealers and major swap
participants, swap data repositories, derivative clearing organizations with regard to
swaps, persons associated with a swap dealer or major swap participant, eligible contract
participants, and swap execution facilities. The SEC has authority over security-based
swaps, security-based swap dealers and major security-based swap participants, security-
based swap data repositories, clearing agencies with regard to security-based swaps,
persons associated with a security-based swap dealer or major security-based swap
participant, eligible contract participants with regard to security-based swaps, and
security-based swap execution facilities.

Title VII further requires the CFTC and SEC to engage in multiple rulemakings and other
regulatory actions related to derivatives. In advance of rulemakings, the agencies are
required to consult with one another and the Federal prudential regulators (the Federal
Reserve Board (“Fed”), Office of the Comptroller of the Currency, Federal Deposit
Insurance Corporation (“FDIC”), Farm Credit Administration, and Federal Housing
Finance Agency, as appropriate) to ensure consistency and comparability to the extent
possible. Functionally or economically similar products or entities must be treated in a
similar manner by each of the agencies. Where one agency believes the rules of the other
may pose conflicts, they are permitted to challenge the rule in the U.S. Court of Appeals
for the District of Columbia.

The CFTC and SEC are required to jointly write rules, in consultation with the Fed, to
address:
 Definitions for “swap,” “security-based swap,” “swap dealer,” “security-based
swap dealer,” “major swap participant,” “major security-based swap participant,”
“eligible contract participant,” and “security-based swap agreement.”

 Books and records to be maintained for security-based swap agreement by

persons recognized as swap data repositories.

Within 180 days of enactment, the CFTC and SEC are to adopt rules to mitigate conflicts
of interest at clearinghouses, clearing agencies, exchanges, and swap execution facilities
 in regards to bank holding companies with total consolidated assets in excess of $50
billion, nonbank financial companies supervised by the Fed, and their affiliates. The rules
adopted may include numerical limits on the control of, or the voting rights of, these
entities.

Title VII gives regulators the ability to limit swap positions held by a derivatives trader or
class of traders. The CFTC imposes aggregate position limits for contracts traded on
exchanges, swap execution facilities, non-U.S. boards of trades and swaps that are not
centrally executed. The SEC would be given authority to impose position limits on
security-based swaps, including aggregate position limits on security-based swaps and
any underlying security or loan that the security-based swap references. The CFTC and
the SEC have further authority to prohibit participation in swaps activity in a foreign
country that undermines the stability of the US financial market system.
In general, the rules required under Title VII must be promulgated in final form no more
than 360 days after the date of enactment unless otherwise specified. (See “CFTC/SEC
Rulemaking Process”).

3.1.3. Derivatives Market Structure

Under the new law, banks can continue to trade most OTC derivatives in-house.
Permissible swap and security-based swap transactions include interest rates, foreign
exchange, cleared credit default swaps (“CDS”) on investment grade entities, gold and
silver swap transactions, and swaps transactions that hedge a bank’s own risk.

However, under Section 716– the “push-out” provision – swap dealers and MSPs are
prohibited from receiving Federal assistance (including access to the Fed discount
window and FDIC deposit insurance) if they conduct other types of swaps transactions
within a depository banking institution. This effectively prohibits insured depository
institutions from conducting certain derivatives activities and requires them to “push-out”
the non-permissible swaps activities into a separately capitalized bank holding company
affiliate. These non-permissible swaps activities include: all commodity, energy and
metals, agriculture, CDS on non-investment grade entities, equities, and uncleared CDS.

A transition period of up to 24 months is available to banks that are required to cease

non-permissible swaps activities or divest themselves of their swaps activity in order to
avoid the prohibition against Federal assistance. The appropriate Federal banking
regulator shall consider the potential impact of divestiture or cessation of activities when
establishing the transition period. An extension of up to one year may be added to the
transition period following consultation with the CFTC and SEC. The prohibition against
Federal assistance applies only to swaps entered into by an insured institution after the
end of the transition period and the prohibition will be effective two years following the
effective date of the legislation.

Derivatives clearing organization, clearing agencies and swap execution facilities must
register with the CFTC or SEC or both and meet certain requirements including, among
other things, designating a chief compliance officer, adhering to core principals; and
reporting requirements.

The CFTC and SEC must issue rules no later than 1 year after enactment requiring swap
dealers and MSPs to register with the CFTC or SEC or both. Registered swap dealers and
 MSPs are required to meet certain minimum capital and minimum initial and variation
margin requirements as well as business conduct standards and reporting requirements.

3.1.4. Clearing

The legislation mandates clearing of standardized OTC derivatives. The law explicitly
requires that swap dealers and MSPs use a clearinghouse for standardized or “clearable”
derivatives transactions. Under the law, the CFTC and SEC are required to promulgate
rules and regulations to provide for the mandatory clearing of such swaps.
A swap that is accepted by a derivatives clearing organization (“DCO”) or clearing
agency for clearing and that the CFTC or SEC has designated as clearable must be
cleared. All swaps subject to the clearing requirement must be executed on a designated
contract market, an swap execution facility or an exchange.

Central clearing is initially limited to a few “plain vanilla” swap products. On an ongoing
basis, regulators will review each swap, or any group, category, type, or class of swaps to
make a determination as to whether the swap or group, category, type, or class of swaps
should be required to be cleared.
Foreign exchange swaps and forwards are treated as swaps under the law and therefore
are subject to the clearing requirement, unless the U.S. Secretary of the Treasury
determines otherwise. Note: Foreign exchange swaps and forwards were exempt from the
clearing requirement in prior drafts of legislation.

Exceptions to the clearing requirements are provided for:

 Commercial end-users, such as farmers, airlines and manufacturers, provided

they explain to regulators how they are meeting their financial obligations with
entering into un-cleared swaps.

 Affiliates of commercial end users if the affiliate uses swaps to mitigate the
commercial risk of the commercial entity or other affiliate that is not a financial
entity.
Except for affiliates that are swap dealers, MSPs, investment companies,
commodity pools or bank holding companies with more than $50 billion
in consolidated assets. A two-year transition applies.

 Swaps entered into before the date of enactment and swaps entered into before
the application date of the clearing requirement, provided they are reported to a
swap data repository or the CFTC or SEC, as appropriate.

 Certain depository institutions, farm credit institutions and credit unions with
total assets of $10 billion or less (except for those whose primary business is to
provide financing related to the activities of its parent or holding company
affiliate) if determined by the CFTC and SEC to be exempt through a
rulemaking.

3.1.5. Trading

All swaps subject to the clearing requirement must be executed on a regulated exchange
or a swap execution facility. A swap execution facility is defined as “a 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…” It is unclear at this time
exactly what constitutes, and what types of trading platforms may qualify as a swap
execution facility.
Section 619 under Title VI of the Dodd-Frank Act prohibits and limits the ability of
banking entities from engaging in certain activities (the “Volcker Rule”). These
provisions include prohibitions on “proprietary trading” and investing more than 3
percent of the bank’s Tier 1 capital in private equity and hedge funds, and from owning
more than a 3 percent stake in any one private equity or hedge fund. The prohibitions on
proprietary trading extend to certain derivatives trading activity. Systemically significant
nonbank financial companies are not prohibited from engaging in proprietary trading.
However, these companies are subject to additional capital requirements and quantitative
limits determined by the regulators.

3.1.6. Capital & Margining Requirements

Under Title VII, swap dealers and MSPs are subject to capital and margin requirements.
The law requires initial and variation margin (also referred to as collateral posting) for all
OTC derivatives that are not cleared. Existing swaps are not specifically exempt from the
margin requirement. Regulators are also likely to set minimum margin requirements for
clearinghouses.
Early versions of the legislation specifically exempted commercial end-users from
margin requirements. This exemption is not in the enacted law, though the sponsoring
legislators have indicated that their intent was to provide such an exemption.
Section 171 under Title I of the Dodd-Frank Act (the “Collins Amendment”) requires
Federal banking agencies to set leverage and risk-based capital requirements for insured
depositories, depository holding companies and systemically significant non-banks. Such
requirements must at a minimum address such risks as significant volumes of derivatives
activity or activity in securitized products, financial guarantees and certain other financial
instruments, as well concentrations in assets or market share. Presumably, capital
requirements developed by supervisors for depositary institutions will be consistent with
the soon-to-be-revised Basel Capital guidelines.

3.1.7. Reporting & Recordkeeping

Under Title VII, all swap dealers and MSPs are required to maintain daily trading records
of swaps. These daily records include recorded communications, such as electronic mail,
instant messages and recordings of telephone calls; daily trading records for each
customer or counterparty; and a complete audit trail for conducting comprehensive and
accurate trade reconstructions.
The law also requires data collection and publication through clearing houses or trade
repositories. Each DCO is specifically required to publicly disclose following
information:

 The terms and conditions of each contract, agreement or transaction cleared and
settled.
 Clearing and other fees charged members;
 Its margin setting methodology;
 Daily settlement prices, volume and open interest for each contract settled or
cleared.
 Repositories have already been launched for credit and interest rate products and the
industry is in the process of building a repository for equity derivatives. All trades that
are cleared and un-cleared will be recorded in these repositories.
Transition rules provide that swaps entered into prior to the enactment date that are still
outstanding as of the enactment date must be reported to a swap data repository or the
CFTC or SEC, as appropriate. Similarly, swaps entered into after the enactment date and
prior to the effective date will also be required to be reported. The CFTC and the SEC are
required to issue an interim final rule regarding these reporting requirements within 90
days after enactment.

3.1.8. CFTC / SEC Rulemaking Process

While the Dodd-Frank Act establishes the broad outline of OTC derivatives market
regulation, many questions about its impact and scope remain unanswered and are left to
the CFTC and SEC to determine. These agencies are required to promulgate final rules
no later than 360 days following enactment.
In advance of the official rule-writing process, the CFTC has identified 30 topics where
rule-writing is necessary to regulate the swaps markets. The rule-writing areas have been
divided into eight groups:

 Comprehensive Regulation of Swap Dealers & Major Swap Participants;

 Clearing;
 Trading;
 Data;
 Particular Products;
 Enforcement;
 Position Limits;
 Other Titles;

The CFTC indicates that teams of staff within the agency have been assigned to each
rule-writing area and will be involved with the process “from analyzing the statute’s
requirements, to broad consultation, to recommending proposed rulemakings to
publishing final rules.” The CFTC is currently soliciting public input on each of the areas.
Comments may be submitted through the CFTC web site and will not be considered
official responses to a specific rulemaking.
Similarly, the SEC has also identified broad areas for which it is seeking public input in
advance of rule-writing. With regard to Title VII, these areas include:
 Definitions (e.g., “swap,” “security-based swap” and “mixed swap”);
 Security-based swap dealers and major security-based swap participants;
 Mandatory clearing of security-based swaps, end-user exception and security-
based swap clearing agencies;
 Mandatory exchange trading and swap execution facilities;
 Governance and conflict of interest controls for clearing agencies, swap
execution facilities and exchanges;
 Swap data repositories;
 Real-time reporting;
 Anti-manipulation protections.
3.2. OTC Derivatives Trading - Under DFA Guidelines
All Standardized swaps will be traded on exchanges or on Swap Execution Facilities (left
undefined in DFA, but will likely include many of the current electronic trading platforms in
addition to new entrants to the market). Once the trade is completed it must be cleared, the same
way that exchange traded derivatives are currently cleared. A clearinghouse could also clear
swaps trades executed on a Swap Execution Facility when such arrangements are established.
All un-cleared swaps could be cleared in much the same way as an OTC trade is cleared.

3.2.1. OTC Derivatives – DFA Proposed Trade Flow

Following diagram illustrates the proposed trade flow of OTC Derivatives:

OTC Derivatives – Trade Flow (Proposed under DFA)

1 2

Trading Trading
Eligible for
Swap Dealer No Yes Major Swap Participant
Clearing

3
Un - Cleared
Swap 5

Swap Execution Facility

Electronic Manual
Confirmati Confirmation 6

Clearing Member
7

Clearing Clearing

Clearing House

Reporting

8
Reporting

Reporting Swap Data

Repositories

Page 1
3.2.1.1. Trade Flow – Details
TF# Trade Flow Descriptions
Function
Swap Dealer A dealer is a person or organization who “makes a market”
by maintaining bid and offer quotes to other market
participants.
Major Swap A “Major Swap Participant” (“MSP”) is defined as anyone
Participant that maintains a substantial net position in swaps or whose
positions create substantial counterparty exposure that could
have serious adverse effects on the financial stability of the
U.S. banking system or financial markets.
Clearing Eligibility Derivative contracts which are unique and created for
mitigating commercial risks are exempted from centralized
clearing. All other derivatives contract would have to go
through centralized clearing process.
Un-cleared Swap Un-cleared OTC Contracts are contracts which are exempted
from centralized clearing processes. These transactions will
receive advantageous treatment, which implies less stringent
capital and margining requirements than will be applicable
to the outright trading of tailored swaps. These Swaps may
follow the current OTC Derivatives trade flow.
Swap Execution A Swap Execution Facilities will be a trading system or
Facilities platform in which multiple participants have the ability to
execute or trade swaps by accepting bids and offers made by
other participants that are open to multiple participants in the
facility or system, through any means of interstate
commerce. The execution of cleared swap will be mandatory
on Swap Execution Facilities.
Clearing Member Clearing Membership is required for a Counterparty to avail
the facility of a Clearing house.
Clearing House A clearing house is a financial institution that
provides clearing and settlement services for financial and
commodities derivatives and securities transactions. A
clearing house stands between two clearing firms (also
known as member firms or clearing participants) and its
purpose is to reduce the risk of one (or more) clearing firm
failing to honor its trade settlement obligations. A clearing
house reduces the settlement risks by netting offsetting
transactions between multiple counterparties, by
requiring collateral deposits (a.k.a. margin deposits), by
providing independent valuation of trades and collateral, by
monitoring the credit worthiness of the clearing firms, and in
many cases, by providing a guarantee fund that can be used
to cover losses that exceed a defaulting clearing firm's
collateral on deposit.
Swap Data All Cleared and un-cleared Swaps information will be
Repositories reported to Swap Data Repositories. Public will be able to
access the volume and pricing details of all Swap
Transactions.
4. Evaluation of Proposed DFA Reforms:
The main market failures in the OTC derivatives market are the buildup of excess leverage, opacity
and difficulties of resolution when a large counterparty gets into trouble. Does the Wall Street
Transparency and Accountability part of Dodd Frank Act on financial reforms address these issues?

4.1. Market Participants:

Key provisions of Title VII – including clearing, trading, capital, margining, reporting and
recordkeeping requirements -- are likely to fundamentally alter the OTC derivatives market. As
stated earlier, virtually all derivatives market participants are impacted by the legislation, though
the degree of impact will depend on how an individual firm is classified: swap dealer, major
swap participant or commercial end-user. Some potential key strategic impacts to consider for
each of these classifications include:

4.1.1. Swap Dealers:

Increased transparency from the exchange trading/swap execution facility requirement

could reduce dealer profits but could also impact availability and liquidity for certain
bespoke and non-standardized contracts.

 New entrants may try to capture a piece of the derivatives business that becomes
more standardized and exchange traded.

 Increased regulation, potentially decreased profits and the prospects of increased

competition from new market entrants may further alter the dealer landscape.

 Margining and other requirements could raise the cost of certain swap
transactions. Swap dealers will almost certainly need more capital to support
their derivatives businesses.

 The structure of major dealers’ swaps businesses may change. Dealers may look
to optimize where they book derivatives within their organizational structures
and global office networks. New corporate governance structures will be required
to oversee the derivatives businesses in the new entities created for activity
“pushed out” of the banking entity.

4.1.2. Major Swap Participants (MSPs):

 MSPs face many of the same requirements as dealers. Some MSPs may decide to
shrink their businesses to avoid dealing with MSP requirements. Others will see
opportunities to expand into an area previously dominated by a handful of
dealers.

 In either event, MSPs will need to review their derivatives governance, activities,
operational support and related areas to ensure they are structured and
functioning within appropriate guidelines.
 4.1.3. Commercial End Users:

 As dealers pass on increased costs to end-users, and as end-users grapple with a

more complicated regulatory environment, the appetite for using OTC derivatives
may decrease.

 On the other side of the coin: greater transparency may narrow spreads and
reduce costs, leading to increased volume and usage for certain products (which
is generally what occurred after US futures exchanges went electronic).

 While the intent of Congress is to exclude commercial end-users from capital and
margining requirements, regulatory rulemaking to that effect may need to be
promulgated.

4.2. Regulatory Rulemaking:

The regulatory rulemaking process is likely to be a lengthy affair that reflects the need for a
significant increase in regulatory resources, as well as the number and complexity of the issues
to be addressed. Some key questions yet to be answered are:

Clearing:
 How the CFTC and the SEC will determine which swaps must be cleared?

Margining requirements:
 How will margining requirements be set for cleared and un-cleared trades?
 Will end-users be exempt from margin requirements? If not, what will be the impact?

Capital requirements:
 How will capital requirements for dealers and major swap participants be determined?
 What is the process for achieving consistency amongst US Federal supervisors (and the
Basel Committee) on capital requirements?

Trading practices:
 How will the process for developing and launching new swap products change under the
new law?
 How will the supervisors determine aggregate position limits?

Reporting and recordkeeping:

 How will the trade reporting process work for cleared and un-cleared trades?
 What additional information will be required to be disclosed?
5. Glossaries:
Term Description

SEC The U.S. Securities and Exchange Commission (frequently abbreviated SEC) is
a federal agency which holds primary responsibility for enforcing the federal
securities laws and regulating the securities industry, the nation's stock and
options exchanges, and other electronic securities markets in the United States.

CFTC The U.S. Commodity Futures Trading Commission (CFTC) is an independent

agency of the United States government that regulates futures and option
markets.

FDIC The Federal Deposit Insurance Corporation (FDIC) is a United States

government corporation, which guarantees the safety of deposits in member
banks, currently up to $250,000 per depositor per bank.

BIS The Bank for International Settlements (BIS) is an intergovernmental

organization of central banks which "fosters international monetary and
financial cooperation and serves as a bank for central banks..