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Proposed ReformoftheOTCDerivativesMarket:Turning

"Weapons"into Plowshares?J. PAUL FORRESTER, JOEL TELPNER, EDMUND PARKER,LAWRENCE HAMILTON, AND JMILA PIRACCI

PA U L F O R R E S T E Rpartner at Mayer

wn LLP in Chicago,

[email protected]

T E L P N E R

partner at Mayer

wn LLP in New York,Y.

[email protected]

M U N D P A R K E Rartner at Mayer

wn LLP in London,

[email protected]

R E N C E H A M I LT O N

partner at Mayer

wn LLP in Chicago,

[email protected]

M I L A P I R A C C I

associate at Mayer

wn LLP in Chicago,

[email protected]

Populist politicians and press, anxious

to identify villainsto blamefor theglobal economic meltdown, haveenthusiastically endorsed Warren

Buffett's derisive 2003 "financial weaponsofmass destruction" labelfor derivative prod-ucts.Buffett's concerns, which now ring pre-scient to many ears, centered on the fact that,before a derivative contract is settled, the par-tiesto that contract record profits and lossesbasedon mark-to-market estimates withoutany money having changed handsand not-withstandingthe fact that some derivativesdo not havea sufficient marketon whichtobase the m arks. Further, derivatives can exac-erbate the problems a company may face thatotherwise would have been under control.Thisis becauseof the use of requirementsfor collateralto be postedin the eventof aratings downgrade. First Enron and now AIGare the poster childrenfor this conundrum:collateral triggers designedto limit coun-terparty credit riskcan create troublesomeconsequences. As a ratingis downgraded col-lateral callsare madeand, as the companyfacesthe needto put up additional cash,itsspiraling illiquidity leadsto further ratingsdowngrades, additional collateral triggers andstill greater pressureon liquidity.

FormerFederal Reserve Board ChairmanAlan Greenspan hasin the past beena cham-pionof OTC derivativesas instruments thathave permitted the unbundling and dispersion

of riskand therebya reductionof systemic

risk. Most observers,in fact, still tout theinstruments for their efficient re-allocatvariety ofrisks.For example, O TC derivatare key building blocksin structured financinsofarasthey are the primary means to hor transfer related commodity, credit, cuand interest rate risks inherentin transactionsthat underlie structured finance . Of coinany useof these productsthe managementofcounterparty credit riskis of utmost importance since real risk transfer fails if the pwhom risk is transferred cannot perforcontractual obligations. Debate continasto whether there is sufficient transparencounterparty credit risk mitigation in thderivatives m arket. Regardless of the oof the academic arguments, most acknothata certain am ount of legislative and retory attention is inevitable.

The OTC derivatives market is ininglythe policy focusof lawmakersin theUnited States,in Europeand elsewhere.Theobjective and details of reaching statedgoalsof transparencyand regulatory reformcontinueto prove elusive, however,and thevarious legislative effortsto date leave manquestions unansweredand conceivablycon-fiict withone another.It willbe importantthat the political needto providea timelyresponseto concerns about transparencyandcounterparty credit riskbe balanced againsthe needto face head-onthe complication

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that will necessarily be involved in the responsible rede-sign of a complex and global OTC derivatives market.This article examines proposed legislative and regulatorydevelopments as well as OTC derivatives industry effortsthat are likewise afoot.

The activities in the United States have been fre-quent and myriad and thus comprise a large portion ofthis discussion, but that is not to give the impressionthat other foreign officials are not similarly focused onthese issues. Note that European regulators compelledindustry participants to commit to CDS clearing in theEU a full year before it turned to rule proposals. Mean-while, in the United States, legislative proposals havebeen intertwined among industry commitments withrespect to a variety of O T C derivatives reform goalposts.While none of these developments are the final word

on what can be expected in the future, they representkey steps toward an imminent broad financial systemoverhaul, potentially on a multi-jurisdictional basis.

U.S. CONGRESSIONAL ACTIVITIES

O n January 15, the Derivatives Trading IntegrityAct of 2009 (DTIA), sponsored by Senator Tom Harkin(D-IA), was introduced to the Senate Committee onAgriculture, Nutrition and Forestry. On February 11,the Derivatives Markets Transparency and Account-

ability Act of 2009 (DMTA), sponsored by Represen-tative Collin Peterson (D-MN), was introduced to theHouse Committee on Agriculture. The bill was con-sidered and passed by the Committee by voice vote onFebruary 12. On May 4, the Authorizing the R egulationof Swaps Act (AR SA), sponsored by Senator C arl Levin(D-MI) and Senator Susan Collins (R-ME), was intro-duced to the Senate Committee on Banking, Housing,and Urban Affairs. Ne xt, on M ay 13, Treasury SecretaryTimo thy Geithner outlined the Obama Administration'sgoals for the regulatory framework for OTC derivatives.Mo re recently, on ju ne 17, the U.S. Department of theTreasury published its proposed regulatory overhaul forthe U.S . financial system in a docum ent entitled "Fin an-cial Regulatory Reform: A New Foundation." Finally,on Jun e 26, the House of Rep resentatives narrowlypassed the American Clean Energy and Security Act of2009 (ACES), which, though focused on clean energyreforms, incorporates important regulatory limitationson derivatives. This flurry of bills and pronounce-ments has done little to add substance to the Treasury

framework, but ACES may be an indication of whbecoming abundantly clear: OTC derivatives wilsubject to new legislation in the United States innear term.

Congressional B ills and the ObamaAdministration's Directives

The DTIA proposed to amend the CommoExchange Act (CEA) by repealing the exemptionexclusions from regulation currently afforded to spfied derivatives, requiring all futures contracts (incluvirtually all OTC derivatives) to trade on a designcontract market or a derivatives transaction execufacility, and abolishing exempt boards of trade.

The DMTA would subject OTC derivatives

reporting and recordkeeping requirements as demined by the Com mo dity Futures Trading Com mis(CFT C). The bill would also require the CF TC to dmine whether fungible OTC agreements have the potial to disrupt market liquidity and price discovery anso, to impose and enforce position limits for speculatrading the agreements. Finally, the DM TA aimed to ject prospective OTC transactions either to settlementclearing on a CF T C - or Securities and Exchange Cmission (SEC)-regulated derivative clearing organizaor to reporting to the CFTC. Because of the hei

ened concerns regarding credit default swaps (CDS)DM TA also would grant the CF TC the authority topend CDS trading with the concurrence of the Presiand would establish that CDS traded or cleared by retered entities will not be considered exempt for purpof enforcing insider trading prohibitions.

ARSA, the most recent legislative proposal, worepeal current exemptions and exclusions affordedderivatives products and grant federal regulators au thoto regulate all types of OT C and exchange-traded dertives, withou t exception, imm ediately. T he sponsors of

bill offered itas

an interim step, making the way for antpated comprehensive financial reform later in the yeaOn May 13, the Obama Administration, through

Treasury Department, outlined the framework on wit expects Congress to build a new regulatory regimeOTC derivatives. Treasury Secretary Timothy Ceithlaid out several principles. First, he instructed that the should be amended "to require clearing of all standardO T C derivatives through regulated central counterpartSecond, he recommended that all OTC derivatives de

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and others who create large exposures to counterparties besubject to "a robust regime of prudential supervision andregulation." Next, Secretary Geithner proposed that theCEA and securities laws be am ended to allow fora varietyof recordkeeping and reporting rules and to ensure that the

CFTC and SEC have "clear and unimpeded authority"with respect to policing market abuses and the authorityto set position limits. Finally, he noted that the CFTCand SEC are reviewing the limitations on participants inOTC derivatives markets to recommend amendments tothe CEA and securities laws to tighten those limits orimpose additional disclosure.

The n, in June, the Treasury Departmen t publishedits proposed regulatory overhaul for the U.S. fmancialsystem in a document entitled "Financial RegulatoryReform : A N ew Found ation." In particular, four public

policy objectives w ere ou tlined: 1) preven ting activitiesin OTC derivatives markets from posing risk to thefinancial system; 2) pro m oting the efficiency and trans -parency of those markets; 3) preventing market m anipu -lation, fraud, and other market abuses; and 4) ensuringthat OTC derivatives are not marketed inappropriatelyto unsophisticated parties.

Finally, ACES, though still before the U.S. Senate,may reflect greater Congressional consensus around O T Cderivatives legislation than the introduced bills discussedabove. First, as a clean energy bill, ACES addresses cli-

mate change and renewable energy issues, including withrespect to the regulation of trading the related emissionsallowance and renewable credit derivatives. ACES alsowould eliminate current exemptions for OTC derivativesinvolving energy commodities, amend the CEA to placeeligibility limitations on entering into a CDS, and elim^i-nate the CEA's preemption ofstate gaming and "bucketshop" laws. Eliminating such preemption w ould have theeffect of prohib iting naked C DS (CDS in which the buyerof protection does not own the obligation thatis the subjectof the trade). These provisions, embedded in the shroud of

climate change, are an end -run around seemingly slower-paced, direct discussions about OTC derivatives reform.

WHAT DOES ALL THIS MEAN?

Central ClearingWhat's "Standard"Anyway?

There are many themessome overlapping andsome contradictory^in the bills that have been introduced

and in Secretary Geithner's statements. The commonthread am ong all of themis transparency. Clearing seemsto be the oft-quoted solution to the transparency problem .ARSA would not specifically require clearing but insteadwould give broad authority to regulators to work with one

another on the consistent treatment of derivatives. Secre-tary Geithner stated that all standardized O T C derivativesshould be cleared through regulated central counterpar-ties (CCPs) and that the acceptance of an OTC derivativeby one or more CCPs should create a presumption thatit is a standardized contract. He elaborated that the stan-dardized part of the OTC market should be moved ontoregulated exchanges and regulated transparent electronictrade execution systems. In prepared testimony before theHouse Financial Services and Agriculture Committees onJuly 10, Secretary G eithner stated that "a high volume oftransactions in a contract and the absence of economicallyimportant differences between the terms ofthe contractand the terms of other contracts that are centrally c leared"would be indicators that it is standardized.

What is not clear is what other parameters wouldestablish whether a product is "standardized" and, oncethat is determined, which contracts should be clearedvia CCPs, traded on an electronic trading platform, orquoted on a regulated exchange. None of the currentbills nor Secretary G eithner has identified wh o mark etconsensus, individual participants ora regulatorwould

determine whether a derivative is standardized. Secre-tary G eithner's latest comm ents suggest that there w ouldnot be a product-based approach for making this deter-mina tion. Since, according to the Treasury's framework,some contracts would be presumed to be standardizedbecause of their acceptance by a CCP, it would appearthat there might bea voluntary component in the initialdecision to submit a trade to a CCP.

Further, Secretary Geithner suggested that regu-lated institutions be encouraged to make greater use ofregulated exchange-traded derivatives. Which deriva-

tives would be requ ired (versus elected) to be traded ina certain mann er is an issue that has not been settled. O fcourse, all these questions arise without getting to thequestion of whether certain OTC derivatives are suit-able for any of these trad ing options in the first instance.As noted below, the OTC derivatives industry hasalready indicated that substantial portions of the OTCderivatives market are only made "electronically eli-gible" with difficulty and perhaps for some products itmay not be possible as a practical matter. The current

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bills and the Treasury proposal have lumped all OTCderivatives together and suggested the same (or substan-tially similar) treatment.

Are My Margin Requirements the Sameas Yours?

As part of the overall Treasury proposal, the Fed-eral Reserve Board would be given supervisory andregulatory oversight of any firm whose failure couldpose a threat to financial stability due to its combina-tion of size, leverage, and interconnectedness (referredto in the proposal as a "Tier 1 FHC"), regardless ofwhether such firm owns an insured depository institu-tion. Th rou gh its expanded powers, the Federal ReserveBoard would be able to impose these new capital and

regulatory requirements on all Tier1 FHCs engaged inderivatives activities.Since standardized trades were not defined, it is

unclear what transactions would be deemed to be cus-tomized. This distinction could have very importantpractical implications for the economics ofa particulartransaction. For example, since trades that are consid-ered customized need not be cleared, they would not besubject to mandatory margin rules. Secretary Geithnerstated that CCPs would be expected to impose robustmargin requirements and that there would be an effort

to ensure that customized OTC derivatives not becomea means of avoiding the use of CCPs. Certainly, anydifference between cleared and customized OTC deriv-atives would create an arbitrage opportunity that leg-islators likely would seek to avoid. On the other hand,imposing margin requirements eliminates an im portantfacet of having a so-called customized trade. In SecretaryGeithner's comments on July 10, he stated that deriva-tive contracts that are not centrally cleared must havemargin requirements "substantially above" those that arecentrally cleared. Again, it remains to be seen whethervariations in margin standards would be p ermitted basedupon the particular derivative product category or thesophistication of the parties to the trade.

It is also unclear at this junc ture the extent to w hichmargin requirements and capital requirements willoverlap. It seems that perceived derivatives risk exposurewill be addressed in the case of Tier I FHCs and otherregulated financial institutions through more conser-vative regulatory capital requirements, but not neces-sarily to the exclusion of margin rules. Will perceived

derivatives risk exposure be addressed in the casregulated financial institutions primarily throughproposed more stringent capital requirements? In trast, will participants that are not Tier 1 FHCs are not otherwise regulated financial institutions

subjected to stricter margin requirements given they may not otherwise be required to set aside cafor their derivatives trading activities? This assumecourse that non-regulated entities would be allowecontinue to directly enter into derivatives transactiAs a practical matter, if the capital or margin requments that are required are more than the econocapital that the related derivatives positions should hthe related trades will simply move to a jurisdiction a forum where the "excessive" capital or margin re qments do not apply.

Are Derivatives Too Dangerousfor Your Own Good?

The Treasury Secretary did not suggest derivatives markets be limited solely to regulated ficial institutions. He did, however, note that all Oderivatives dealers and other firms whose activitiethose markets create large exposures to counterpashould be subject to an appropriate and "robust" reof prudential supervision and regulation. Specific

Treasury recommended more conservative regulacapital requirements on OTC derivatives (which wbe more stringent than existing bank regulatory carequirements for OTC derivatives), business constandards, reporting requirements, and conservainitial margin requirements. Presumably, players wnot need to be regulated financial institutions to tin derivatives as long as they are subject to appropreporting, margin, and business conduct standards

Reporting and Recordkeeping

A secondary them e to the Treasury frameworkthe bills that have been introduced in Congressicomm ittees is recordkee ping/reporting. Secretary thner's proposal was that the C FT C and SEC should the authority to impose recordkeeping and reporrequirements on all OTC derivatives. He includedcaveat that clearing standardized transactions throa CCP or reporting customized transactions to a rlated trade repository could obviate the need to m

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certain of these requirements. The trade repositorywould then have to make aggregate data on open posi-tions and trading volumes available to the public andany particular counterparty's trade data available on aconfidential basis to the CFTC, the SEC and the coun-

terparty's primary regulator. Mr. Geithner also notedthe imp ortance of market efficiency and price transpar-ency. Part of what appears to be intended in connectionwith any future reporting requirements is a system toassure dissemination of prices and other trade informa-tion to the market. We will need to see the extent towh ich players will be allowed to com pete in derivativesmarkets in the future on the basis of price and whetherthe same level of price transparency will be re quired forcustomized trades.

Manipulation Issues

Another issue that has been mentioned in Con-gressional bills and in Mr. Geithner's remarks is withregard to preventing market manipulation, fraud, andother market abuses. Secretary Geithner's proposalson this point were not specific; instead, a reference togiving the CF TC and SEC broad and apparently unfet-tered authority to police fraud, market manipulation,and other m arket abuses involving O T C derivatives laidthe foundation for such measures.

In addition. Secretary Geithner proposed that theCFTC should have authority to set position limits onOTC derivatives that have a price discovery functionrelating to regulated markets. It is not clear how thosederivatives would be identified and correlated withthe regulated markets to which they are purportedlyrelated. The assumed means to the goal of preventingmarket abuses is that information provided to regula-tors (whether on a voluntary or man datory basis) by thecombination of CCPs, trade repositories, and marketparticipants will create the picture needed to establish

such correlations. T he gap, of course, is how the variousproducts might be categorized and what would distin-guish trades that are voluntarily reported versus thosethat are reported by mandate. The Secretary stoppedshort of suggesting thatU.S. securities and co mm oditieslaws be am ended to redefine derivatives as either secu ri-ties or regulated commodities. Doing so would give theSEC and CFTC the most explicit means of regulatingderivatives transactions.

Other Developments

As derivatives practitioners well know, currentlaw limits the types of parties that may participate inunregulated derivatives. Treasury's view is that the limits

are not sufficiently stringent. In this regard, the CFTCand SEC are reviewing the current eligibility limits torecomm end how to amend existing laws to tighten thoselimits or to impose additional disclosure requirements orstandards of care with respect to marketing derivativesto less sophisticated counterparties such as small munici-palities. Little detail has been provided as to additionalindicia, beyond current requirements, of sophisticationfor this market.

Another issue that remains unresolved is regula-tory jurisdiction . As many participants in the derivatives

markets are painfully aware, the presentU.S. regulatoryregime with respect to derivatives is mind-numbinglycomplex. Part of this comp lexity is due to the sometimesoverlapping authority of the SEC and CFTC. Therefore,one of the stated goals in the Treasury framework isthe elimination ofthese jurisdictional uncertainties andthe assurance that economically equivalent instrumentsbe regulated in the same manner regardless of whetherit is the SEC or C FT C that has jurisdiction over therelevant instrument or market. Treasury has asked thatthe CFTC and the SEC complete a report to Congress

identifying all existing conflicts in statutes and regula-tions regarding similar types of financial instruments.This report, due by the end of September, would needto explain why the current differences are necessary forinvestor protection, market integrity, and price transpar-ency, or make suggested changes to eliminate the dif-ferences. M oreover, if the two agencies cann ot agree onthe explanations and recommendations by the deadline.Treasury has proposed that unresolved issues be referredto a new Financial Services Oversight Council, whichwou ld then be required to resolve the disagreements and

provide Congress with its recommend ations w ithin sixmonths ofthat council's formation.Following the issuance of Treasury's Jun e proposal,

the heads of the SEC and CFT C affirmed their willing -ness to work together to better delineate the respectiveresponsibilities of each agency over the vast derivativesmarket. They comm ented that the SEC should continueto have responsibility with respect to derivatives linkedto stocks, bonds and securities and that the C FT C shouldoversee all other derivatives. The new directive that the

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two agencies identify and resolve conflicts is at least animportant recognition of the need to harmonize theseconflicts, once and for all.

One major open issue relates specifically to CDS.Since last fall, state insurance regulators have been scruti-

nizing covered CDS (thatis, CDS in which the buyer ofprotection owns the obligation that is the subject of thetrade) as potentially appropriate to subject to state insur-ance laws. On September 22, 2008 , the New York StateInsurance Department issued Circular Letter No. 19,announ cing that on January 1, 2009 the Departmentwou ld start treating covered C DS as insurance co ntractsunder the New York Insurance Law. That effort wastabled whe n O T C derivatives began to take a place onthe federal financial reform agenda. In Jun e of this yearamendm ents drafted by the Departm ent were introduced

in the Ne w Y ork legislature. Those am endments w ouldexempt CDS from insurance regulation, provided thatthe New York Insurance Department determines thatCDS are otherwise being "effectively and comprehen-sively regulated," including by requiring CDS writersto maintain adequate capital and post sufficient tradingmargins to minimize counterparty risk.

Th e D ivision of Insurance of the State of Missouri(whose state sloganis "I'm from Missouri, and you've gotto show me") has taken an even more activist role thanthe New York Insurance Department. O n N ovember 19,2008, the Division issued Bulletin No. 08-12, providingthat covered CDS are insurance contracts and thatissuing covered CDS in Missouri constitutes an insur-ance business that requires a certificate of authority fromthe Division. The Division has so far refused to suspendits effort to regulate covered CDS, citing as its reasonthe fact that no comprehensive federal regulatory schemehas yet been put in place.

Meanw hile, the Task Force on Cred it Default Swapsof the National Conference of Insurance Legislators(NCOIL) has drafted model legislation that would classifycovered CDSas "credit default insurance" and regulate theissuers of covered CDS as "credit default insurance cor-porations" along the lines of financial guaranty insurancecorporations (often called "monolines"). Among otherthings, the NCOIL Task Force's draft proposal wouldrequire credit default insurance corporations to main-tain contingency reserves against their CDS exposures.The NCOIL Task Force's draft proposal has been sharplycriticized by ind ustry pa rticipants, but it was presented tothe NCOIL Financial Services & Investment Products

Committee on July 9. After two hours of testimonydebate, the draftwas tabled until N COIL's annual meein November. Even if the proposalis eventually adoptemodel law by NCOIL, it is unclear whether it woulenacted into law by state legislatures. In short, it rem

uncertain whether federal legislative action with resto OTC derivatives in general and CDS in particcould alter or obviate the perceived need for actionstate insurance regulators and legislators.

Finally, all of these efforts leave unresolved a cical problemthat is, the regulatory arbitrage that be created by a U.S. regulatory regime that is diffefrom that continuing or established in other juristions. A more harsh atmosphere in the United Ston any number of points could send OTC derivatabroad. For example, the requirements for reporting

recordkeeping could place such a heavy burden on ticipants in the United States that engaging in derivattrading here w ould no longer be justifiable or financworthwhile. None of the proposals address the fact much of the derivatives market is truly global and gible. Indeed, even differences in clearinghouse rmay introduce a similar kind of regional arbitrage.

A C R O SS T H E P O N D

Derivatives have received no less scrutiny in Brand Europe than in the United States. In 2008, mderivatives dealers signeda commitment concerning establishment of a central clearing cou nterparty for Cin Europe. The central clearing platform is to be eslished, regulated and supervised in Eu rope by Julof this year. Wh ile central clearingis technically voltary, the pressure from regulators to increase transency and mitigate counterparty credit risk, which lethis commitment, was brought home through expmention of regulatory intervention as an alternatThis pressure has only increased with growing s

tiny of the credit crisis and the market that is belieto be one of its major causes. In a report publisheFebruary of this year, Jacques de Larosire, a forFrench Treasury official, recommended the simplition and standardization of most OTC derivativesthe intro duc tion and use of at least one well-capitalcentral clearinghouse for CDS in the EU. In Marcthis year. Lord Turne r, ch airman of the U.K.'s FinanServices Authority, reviewed events leading to the rent financial crisis and recomm ende d reforms inten

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to address steps that the international community couldtake to enhance regulatory and supervisory standardsand international coordination . O ne area of focus for theTurner Review was the complexity and opacity of struc-tured credit and other derivatives, with an emphasis on

the exaggerated effect that CDS can exert upon boomand bust cycles. The Turner Review was accompaniedby Discussion Paper 09/2 (DP 09/2), which outlineddetailed policy proposals, including consideration ofrevised capital requirements, regulated collateral calls,and additional product-specific regulation.

Reg ulators in Europ e have not issued proposed rulesto date, but the relatively early date by which market p ar-ticipants committed to central clearing for CDS revealsthe serious tone that has been taken there. On the heelsof the de Larosire report, in M arch of this year the E uro -

pean Parliament and European Council initiateda reportthat was designed to identify regulatory gaps with respectto derivatives. That report was announ ced on July3, andthe European Comm issionis expected to make rule pro-posals on the basis oft hat report as a matter of priority.The outline recommended a greater use of standardizedcontracts, central data repositories, public exchanges, andclearinghouses through which market participants canpost and have the benefit of collateral. A consultationperiod will continue until August31 , followed bya Euro-pean Commission hearing expected on September 25

and preparation of legislation by year-end .Previously, European regulators had considered a

voluntary code of conduct for the derivatives market.This would have required equity exchanges and clear-inghouses to offer pricing transparency and a greaterchoice of services. It is now believed that a mandatorycode is on the table. It is important to note that, fromthe time the voluntary, though pressured, commitmentto CDS clearing was made, the European Commissionhas escalated its attention to, and willingness to act on,perceived weaknesses in the derivatives market. Itis clear

that, while the commitments from industry have beenwelcomed, the book being written on the regulation ofderivatives is far from complete.

CLEANING HOUSE

CDS Auct ions

Though it seems certain that the regulatorylandscape for derivatives in general and CD S in pa rticular

will change in both the United States and in Europe, itwill not have been because ofa lack of industry-drivenefforts to establish and maintain good order. T he industryhas taken significant steps to increase the transparencyand fungibility of these products over many years but

with greater resolve as the credit crisis deepened.One of the major areas of recent focus for the deriv -

atives industry, both of its own volition and due to re gu -latory attention, has been CDS. Regardless of whetherit's warranted, AIC's large exposures to CDS have beenblamed in part for this level of attention. Moreover, theFederal Reserve Bank of New York has for some yearsraised concerns about settlement risk in the CD S market.The exponential growth in volume of CDS transac-tions resulted in the notional amount of CDS writtenon heavily traded underlying credits becoming many

multiples of the outstanding principal amount of debtavailable for purchase. Since the buyer of protection inthese mostly physically traded, transactions w ould needto deliver debt of an underlyin g reference entity in orderto settle "Credit Events" (defined below), there wereconcerns that the unavailability of sufficient debt couldresult in an inability to settle a large number of transac-tions. These con cerns came to a head in the fall of 2005,whe n the tradin g price of Delphi bo nds far exceeded thebond price that would be merited for a bankrupt autoparts manufacturer in standard distressed trading con-

ditions. The spike in trading price had been caused bycredit protection buyers chasing after a limited amountof Delphi debt to deliver under their physically settledCDS contracts. Once the settlement period had passed,debt trading prices fell back to expected levels. Creditprotection buyers and sellers had traditionally shunnedcash settlement, lacking confidence that the mechanismcontained in the 2003 ISDA Credit Derivatives De fini-tions (Credit Derivatives Definitions) would produce afair result. Now credit protection buyers had sufferedunder physical settlement, and a solution was required

(not least because the explosion in outstanding creditderivatives contracts, versus outstanding debt, made theoutcome for Delphi likely to be the future norm).

As if the solution neededa greater sense of urgency,a period that had seen very few credit events gave wayto the begin ning of what became a very troubled creditcycle. Beginn ing w ith the bankrup tcy filing of Collins &Aikman Products Co. in May of 2005, the Interna-tional Swaps and Derivatives Association, Inc. (ISDA)began publishing protocols that facilitated multilateral

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amendments to remove physical settlement and replaceit with an auction process to generate a cash settlementamount for trades subjected to each protocol. Oncethere was consensus that a Credit Event had occurredwith respect to heavily traded underlying credits, ISDA

typically published a protocol to allow parties wishingto participate in the protocol to amend their tradesfrom physical settlement to an auction procedure, and,pursuant to an agreement with Markit Group Limited(Markit), Markit subsequently conducted an auction todeterm ine the price that would be used to calculate cashsettlement amounts. The first several ofthese protocolscovered only index C DS due to the high volume of thosetrades and standardized terms governing them, and thusonly derivatives dealers participated. Over time, creditevents began to occur with respect to single name CDS

with higher trading volumes, and pressure mounted toinclude a wider range of the market. As the pace ofcredit events began to quicken, ISDA began facilitatingmeetings amo ng major dealers and large hedge funds todevelop an auction mechanism that could, in the future,be embedded in the standard credit default swap.

That mechanism was eventually hardwired intocredit default contracts through the ISDA CreditDerivatives Determinations Committees and AuctionSettlement Supplement (Auction Supplement), whichwas published in April of this year. Under the Auction

Supplement, newly established ISDA C redit D erivativesDeterminations Committees (Determinations Commit-tees or DCs), at the request of market participants, maymake determinations as to whether payment defaults orbankruptcies (Credit Events) have occurred with respectto an issuer of debt obligations (a Reference Entity),whether an auction will be held, and whether an obliga-tion is deliverable in settlement of credit default swapscovering that Reference Entity. Determinations Com-mittees also determine whether certain recapitalizations,mergers, spin-offs, or similar events (Succession Events)

with respect to Reference Entities have occurred.Determ inations C om mittees have been established

on a regional basis. Each D C is comprised of both dealerand buy-side representatives. To increase transparency,after each meeting the applicable DC publishes on theISDA website all of its decisions as to whether or nota Credit Event or Succession Event has occurred withrespect to a designated Reference Entity. The AuctionSupplement "hardwires" the auction procedures as wellas the Determinations Committees rules by amending

the Credit Derivatives Definitions. Thus, partiesable to incorporate these terms into their future tractions by incorporating the Credit Derivatives Detions (unless they otherwise specify) into their traThe N orth American Determinations Co mm ittee m

recently determined that a Credit Event had occuwith respect to General Motors Corporation and aurized an auction for the settlement of CDS transactsubject either to the Auction Supplement or toso-called "Big Bang Protocol" discussed below.

In addition to the introduction of DeterminatCommittees and hardwiring auction settlement asmethod of settlement, the Auction Supplement also vided for a standard look-back period for Credit Evand Succession Events. That is, to be effective, a CEvent must not have occurred more than 60 days p

to the date that notice of the potential Credit Eventfirst provided to the applicable DC. In the case ofSucession Events, the event must not have occurred mthan 90 days prior to the date that notice of the poteSuccession Event was first provided to the relevant These look-back rules allow Credit Events or SuccesEvents that occur prior to the trade date for a trade ertheless to be covered by the trade so longas the CreEvent or Succession Event occurred within 60 day90 days, as the case may be, ofthe trade date.

As with other ISDA protocols, upon adhere

the Credit Derivatives Determinations Com mitteesAuction Settlement CDS Protocol (the so-called Bang" Protocol) amended the terms of covered transactions between one adhering party and each oadhering party, on a multilateralbasis. In the case of Big Bang Protocol, the impact of adherence wasimplementation of the substance of the Auction Supment (including incorporating resolutions of the Dminations Committee, applying auction settlementhe settlement method, and adding backstop datescredit and succession events in existing and future tr

between adhering parties).As has been the case in previous ISDA CDS

tocols, certain transactions, including loan-only tractions, U.S. municipal transactions, and CDSasset-backed securities, are specifically excluded fthe Big Bang Protocol. Transactions are split amthose transactions that are subject to all the provisof the Big Bang Protocol and those that are exclfrom the auction provisions of the protocol (CovNon-Auction Transactions). Covered Non-Auc

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Transactions include fixed recovery, reference obligationonly, preferred CD S, and party-specified No n-Au ctiontransactions. For these trades, the remaining provisionsof the Big Bang Protocol, including DeterminationsCommittee determinations, still apply. For example,

parties will be bo und by a decision of a Determ inationsCommittee that a Credit Event occurred, but they willnot have to settle their trades pursuant to the subsequentauction settlement that is held.

Going forward, adherents can bilaterally excludespecific transactions from the Big Bang Protocol byspecifying so in their trade documentation or a sideletter for such a transaction. Most major market par-ticipants adhered to the Big Bang Protocol. ISDA doesnot expect to publish ad-hoc protocols for future CreditEvents (excluding "R estru cturi ng" as described below);

therefore, parties that did not adhere or that face non-adhering counterparties will need to settle their tradesin a bilateral man ner going forward.

If a Determ inations Co m mitte e decides not tomake a ruling on whe ther there has been a Credit Eventwit h respect to a particu lar Reference E ntity, then pa r-ties having CDS covering that Reference Entity mayindependently determine whether a Credit Event hasoccurred in accordance with the terms of their docu-mentation. If a DC does makes a ruling, its decision(whether positive or negative) is binding on all par-

ties that adhered to the Big Bang Protocol. All of thesechanges have operated in a robust and efficient m anne rto date, tested throu gh a num ber of recent C redit Events.The General Motors auction had been the most antici-pated test, as that company's default was in years past the"big o ne" that market watchers had feared w ould b ringdown the CDS market if physical settlement remainedthe only option.

Other Deve lopm ents for Standard CDSContracts

One of the ISDA initiatives to standardize CDScontracts in recent years was the development of a matrixthat, if incorporated by reference, sets forth certain keycommon terms for standard single name CDS dependingon region-based transaction types. Simultaneous withthe publication of the Auction Supplement and thelaunch of the Big Bang Protocol, a few changes weremade to the standard N orth Am erican C DS in an effortto increase trade liquidity and fungibility. First, pricing

for standard single-name CD S covering the most heavilytraded Nort h Am erican corporate and high-yield refer-ence entities moved from run nin g premium s to a fixedcoupon plus an upfront fee. Under the new conven-tion, protection buyers pay a fixed rate of either 100

(initially for North American corporate entities) or 500basis points (initially for North American high-yieldentities), and pay an up-front fee equal to the presentvalue of the risk represented by the underlying bonds lessthe fixed coupon. This structure intentionally mirrorsthe convention for trades based on CDS indices.

Ne xt, after a long saga, "Re stru ctu rin g" w asremoved as a Credit Event for the standard North Amer-ican CDS contract. This change was part of an effort tohave CD S trade in a fashion similar to that of bonds andindices. Trades that already included Restructuring at

the time of the change retained it, and parties may stillinclude R estruc turing as a Credit Event if they specifi-cally build it into their documentation, but new stan-dard Nort h A merican trades only include C redit Eventsrelating to a payment failure or insolvency ofa ReferenceEntity. The N orth A merican DC will have the authorityto determine whethera Restructuring Credit Event hasoccurred, but that decision will not bind participants toany auction held. Rather, it is envisioned that R est ruc -turing will be dealt with on an ad-hoc basis, with volun-tary adherence on any auction that is decided to be held.

In mid-June of this year, ISDA circulated a draft termsheet outlining auction mechanics designed for Restruc-turing Credit Events. The key settlement mechanic ofwhat is being called the "Small Bang" protocol is thatwhen a Restructu ring triggers CDS contracts, they willbe settled based on buckets depending on the m aturity oftheir underlyin g reference obligations. As with the dec i-sion that a Restructuring Credit Event has taken place, aDeterminations Committee decision would determinewhether an auction is to take place with respect to CDSassigned to each bucket. T he formal protocol is expected

to open for adherence around July13, with implementa-tion of its terms expected on July 27.

As the single name CDS market moved towardthese new standard terms, ISDA made available the C DSStandard Model, a tool for increased CDS pricing trans-parency. The model uses an underlying code (based onJ.P. Morgan's CDS Analytical Engine) that is widelyused to price CDS contracts, and is now available to theentire industry thro ugh an open source license. Standard

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broker-dealer registration and regulatory requirementsthat might have otherwise applied if CDS cleared byICE Trust were deemed to be securities.

Taking the Bull by Its Horns

On June 2, ISDA through the ISDA Board Over-sight Committee, the Managed Funds Association, theOperations Management Group (OMG), and the AssetManagement Group of the Securities Industry andFinancial Markets Association submitted to the Presi-dent of the Federal Reserve B ank of Ne w York a letteroutlining the commitments of market participants tosignificantly reduce systemic risk and increase trans-parency. The letter notes the industry's goal of fairlybalancing interests of dealers and customers and is in

line with the goals expressed by Secretary Geithner ear-lier in the year. With respect to credit derivatives, theletter commits participants to continue to strengthensettlement and recounts the milestones met in relationto auction hardwiring and CDS clearing. As for equityproducts, participants set deadlines for implementa-tion of centralized repo rting of July 3 1, 2010 and forT+4 matching of95% of electronically eligible trans-actions between OMG members of September 30 ofthis year. The industry will seek to expand the numberof interest rate products eligible to be centrally cleared

and implem ent a centralized reportin g infrastructurefor standardized products by year-end. Finally, marketparticipants will identify and pursue additional advancesin collateral management and complete a market-wideproposal for margin dispute resolution by Septemberof this year. While meaningful measures in their ownright, these commitments also demonstrate the con-siderable inherent technical issues and complexities ofmaking various OTC derivative products "electroniceligible" so as to facilitate th e desired nettin g/settle me ntand reporting benefits.

CONCLUDING REMARKS

Headlines have played perhaps too large a rolen the ongoing debate about whether and how OTC

derivatives posed a systemic risk that triggered the cur-rent credit crisis. M esm erized by Buffett's oft-quo ted

phrase, "financial weapons ofmass destruction," manyhave stopped short of reading the entirety of the annualreport in which that phrase appeared and have ignoredthat company's apparent recognition of the value ofderivatives as a risk management tool. Citing the AIG

debacle, some observers at times have demonized CDSand OTC derivatives in general without an under-standing of what was uniqu e (thou gh dysfunctional)about AIG's situation and contracts. For example, theuse of rating triggers is only one of many tools availableto OTC derivatives market participants for managingcounterparty credit risk, and indeed many commenta-tors argue that such rating triggers are (citing Lehman'sdecent rating) too late and after the fact to effectivelymanage such risk. While it is hard to argue about the"value" of transparency and the need to have effective

tools for "systemic" risk, the current proposed bills inthe United States appear to go substantially furtherand significantly increase the risk of unintended con-sequences. If any enacted legislation overreaches, theaffected transactions will almost surely flow to a forumor an alternative form that does not impose undue bur-dens. Worse, banks and insurance companies may belimited in their ability or unable to effectively managetheir portfolio risk.

Any potential damage to the OTC derivativesmarket is no t a threat that would be limited to the finan-cial services industry. Commercial enterprises utilizeOTC derivatives to protect their operations from avariety of ma rket risks, including currency, interest rate,and other market fluctuations. If they cannot use theseinstrum ents or if the costs of doing so are not justifiable,the risks they manage will be passed on to consumers oftheir products throu gh higher prices. Strikinga balancebetw een the desire to havea greater level of transparencyto effectively curb systemic risk on one hand and thetemptation to succumb to the headlines of the day on theother hand will be difficult. Nonetheless, participants

in this process ought to face the complexity involvedhead-o n, m uch like responsible users of O T C derivativeshave done to date.

To order reprints of this article, please contact Dewcy Palmieriat dpalmieri@ iijournals.com or 212-224-3675 .

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proposed reform of the otc derivatives

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