The Impact of OTC Derivatives Industry Change on Buy-Side Operations

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September 29, 2009
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Agenda
Background Central Counterparty Clearing Central Settlement Derivatives Collateral Management Credit Derivatives Standardisation Trade Reporting & Transparency

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Background

September 29, 2009

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2 June 2009 Fed Letter

30 Jun 2009 Analysis complete for buy-side access to CDS clearing Agreed plan for one-step novation consent = confirmation 31 Aug 2009 90% of settlements on DTCC-eligible trades to be centrally settled via TIW / CLS

Summary of buy-side commitments

General Notes Reflects whole industry commitments only, excludes OMG dealer-specific and Fed Letter signatory-specific commitments Includes ongoing commitments set-out in the 31 October 2008 letter; excludes collateral-related commitments For asset management firms, these commitments are subject to applicable fiduciary responsibilities, including any client-specific duties or obligations *Subject to regulatory approval of MarkitSERV (now obtained) ** Strongly encouraged

17 Sep 2009 Weekly recording of CDS trades in a centralised regulated repository: represents 17 July for Signatories + 60 days** 30 Sep 2009 All eligible new trades & novations must be confirmed on DTCC or other electronic platform Dec 2009 90% T+0 submission, and 94% T+2 matching for electronically eligible transactions (31 Dec) Latest date for Buy-side access to CDS Clearing (15 Dec)

Credit

30 Nov 2009 All eligible credit derivatives backloaded onto DTCC TIW 96% of settlements on DTCC-eligible trades to be centrally settled via TIW / CLS

Jun 09

Jul 09

Aug 09

Sep 09

Oct 09

Nov 09

Dec 09

Jan 10

Feb 10

Mar 10

Apr 10

May 10

Jun 10

Jul 10

Equity

31 Dec 2009 50% of total volume able to be electronically matched

30 Sep 2010 Universal recording of equity trades in a centralised regulated repository: represents 31 Jul 10 for signatories + 60 days**

30 Jun 2009 Plan for rollout of automated allocation functionality*

30 Sep 2009 Strategic road map for cash flow recs, central netting & settlement

30 Nov 2009 Plan for rollout of electronic novation consent *

28 Feb 2010 Universal recording of IRD trades in a centralised regulated repository: represents 31 Dec 09 for signatories + 60 days**

Rates

30 Sep 2009 Marketwide solution for improved resolution of disputed margin calls (DR protocol), implementation schedule to follow

Collateral

31 Oct 2009 Feasibility study on market-wide portfolio reconciliation (undertaken by the ISDA Collateral Committee)

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Legislative change is coming

US - OTC Derivatives Markets Act 2009 11 August 2009
Key Proposals
Central Clearing requires standardised OTC

EC Communication on Derivatives Markets 3 July 2009

Key Proposals
Further Standardisation incentivise investment

derivatives to be centrally cleared by a regulated (CFTC, SEC) clearing organisation;

Trading requires standardised OTC derivatives to

be traded on a regulated (CFTC, SEC) exchange or alternative swap execution facility (ASEF)
Encourage Greater Standardisation through

in broader take-up of standard contracts, electronic confirmation services, central storage, payment automation and collateral management processes
Central Data Repositories to improve

higher capital & margin requirements for nonstandardised derivatives

More Transparency Access by all relevant federal

transparency and improve operational efficiency (e.g., DTCCs Trade Information Warehouse); the EU will act upon the findings of a CESR review
Central Clearing industry commitment to achieve

regulators to the specific OTC transactions and positions of participants; also public access to aggregated data Also:

CCP clearing in Europe by 31 July 09; further incentivise the broader use of CCPs (e.g., through regulatory capital rules)
Move to Public Trading Venues the EC will

Extended regulation of dealers and major participants Robust and comprehensive regulation Position limits Protection of unsophisticated investors

examine how to arrive at a more transparent and efficient trading process for OTC derivatives

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Central Counterparty Clearing

September 29, 2009

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What is central counterparty clearing?

Trade execution remains bilateral; once the trade is agreed, it is transferred (novated) to a central counterparty (CCP) The CCP intermediates the trade, replacing original counterparty risk; the CCP guarantees financial performance, even if the party to the offsetting trade defaults Initial and variation margin is posted with the CCP by each party Dealer to dealer clearing has been operational for nearly 10 years for rates and six months for credit Buy-side firms are not generally expected to become direct members of CCPs themselves; instead, access will be via a designated derivatives clearing member (DCM, or clearing broker)
Trade Execution Trade Cleared
Party A Party B

Trade Cleared

Party A

CCP

Party B

Counterparty Risk Mutualised

Market Risk Flat

Counterparty Risk Mutualised 7

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CCP models are still evolving

Industry Industry Status Status / / Plans Plans
Rapidly evolving CCP picture across credit and rates, but industry standards and operating models starting to take shape June Fed Letter commitment to buy-side clearing of CDS by mid-Dec 09; rates client clearing in 2009 is also a focus area Individual broker firms are designing and planning their clearing member offerings

Example Offerings:
ICE (ICE Trust, ICE Clear) Contract type Full ISDA CME Future on commodity under Clearing Agreement referencing ISDA Language $300mn of ANC/Tier 1 capital $5m CDS security deposit, with fall-back to wider fund Stress-based IM Credit CDX IG, HVOL, XO iTraxx HVOL, XO 3, 5, 7, 10 yr tenors Latest 4 series SN constituents Key Infrastructure Full Support of DTCC, TIW, Icelink(T Zero), auctions TIW bronze entry, Clearport, CMDX Planned connectivity to DTCC EUREX SwapClear

ISDA language within ISDA Annex standard Clearing Conditions EUR 1bil of Tier 1 capital or higher Min $50m security deposit, risk adjusted FTD and liquidity based IM EU Domicile Credit iTraxx HVOL, HY, XO Latest 3 series Rates Vanilla IRS up to 30 years Euribor/Libor, 14 currencies Further products under development MarkitWire $5bil minimum capital Swap portfolio of $1trn+ A credit rating or above Required to bid in auctions

Membership requirements

$5bil of Tier 1 capital, A Credit $50m CDS security deposit Var/Monte Carlo-based IM Operational competence

Product Scope

Credit CDX IG, HVOL, HY, XO, iTraxx HVOL, HY, XO Latest 4 series Single names in testing

30-40 SN iTraxx constituents OIS

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What might the buy-side model look like?

Example workflow for credit
Execution

1 2

Client
6 3

Dealer
2 6

Agreement of Trade Detail

4
Acceptance for Clearing

Middleware
5

Legal Confirmation

6a 6

Submission to TIW

DCM

CCP

6a
Transaction and Position Reporting

TIW
8 7

Settlement

CLS
(fees, coupons)

CCP
(margin)

Trade executed Dealer submits trade executed bilaterally to middleware for matching CCP is specified, this is a matching field Client Agrees trade in middleware (at this point legally binding bilateral trade) Client specifies the DCM, this is not a matching field Client specifies allocations if applicable Middleware will send a notification of the matched trades to DCM for acceptance DCM completes limit/eligibility checks and accepts/rejects trade for clearing Once all three parties have affirmed (client, dealer, DCM), middleware submits the trades to the CCP for clearing CCP determines if the trades are accepted for clearing and sends a message back to middleware If the trades are cleared middleware sends a message to all parties, with all trades DCM v client DCM v CCP (DCM client account) Dealer v CCP (dealer house account trade) DCM sends a message back to middleware with their references on the booked trades Either the dealer or client may also add IDs for submission to TIW, but assume they could have added these on initial submissions Middleware submits all trades on an individual (gross) basis to TIW as matched trades Settlement of fees and coupons via CLS, margin settles via CCP and clearing members, and between DCM and client

Legend:
Initial trade agreement and acceptance Trade notification (and enrichment)

Key Considerations Agreed trade between client and dealer should be a legally binding bilateral trade until cleared (potentially only for minutes but that state should exist) If trades not accepted for clearing then fallback to being bilateral If a trade is not affirmed then it cannot process through to clearing but is still legally binding between client and dealer based on execution Trades submitted on individual (gross) basis, netting/compression process to be completed separately from clearing submission Confirmation process unchanged initially, strategic goal to have affirmation = confirmation within middleware

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How are buy-side process flows impacted?

FUNCTION
Trade Capture Up-front capture of specified CCP as agreed with executing broker Give-up to DCM initial booking straight to DCM, or to executing broker and subsequent amendment to DCM? Timeliness of capture and early allocation (no clearing until allocations completed) May need subsequent capture of clearing ID

FUNCTION
Valuation Move to CCPs as source of MTM valuations on cleared trades Need to review and approve CCP valuation methodology by pricing committees? Comparison of CCP valuation to independent source

Reporting Enhanced risk reporting CCP vs non-CCP positions

Confirmation CCP becomes a matching field, DCM to be determined/specified More aggressive timing (e.g., 30 mins following execution) Tracking of DCM and CCP acceptance, management of exceptions Access to Middleware workflow required (e.g., MarkitWire, ICE Link) Maintenance of CCP-related static data in middleware Backloading requirement

Counterparty Reconciliation Reconciliation of cleared positions to DCM and non-cleared positions to executing broker Reconciliation of eligible positions to DTCCs TIW

Collateral Management Management of initial margin and daily variation margin to & from DCMs Verification of margin amounts per CCP algorithm and clearing agreement with DCM no recourse to challenge Additional documentation (e.g., ISDA appendix, clearing agreements, compensation agreements)

Settlement Potential netting of daily cash flows to a single payment (i.e., coupon and fee settlements + daily margin requirement) Central settlement via CLS remains a goal for the buy side

Other (Credit) Processing impact of credit events (Rates) Impact of novation event: requires a declear and reclear process

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CCP checklist
9 Choice of CCP Are you making an assessment of the various CCP provider offerings? 9 Selection of Clearing Broker(s) Are you reviewing clearing broker capabilities?
Who would be your backup broker?

9 Timeline Are you aiming for implementation in 2009? 9 Middleware Are you live on the necessary workflow tools? 9 Process Flows Do your current process flows support the timeliness objectives for clearing? 9 Margin Have you considered the impact on your collateral requirements and process? 9 Backloading What is your existing population of eligible deals to be backloaded? 9 Additional Legals What additional legal documentation will you need to review and sign? 9 Administrator / Outsourced Provider Is your service provider ready to support procedural changes? 9 Commercials Are you clear on the costs of Clearing? What rate of interest will your DCM pay on
margin posted to them?

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Central Settlement

September 29, 2009

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Implementation of CDS central settlement

Industry Status Status / / Plans Plans Industry Dealer community live on central settlement via DTCC TIW and CLS since Q4 2007 Initial buy-side firms went live in May/June this year Broader industry commitments for buy-side roll-out in 2009 have not been achieved revised targets under consideration

Benefits Benefits Certainty of settlement elimination of unexpected cash breaks and compensation claims Operational risk reduction through move from bilateral settlement to automated netted settlement Reduction in need for presettlement matching across multiple counterparties DTCC cash flow record is golden Netting across FX and OTC has the potential to reduce funding costs Impact Impact Move from bilateral (SWIFT, fax, file) instruction to custodian/PB, to automatic settlement messaging via TIW and CLS No match, dont pay settlement depends upon timely completion of confirmation process (by 12:00 ET on VD-1) Settlement netting by fund, counterparty, currency and value date Bifurcation of settlement processing based on instrument, currency, legal entity and position certainty status

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Central settlement checklist

9 Process Reengineering Have you adapted your settlement processes and controls? 9 Confirmation Dependency Can you meet the necessary confirmation deadlines for all eligible
events?

9 Backloading Have you backloaded all of your eligible positions into DTCC TIW (30 Nov 2009 target) 9 CLS Settlement Member Do you have access to a CLS settlement provider (direct, custodian, third
party)?

9 Custodian Readiness Have your custodians implemented central settlement capability? 9 Onboarding Notification Have you notified DTCC of your implementation plans? 9 Implementation Window Have you considered the implementation blackout periods around the
quarterly rolls?

9 Legal Documentation Have you signed the incremental documentation required by DTCC and your
custodian(s)?

9 User Acceptance Testing have you planned UAT with all participants (custodian, CLS,
counterparty)?

9 Outsourced Provider Is your provider ready to support the necessary changes to their OTC
settlement process flows?
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Derivatives Collateral Management

September 29, 2009

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Developments in derivatives collateral management

Industry Industry Status Status / / Plans Plans
ISDA Dispute Resolution Protocol due on 30 September 2009 ISDA Portfolio Reconciliation Best Practice due on 31 October 2009 ISDA Hedge Fund Independent Amounts white paper due to be published 31 October 2009 ISDA Best Practice Guide for Collateral Management due in June 2010 Development of new CCPs will create a more complex collateral management landscape for both buy side and sell side

Benefits Benefits
Dispute Resolution Will set out roles and obligations during a dispute, set up escalation timelines and procedures Portfolio Reconciliation Will set out best practice guidelines around frequency, timelines and escalations during a reconciliation Independent Amounts Will set out possible solutions to issue of collateral held as an independent amount, and ways to implement Best Practice Collateral Guidelines Will set out an industry best practice around valuations, calculations, messaging and settlements

Impact Impact
Reconciliations and dispute resolution will create tighter standards of performance and remediation that will require training and infrastructure in order to comply Independent amount solutions may necessitate the bifurcation of initial and variation margin, create more segregated accounts at custodians, more tri-party agreements, and more infrastructure links between the sell side and custodians Best practice guidelines will tighten up procedures around grey areas in the market, and provide more guidance on standard practice and electives

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Collateral management checklist

9 Tracking Developments Are you participating in the relevant ISDA forums to keep up to date
with collateral and reconciliation initiatives?

9 Wait and See Some of the developments around CCPs, especially around buy-side participation
and scope, are still being worked through. Some of the more immediate recommendations from ISDA are just that, and intended for large sell-side firms, although using them as a yardstick to view appropriateness is useful.

9 Technology and Operational Impact The impact of the changes being discussed may mean
more collateral accounts, with different margin practices (around accruals and upfront margin), so some form of mapping change will need to be implemented once confirmed, and SOPs (standard operating procedures) updated.

9 Outsourced Provider make sure that your outsourced provider has a view on all the upcoming
recommendations and changes, and that you are in regular discussion to ensure adherence to those changes. Futureproofing from potential changes is a key benefit of outsourcing.

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Credit Derivatives Standardisation

September 29, 2009

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Ongoing standardisation of credit derivatives

Industry Industry Status Status / / Plans Plans The ISDA Big Bang Protocol in April09 introduced the auction supplement and hardwired auction settlement for CDS contracts The ISDA Small Bang Protocol in July09 incrementally refined the auction process for a restructuring credit event CDS single name standardisation already adopted for North American Corporates (SNAC), and European Corporates (SEC) Further move to 100/500 fixed strikes for emerging markets, Australia and New Zealand scheduled commenced on 21 Sep 09 Asia (ex-Japan) and Japan trades expected to adopt 25/100/500 strikes commencing 21 Dec 09 Benefits Benefits To aid in the reduction of gross notional amount outstanding in the market trades more easily compressed To gain efficiencies in operational processing ISDA Determination Committees as the authoritative source for credit and succession event decisions To facilitate the implementation of CCP

Impact Impact Changes to CDS contract terms: applicable to full open population - Big/Small Bang Protocols; applicable to new transactions only standardized CDS Changes to operations: existing responsibilities and procedures may need to be adapted (e.g., restructuring event processing on CDS indices requires additional bookings); Determination Committees activity requires monitoring Change management: rollout of multiple initiatives throughout the year has meant that timeframes may be compressed for planning, analysis, build (if applicable) and implementation

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Credit derivatives standardisation checklist

9Tracking Developments Are you participating in the relevant ISDA forums to keep up to
date with standardisation initiatives?

9Adherence Did you adhere to the Big/Small Bang Protocols in April and July 2009? Did
you check whether your counterparties have adhered?

9Operational Impact Do you have the right tools to identify your trades impacted by
specific events that Determination Committees opine on?

9System Impact Can you differentiate between nonstandard and standard CDS? Do you
need to enhance any of your messaging to external parties?

9Outsourced Provider Is your provider ready to support the necessary changes: trade
processing, reporting, settlements, confirmations?

9Residual Population Are you trading any nonstandard CDS? 9Recouponing Has your front office considered whether potential liquidity reduction
might warrant recouponing of your legacy nonstandard trades?

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Trade Reporting & Transparency

September 29, 2009

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Trade reporting & transparency

Industry Industry Status Status / / Plans Plans Regulatory goal of full transparency of the OTC markets, through implementation of a centralised reporting infrastructure 2 June 2009 Fed letter commitment to universal reporting of all trades not cleared through a CCP phased deliveries by asset class through 2009/10 Not yet mandatory for buy side, but all market participants strongly encouraged to comply within 60 days from implementation by the signatories to the letter Asset class-aligned repositories (e.g., DTCC TIW for eligible credit derivatives), with additional weekly Copper trade upload TriOptima selected as provider for the rates repository 31 December 2009 deliverable Industry RFP in progress for equity derivatives vendor selection expected to complete by 31 October 2009 Benefits Benefits Compliance with regulatory requirements for OTC position reporting Increased market transparency Impact Impact Focus on backloading of eligible credit derivatives to the DTCC TIW (target of 30 Nov 2009) Potential need to upload non-TIW credit derivatives to DTCC Copper reporting database Requirements for rates and equity OTC reporting to follow once plans finalised

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For more information

Visit: www.jpmorgan.com/visit/gds Contact: EMEA: Rob Wood +44-(0)207-777-0485 United States: Darren Woolford at +1-212-552-0588 or Darren Measures at +1-212-623-5143

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