Regulation of the Over-the-Counter

Derivatives Market:
An overview of the key provisions

KPMG LLP
1 Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions

Regulation of the Over-The-Counter

Derivatives Market:
An overview of the key provisions

On July 21, 2010, the Dodd-Frank Wall Street Reform and

Consumer Protection Act was signed into law by U.S. President
Barack Obama. The 2,300-page law touches on nearly every
facet of the financial sector. In this white paper we summarize
the key provisions in Title VII of the new law, which relates to
derivatives regulation.
We expect that this will be the first in a series of updates as
the legislation is implemented and the derivatives regulatory
rulemaking process takes shape.

Overview of key
derivatives provisions
Title VII of the new law gives federal
regulators oversight of the $615 trillion
over-the-counter (OTC) derivatives
market for the first time. Key provisions
of the legislation—including clearing,
trading, capital, margining, reporting
and record-keeping requirements—are
likely to fundamentally alter the OTC
derivatives market.
Among the highlights:
• Regulators gain far-reaching authority
over virtually all aspects of the OTC
derivatives market.
• Firms classified as swap dealers and
major swap participants (MSPs) face
the brunt of the new regulations, but
a new market environment also lies
ahead for commercial end-users.
• More derivatives will be cleared
through central counterparty clearing
(CCP) facilities. A swap that is
accepted by a derivatives clearing
organization (DCO) for clearing and
that the regulators have designated as
clearable must
be cleared.
• All swaps subject to the clearing
requirement must be executed on
a regulated exchange or a swap
execution facility (SEF).
• Regulators are charged with setting
capital and margining requirements for
uncleared swaps. These requirements
could have significant impacts on
commercial end-users.
• The swaps’ “push-out” provision
forces banks to move certain swaps’
trading operations into separately
capitalized, nonbank affiliates.
Importantly, over 80 percent of the
derivatives market is exempt from
the new swaps push-out provision.
It primarily impacts high-yield credit
default swaps (CDS), commodities,
and equity swaps.
• In terms of reporting and record-
keeping, cleared swaps are subject
to real-time price and volume
reporting requirements and all swaps
are required to be reported to trade
repositories.
Importantly, legislators confirmed
the legal standing of existing swaps
contracts in the event their provisions
conflict with any of the new law’s
requirements. The law also specifically
exempts existing swaps transactions
from its clearing requirements.
Who’s affected by the
new law?
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 dealer, major swap participant, and
commercial end-user.
A swap dealer is “any person who
(1) holds itself out as a dealer in swaps;
(2) makes a market in swaps; (3) regularly
engages in the purchase or sale of swaps in
the ordinary course of business; or
(4) engages in any activity causing the
person to be commonly known in the trade

as a dealer or market maker in swaps.”
A person may be designated as a swap
dealer for “a single type or single class or
category of swap” but not for other types,
classes, or categories of swaps.
An MSP is anyone who 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.
Businesses that use derivatives to
hedge risk from producing or consuming
commodities are deemed “commercial
end-users.” As discussed below,
commercial end-users would be exempt
from the clearing requirement, as well as
existing swaps.
Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions 2
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.
Role of Regulatory
Supervisors
Under the new law, the regulatory
supervisors have expanded powers
over the derivatives business. The law
provides the Commodity Futures Trading
Commission (CFTC) and Securities
and Exchange Commission (SEC) with
extensive new authority and imposes
significant requirements on the agencies
to regulate the OTC derivative markets,
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 MSP, 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. The CFTC and the SEC would
be able to challenge each other’s rules,
which may conflict in the U.S. Court of
Appeals for the District of Columbia.
Both agencies also have significant
responsibilities as members of the
3 Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions
Financial Stability Oversight Council
(FSOC). The FSOC is an independent
rulemaking agency focused on
identifying, monitoring, and addressing
systemic risk. Chaired by the Treasury
Secretary, the FSOC consists of federal
financial regulators.
Title VII restricts the authority of the
CFTC/SEC to use expedited rulemaking.
As a result, the regulators will solicit
public comment throughout the
rulemaking process to a greater
degree than previously expected.
In addition, the CFTC and SEC are to
adopt rules to mitigate conflicts of
interest at clearinghouses, clearing
agencies, exchanges, and SEFs. 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, SEFs,
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 partic-
ipation in swaps activity in a foreign
country that undermines the stability of
the U.S. financial market system.
The law is by no means the end of
the regulatory process. The CFTC and
the SEC generally have 360 days after
the enactment of the law to promulgate
the required rulemakings in Title VII,
though some are required to be
completed sooner. (See “CFTC/SEC
Rulemaking Process”).
Derivatives market structure
Under the new law, banks can continue
to trade most OTC derivatives in-house.
These include interest rates, foreign
exchange, cleared CDS on investment
grade entities, gold and silver swap
transactions, and swaps transactions that
hedge a bank’s own risk.
However, under Section 716 of the law—
the “push-out” provision—swap dealers
and MSPs are prohibited from receiving
federal assistance if they conduct other
types of swaps transactions within their
depository banking institutions. This
effectively prohibits insured depository
institutions from conducting certain
derivatives activities. As a result,
banks must push some of their swaps
activities into a separately capitalized
bank holding company affiliate. These
swap 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 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. 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.
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.
 Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions 4

A swap that is accepted by a DCO

for clearing and that the CFTC has
designated as clearable must be cleared.
All swaps subject to the clearing
requirement must be executed on a
designated contract market, an SEF 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 determi-
nation as to whether the swap or group,
category, type, or class of swaps should
be required to be cleared.

In terms of foreign exchange (FX) swaps,

a $60 trillion market, they are treated as
swaps and therefore are subject to the
clearing requirement, unless the U.S.
Secretary of the Treasury determines
otherwise. FX swaps and forwards were
exempt from the clearing requirement in
prior drafts of legislation.
Commercial end-users, such as farmers,
airlines, and manufacturers, are exempt
from the clearing requirement. However,
they do need to explain to regulators
how they are meeting their financial
obligations. Existing swaps are also
exempt from the clearing requirement.
All uncleared swaps must be reported to
the CFTC, SEC, or a trade repository.
Another section of this provision relates
to Open Access and Fungibility. DCO
rules must prescribe that all swaps
with the same terms and conditions
are economically equivalent and may
be offset with each other within the
DCO. Clearinghouses cannot be
forced to accept credit risk from other
clearinghouses.
Key takeaways: more clearing ahead
For the past several years, derivatives dealers have made substantial
investments of time and resources to increase their ability to centrally clear
derivatives transactions. Today, for example:
• Approximately $10 trillion of CDS trades and over $210 trillion of IRS have
been cleared through CCPs. Most of the cleared CDS volume is index
transactions. These are the most commoditized, standardized types of
trades. (Sources: ICE Trust, LCH.Clearnet)
• Portfolio compression has enabled firms to significantly reduce the level
of notional outstanding by approximately $100 trillion, of which $68 trillion
is CDS. (Source: TriOptima)
As the new law requires that standardized swaps be cleared, industry
participants will look to further increase their commitment to and
investment in clearing:
• If current trends continue, some market participants believe the volume
of cleared OTC derivatives transactions could double in the next two
or three years. Progress will be faster in some areas—the most liquid,
standard products—than in others. (Source: ISDA)
• Although estimates vary, the chief executive of one of the largest financial
institutions and swap dealers in the United States has publicly testified
that as much as 75 to 80 percent of the OTC derivatives marketplace is
standard enough to be centrally cleared. (Source: Time Magazine , July 1,
2010)

• In March 2010, the International Swaps and Derivatives Association

(ISDA) submitted a letter with market participants and industry
­associations to global supervisors stating that more than 90% of new
dealer-to-dealer volume of clearing-eligible IRS is now cleared and more
than 90% of total dealer-to-dealer volume of clearing-eligible CDS is now
cleared. (Source: ISDA)
5 Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions
Key takeaways: strategic impact
on derivatives market participants
How will the new law impact different
types of market participants? Some
potential key strategic impacts are
as follows:
Dealers:
• Increased transparency from the
exchange trading/SEF requirement
could reduce dealer profits but
could also impact availability and
liquidity for certain bespoke
and nonstandardized 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 organi-
zational 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.
MSPs:
• MSPs face many of the same
requirements as dealers. Some
MSPs may decide to shrink their
derivatives business 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.
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 U.S. futures
exchanges went electronic).
• Capital and margining requirements.
While the intent of Congress is
to exclude commercial end-users
from such requirements, regulatory
rulemaking to that effect may need to
be promulgated.
Trading
All swaps subject to the clearing
requirement must be executed on a
regulated exchange or a swap execution
facility (SEF). According to the law, an
SEF 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's unclear at this time exactly what
constitutes, and what types of trading
platforms may qualify as, an SEF. Firms
that offer systems with a single source of
prices are likely to argue that they should
qualify but the CFTC's acceptance of
their reasoning is uncertain.
Title VI of the law prohibits and limits
the ability of banking entities from
engaging in certain activities (the Volcker
rule). These provisions include a ban
on proprietary trading, from 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 private equity group
or hedge fund. The ban on proprietary
trading extends to 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.
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.
Another section 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
nonbanks. 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
Key takeaways: 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.
The CFTC has begun preparing for
the task of writing rules for the swaps
marketplace by identifying 30 topic
areas where rule-writing is necessary.
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; and Other Titles.
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
to be answered are:
1. Clearing: How will the CFTC and the
SEC determine which swaps must
be cleared?
Regulation of the Over-the-Counter Derivatives Market: An overview of the key provisions 6
well concentrations in assets or market The law also requires data collection
share. Presumably, capital requirements and publication through clearing houses
developed by supervisors for depositary or trade repositories. Repositories have
institutions will be consistent with the already been launched for credit and
soon-to-be-revised Basel Capital guidelines. interest rate products and the industry
is in the process of building a repository
Reporting & recordkeeping for equity derivatives. All trades that are
cleared and uncleared will be recorded in
Under Title VII, all swap dealers and MSPs these repositories.
are required to maintain daily trading
Such repositories will improve market
records of swaps. These daily records
transparency and provide regulators
include recorded communications, such
important tools for monitoring and
as electronic mail, instant messages,
responding to risk. Regulators will gain
and recordings of telephone calls; daily
insight into trading activities of all market
trading records for each customer or
participants. They will be able to see
counterparty; and a complete audit trail for
specific risk concentrations and can sort
conducting comprehensive and accurate
the data any way they want.
trade reconstructions.
2. Margining requirements: How will
margining requirements be set for
cleared and uncleared trades? Will
end-users be exempt from margin
requirements? If not, what will be
the impact?
3. Capital requirements: How will
capital requirements for dealers
and major swap participants be
determined? What is the process
for achieving consistency amongst
U.S. federal supervisors (and
the Basel Committee) on capital
requirements?
4. 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?
5. Reporting & recordkeeping: How will
the trade the reporting process work
for cleared and uncleared trades?
What additional information will be
required to be disclosed?
us.kpmg.com

The information contained herein is of a general nature and is not intended to address the circumstances © 2010 KPMG LLP, a Delaware limited liability
of any particular individual or entity. Although we endeavor to provide accurate and timely information, partnership and the U.S. member firm of the
there can be no guarantee that such information is accurate as of the date it is received or that it will KPMG network of independent member firms
continue to be accurate in the future. No one should act on such information without appropriate affiliated with KPMG International Cooperative
professional advice after a thorough examination of the particular situation. (“KPMG International”), a Swiss entity. All
rights reserved. Printed in the U.S.A. KPMG
and the KPMG logo are registered trademarks
of KPMG International Cooperative (“KPMG
International”), a Swiss entity. 22512NSS