On March 22, 2013, ISDA published the March 2013 DF Protocol, and on May 20, 2013, ISDA Amend1 became available to accept Questionnaires under the new Protocol. The March 2013 Protocol (which is completely separate from the ISDA August 2012 DF Protocol2) principally addresses Commodity Futures Trading Commission (CFTC) requirements applicable to swap dealers and major swap participants relating to swap trading relationship documentation, portfolio reconciliation and information requirements relating to clearing.
The purpose of this alert is to assist counterparties who are not swap dealers or major swap participants, i.e., end-users, in understanding the requirements of, and commitments under, the March 2013 Protocol.
The following questions are frequently asked by end-users:
Why do I have to adhere to the March 2013 Protocol?
Certain recently enacted CFTC rules require the swap trading relationship documentation between swap dealers and major swap participants and end-users to contain certain provisions. The March 2013 Protocol provides a mechanism for the documentation between the parties to contain the necessary provisions, including that the parties trade new swaps subject to an ISDA Master Agreement or equivalent documentation.
In addition, on December 13, 2012, the CFTC issued a mandatory clearing determination for certain interest rate swaps and certain credit derivatives. On July 19, 2012, the CFTC issued a final rule providing for an end-user exception to the clearing requirement for swaps subject to mandatory clearing (the End-User Exception). The March 2013 Protocol provides a mechanism for an end-user to inform its counterparties if it is currently subject to a mandatory clearing requirement, and if it is entitled to elect the End-User Exception.
What is the importance of the July 1, 2013 date?
July 1, 2013 is the date as of which swap dealers and major swap participants must have in place the new swap trading relationship documentation provisions, and end-users are being asked to adhere to the March 2013 Protocol by that date. Such swap trading relationship documentation includes the requirement for trading new swaps under ISDA Master Agreements (or equivalent documentation). In addition, as discussed below, swap dealers and major swap participants will be required to enter into documentation with financial entities to determine Risk Valuations (as defined below). Therefore, it is clear that financial end-users and parties who wish to use the March 2013 Protocol to put into effect an ISDA Master Agreement to govern future swaps must adhere prior to July 1. The consequences to other end-users for non-adherence to the March 2013 Protocol by July, 1, 2013 are unclear, but absent further industry guidance it would be prudent for non financial end-users to adhere by that date.
The March 2013 Protocol provides end-users qualified to elect the End-User Exception the opportunity (Questionnaire, Question 4(a)) to give a one-time notice to its counterparty that it is electing the End-User Exception for all swaps. If an end-user qualified to elect the End-User Exception has not yet taken appropriate corporate action to elect the End-User Exception by July 1 (including action by the board of directors, if required), the end-user can adhere to the March 2013 Protocol by July 1 and respond in the negative to Question 4(a), or not respond to Question 4(a). After it has taken all necessary corporate action to elect the End-User Exception, it can amend its Questionnaire to respond affirmatively to Question 4(a) if it wishes to do so. In addition, an end-user qualified to elect the End-User Exception but not yet prepared to answer Question 4(b) or 4(c) relating to the End-User Exception can chose not to respond to those questions at the time of its initial adherence, but may do so in an amended version of its Questionnaire prior to September 9, 2013 (the date of initial mandatory clearing for non-financial end-users).
1. CFTC Rules Underlying the March 2013 Protocol
The March 2013 Protocol is designed in large part to facilitate compliance by swap dealers and major swap participants with CFTC rules, which require such parties to: (i) obtain values for swaps for risk management purposes, and (ii) engage in portfolio reconciliation. We begin with an overview of such CFTC rules in order to help ground an understanding of the protocol. The March 2013 Protocol also relates to the CFTC's mandatory clearing determination and the End-User Exception, which will be discussed in the context of the protocol requirements.
Section 4s(i)(1) of the Commodity Exchange Act (the "CEA") was added by Section 731 of the Dodd-Frank Act, and requires swap dealers and major swap participants to "conform with such standards as may be prescribed by the Commission by rule or regulation that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all swaps."
Pursuant to Section 4s(i)(1), the CFTC issued Regulations 23.500 through 23.505 pursuant to CFTC Final Rule, Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants (collectively, the Final Rules).3 The Final Rules become applicable to swap dealers and major swap participants on July 1, 2013, unless the compliance date is delayed.
Swap Trading Relationship Documentation Rules
Pursuant to Regulation 23.504(b)(4)(i), swap trading relationship documentation between: (i) two swap dealers, (ii) two major swap participants, (iii) a swap dealer and a major swap participant, (iv) a swap dealer or a major swap participant and a financial entity, and (v) if requested by any other counterparty, between a swap dealer or major swap participant and such counterparty, must include written documentation in which the parties agree on the process for determining the value of each swap at any time from execution to the termination, maturity or expiration of such swap (Agreed Daily Valuation Methodology). Agreed Daily Valuation Methodology is required to include either: (i) alternative methods of valuing a swap, in the event of the unavailability or other failure of an input required to value the swap pursuant to the principal method, or (ii) a valuation dispute resolution process.
Swap dealers and major swap participants are required to have Agreed Daily Valuation Methodology: (i) for the purpose of determining the capital and margin requirements for uncleared swaps entered into by swap dealers and major swap participants (pursuant to section 4s(e) of the CEA), and (ii) as part of the swap dealers' and major swap participants' internal risk management systems (pursuant to section 4s(j) of the CEA). Since neither the CFTC nor the Securities and Exchange Commission has yet issued final rules relating to margin requirements for uncleared swaps, the valuation methodology (referred to as Risk Valuation) included in March 2013 Protocol is for the exclusive purpose of compliance by swap dealers and major swap participants with risk management requirements under section 4s(j), and is not binding on the parties for other purposes (including for the purpose of margin determinations under existing swap documentation). Accordingly, Section 3.10 of the March 2013 Protocol states that the parties acknowledge that the adoption of margin regulations under section 4s(e) may require additional agreement between the parties both for the purposes of such regulations and for the purposes of section 4s(j).
Pursuant to CFTC Regulation 23.502(b), each swap dealer and major swap participant is required to establish, maintain and follow written policies and procedures for portfolio reconciliation for swaps with counterparties that are not swap dealers or major swap participants. Portfolio reconciliation is a post-trade risk management technique whereby the parties: (i) identify and resolve discrepancies with regard to the terms of the swap either immediately after execution or during the life of the swap, (ii) effectively confirm all of the terms of the swap, and (iii) resolve differences in valuation of the swap, which may include differences in valuations of collateral held as margin.
Pursuant to Regulation 23.502(b), portfolio reconciliation between a swap dealer or a major swap participant and an end-user may be performed bilaterally by the parties or by one or more third parties selected by the parties. Portfolio reconciliation is to be performed quarterly for end-user swap portfolios of more than 100 swaps, and annually for smaller portfolios.
2. The Adherence Process
The architecture of the March 2013 Protocol is similar to that of the August 2012 Protocol and consists of: (i) the Adherence Letter, (ii) the Protocol Agreement, (iii) the Questionnaire, and (iv) the DF Supplement. The procedure for adherence is also similar to that for the August 2012 Protocol and consists of delivery to ISDA of an executed Adherence Letter and exchange of Questionnaires with the counterparty under each Protocol Covered Agreement (as defined below).4 ISDA will publish a copy of each Adherence Letter for viewing by all persons who adhere to the March 2013 Protocol. This will enable participants in the March 2013 Protocol to know which counterparties are available to be sent Questionnaires, and the method(s) by which such counterparties will accept Questionnaires.
The agreements subject to the March 2013 Protocol (Protocol Covered Agreements) are any written agreements between parties governing the terms of a swap (including for this purpose foreign exchange swaps and foreign exchange forwards) where at least one of the parties is a CFTC Swap Entity. A party is a CFTC Swap Entity if it has identified itself pursuant to the Questionnaire as a swap dealer or major swap participant, or as a person who expects shortly to become registered as such.
If a Protocol Covered Agreement is executed directly by a principal, then only such party may adhere to the March 2013 Protocol. If a Covered Agreement is executed by an agent on behalf of one or more principals, only the agent may enter into the March 2013 Protocol on behalf of the principals.
3. The Questionnaire
The ISDA 2013 DF Protocol Master Agreement
CFTC Regulation 23.504 requires that on or prior to the date of execution of a swap (including for this purpose foreign exchange swaps and foreign exchange forwards that are exempted from regulation as swaps), a CFTC Swap Entity party to such trade must have swap trading relationship documentation in place that includes all of the terms of the swap. Therefore, after July 1, CFTC Swap Entities will not be permitted to trade swaps unless the relationship of the parties is governed by an ISDA Master Agreement or equivalent document containing all of the terms of the agreement. In particular, the use of a long-form confirmation in which the parties agree to some but not all of the terms of a schedule to an ISDA Master Agreement with the intent to complete their agreement at later time is not permitted.
By means of an election pursuant to the Questionnaire, each pair consisting of at least one CFTC Swap Entity may elect to enter into a bare bones ISDA Master Agreement, called the ISDA 2013 DF Protocol Master Agreement. The parties will only be deemed to have entered into the ISDA 2013 DF Protocol Master Agreement if both the CFTC Swap Entity and the end-user elect to enter into the agreement.
The ISDA 2013 DF Protocol Master Agreement is an agreement governed by New York law in the form of the 2002 ISDA Master Agreement, without a Schedule supplemented by such terms as are set forth in the March 2013 Protocol or as the parties otherwise agree. The terms of the Schedule set forth in the March 2013 Protocol provide that multiple transaction netting will apply with respect to FX transactions and currency option transactions, but not with respect to other types of transactions.
If the parties make an election to enter into a ISDA 2013 DF Protocol Master Agreement, each future swap (including for this purpose foreign exchange swaps and foreign exchange forwards) entered into between the parties that is not intended to be cleared will be governed by such agreement (unless the parties determine that it be governed by existing documentation). The ISDA 2013 DF Protocol Master Agreement will be supplemented by the March 2013 Protocol, and if the parties have matched questionnaires under the August 2012 Protocol, will also be automatically supplemented by the terms of the August 2012 Protocol.
An end-user should note that if it agreed to the ISDA August 2012 DF Terms Agreement pursuant to the August 2012 Protocol, such agreement will not suffice for the purposes of CFTC Regulation 23.504, and such end-user should ensure that it adheres to the ISDA 2013 DF Protocol Master Agreement or otherwise has an ISDA Master Agreement or equivalent documentation in place by July 1, 2013 with each relevant CFTC Swap Entity to govern swaps entered into thereafter.
Principal Information and Status Representations
Pursuant to Part II of the Questionnaire, a Protocol Participant must give its legal entity identifier (LEI/CICI); identify itself as, or as not: (i) a CFTC Swap Entity, a financial entity, a financial company or an insured depository institution; and give its email address for the purpose of various DF Supplements.
Participants to the August 2012 Protocol were also asked to indicate if they are financial entities (as defined in Section 2(h)(7)(C)(i) of the CEA) but were permitted to respond 'No Answer.' In the March 2013 Protocol, an entity must respond whether it is or is not to the best of its knowledge a financial entity.
As discussed below, a representation that an entity is a financial entity causes an entity to automatically be deemed to incorporate Schedule 3 to the March 2013 Protocol.
Each end-user must also indicate whether or not it is a financial company as defined in Section 201(a)(11) of Dodd-Frank. Such entities include bank holding companies, nonbank financial companies supervised by the Board of Governors of the Federal Reserve, any company that is predominantly engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto, and any subsidiary of any of the foregoing entities that is engaged in activities that the Board of Governors has determined are financial in nature or incidental thereto.
Election of Schedule 3
Since as discussed above, Risk Valuation is required for a swap between a swap dealer or a major swap participant and a financial entity, if an end-user represents that it is a financial entity in the Questionnaire, Schedule 3 (Calculation of Risk Valuations and Dispute Resolution) will automatically be incorporated in the agreement between the parties. However, an end-user that does not represent that it is a financial entity will only be deemed to have elected to have Schedule 3 incorporated in its swap documentation if it affirmatively elects to include Schedule 3 (or fails to respond to the question).
Election of Schedule 4
Both financial and non-financial end-users have the option, but are not required, to agree to engage in portfolio reconciliation pursuant to Schedule 4 (Portfolio Reconciliation). If an end-user agrees to engage in portfolio reconciliation it will be further asked if it prefers to do so by reviewing and confirming data received from a CFTC Swap Entity (an election of Review) or by exchanging data (an election of Exchange). In addition, the end-user will be asked if it agrees to reconcile against the data that its counterparty has reported to a swap data repository (an SDR), rather than requiring a direct delivery of the data reported to the SDR.
Use of the End-User Exception
Section 2(h)(7) of the CEA and CFTC Regulation 50.50 provide an exception for non-financial entities who otherwise qualify to elect not to clear swaps that the CFTC determines must be cleared (the End-User Exception). Question 4(a) in the Questionnaire may be used by an end-user entitled to the End-User Exception to notify its counterparty that it is making a standing election to always elect the End-User Exception for swaps subject to mandatory clearing unless the end-user notifies its counterparty to the contrary (with respect to a particular swap or in general).
In connection with electing the End-User Exception, the end-user must either have reported the information listed in CFTC Regulation 50.50(b)(1)(iii) in an annual filing made no more than 365 days prior to entering into such swap, or notify its counterparty that it has not made such an annual filing and provide its counterparty with the necessary information to make the filing for the particular trade. Question 4(b) in the Questionnaire may be used by an end-user to notify its counterparty that it will NOT make an annual filing for any swap subject to mandatory clearing, unless the end-user subsequently otherwise notifies the counterparty (either with respect to a particular swap or generally).
If an end-user intends to elect the End-User Exception and does not intend to make an annual filing, then it must inform its counterparty of the information solicited pursuant to Question 4(c) so that its counterparty may effect the required report.
4. The Schedules
The DF Supplement consists of four Schedules:
- Schedule 1: Defined Terms
- Schedule 2: General Terms
- Schedule 3: Calculation of Risk Valuations and Dispute Resolution
- Schedule 4: Portfolio Reconciliation
Each pair of Protocol Participants will be deemed to have supplemented each Protocol Covered Agreement as of the date of mutual delivery of Questionnaires) by the inclusion of Schedules 1 and 2. Schedule 2 contains representations and covenants on the part of CFTC Swap Entities and end-users designed to facilitate compliance with the Final Rules and the End User Exception.
Confirmation Through Exchange of Matching Terms
CFTC Regulation 23.501 establishes deadlines by which swap dealers and major swap participants must execute confirmations for swap transactions. Section 2.4 of Schedule 2 provides an agreement between the parties that if they engage in the exchange of matching terms of confirmations through an electronic matching service whereby the terms are confirmed by the parties or a third-party agent or service provider, that such method of confirmation constitutes effective execution for the purpose of CFTC Regulation 23.501. Section 2.4 does not constitute an agreement between the parties to engage in such a matching platform, but does constitute an agreement that such a process, if engaged in, will constitute effective execution for the purpose of the regulation.
Representation as to Entitlement to Enter into Swap on a Noncleared Basis
On December 13, 2012, the CFTC determined that certain classes of interest rate and credit default swaps are subject to mandatory clearing, with the applicability of such mandatory clearing requirement phased in over time on a class of counterparty basis. Pursuant to Sections 2.6 and 2.7 of Schedule 2, end-users represent that if they enter into a swap subject to such initial mandatory clearing determination, the mandatory clearing requirement is not yet applicable to such end-user (unless it notifies the CFTC Swap Entity counterparty to the contrary, or has instructed the CFTC Swap Entity to clear the swap), or is not subject to mandatory clearing with respect to such swap.
If an end-user elects the End-User Exception, it must notify its counterparty before entering into the swap. As discussed above, Question 4(a) of the Questionnaire gives an end-user the option of giving a standing notice that it elects to enter mandatorily clearable swaps on a non-cleared basis by electing the End-User Exception. An end-user may also give such a standing notice outside the March 2013 Protocol or may give notice outside the March 2013 Protocol on a trade-by-trade basis.
If an end-user gives a notice of intent to elect the End-User Exception (pursuant to the March 2013 Protocol, or otherwise), unless it gives its CFTC Swap Entity notice to the contrary, it is deemed to represent that it has reported all required information in a filing with an SDR (or if no SDR is available to receive the information, with the CFTC) no more than 365 days prior to entering into such swap, and that such information is true, accurate, and complete in all material respects.
If the end-user gives notice to its CFTC Entity counterparty that it has not itself completed the report required in connection with the End-User Exception, it must provide all such information to its CFTC Swap Entity counterparty, which it will have done by answering Question 4(c) in the Questionnaire and by the deemed representations in Section 2.9.
Schedule 3 will be applicable to end-users as described above under "The Questionnaire — Principal Elections; Election of Schedule 3," and will be effective when CFTC Regulation 23.504 is applicable to CFTC Swap Entities, which is anticipated to be July 1, 2013 (the STRD Compliance Date).
As discussed above, Schedule 3 is designed to satisfy the obligation placed on CFTC Swap Entities to have written documentation pursuant to which they agree with their counterparties on the procedure to determine the value of swaps solely for their internal risk management purposes. Such obligations apply to swaps between CFTC Entities and all counterparties, except that they do not apply to swaps with counterparties that are not financial entities, unless such counterparties request such documentation. The Final Rules require that such written documentation include either: (i) an alternative method of determining the value of the swap in the case of the unavailability or failure of an input required to value the swap, or (ii) a valuation dispute resolution mechanism. Schedule 3 includes a dispute resolution process.
Risk Valuation will be conducted on a daily basis by the CFTC Swap Entity as Risk Valuation Agent for all swaps entered into after the STRD Compliance Date (and for each swap which is deemed to be a new swap after the STRD Compliance Date because of a material change to the swap such as an assignment, novation or other material change of terms).
The Risk Valuation process is designed to use documentation already in place between the parties to obtain values, and where documentation does not exist to provide fall-backs for the determination of such values. The first step is for the Risk Valuation Agent to use any value for the swap it may have determined pursuant to an ISDA Collateral Support Annex or other written valuation metric agreed by the parties (a CSA Valuation). No such value may exist for a variety of reasons, including that the parties may not have agreed an ISDA Collateral Support Annex or other valuation metric, or the Risk Valuation Agent may not be determining the value of swaps under such documentation on a swap-by-swap basis. As a fallback, the Risk Valuation Agent will determine the close-out amount of the swap as determined pursuant to the parties' existing swap documentation, or if the parties have not agreed to a process for determining the close-out amount it will determine such amount pursuant to Section 6(e)(ii)(1) of the 2002 ISDA Master Agreement, in either case with all estimates at mid-market. Alternatively, if the CFTC Swap Entity has not determined a CSA Valuation but its counterparty has, the Risk Valuation Agent may accept the CSA Valuation calculated by the counterparty as the Risk Valuation.
The counterparty is entitled to receive notice of the Risk Valuations determined by the Risk Valuation Agent.
If a counterparty disputes a Risk Valuation, it must produce its Risk Valuations for all swaps as of the date of the disputed Risk Valuation (although not all Risk Valuations will be deemed to be disputed). If the parties have agreed to a method of resolving disputes with respect to CSA Valuations, which will typically be the case if the parties have entered into a ISDA Credit Support Annex that includes a dispute resolution process, such process will applied to resolve the disputed Risk Valuation. If the parties have not entered into a written agreement by which disputes with respect to CSA Valuations are resolved, Schedule 3 provides a dispute mechanism based on that contained in the ISDA Credit Support Annex.
An end-user (whether or not a financial entity) may elect whether or not it desires to participate in portfolio reconciliation pursuant to Schedule 4.
Portfolio reconciliation involves a comparison of the material terms of all of the swaps between the parties, with the scope and level of detail to be agreed between the parties and the data provided in an agreed form so as to permit data reconciliation by such methods as are used by the parties. The terms must include all terms required to be reported under CFTC Part 45 Regulations (Material Terms), and Valuations (as defined in CFTC Regulation 23.500 as "the current market value or net present value of a swap"). The portfolio reconciliation contemplated by the Final Rules does not conform to industry practice in which valuations are typically reconciled on a portfolio and not on a swap-by-swap basis and in which transaction level reconciliation is conducted only as a means of identifying significant portfolio level collateral disputes.
The CFTC Swap Entity will inform the end-user of the frequency of portfolio reconciliation (annually for portfolios in excess of 100 swaps, and quarterly otherwise). There are three methods of portfolio reconciliation. If an end-user has elected "Review" in the Questionnaire, it will be required (either directly or through a third-party service provider) by the second business day after receipt of portfolio data to affirm such data or identify a Discrepancy. A Discrepancy is a difference in any Material Term, or in Valuations in an amount greater than 10 percent of the higher of the absolute values of the two Valuations. If the end-user identifies a Discrepancy, the parties agree to consult with each other in an attempt to resolve the Discrepancy in a timely fashion.
If an end-user has elected "Exchange," the each party will provide portfolio data to the other or to an agreed third-party service provider on agreed data delivery dates. Neither party is required to affirm the data received, but if either party reports a Discrepancy, the parties agree to consult with each other in an attempt to resolve the Discrepancy in a timely fashion.
Finally, if the parties have agreed to reconcile against data delivered to a swap data repository (SDR Data), they are required to do so as soon as practicable following each data exchange date. The parties will not be required to deliver data that is reconciled against SDR Data. If either party identifies a Discrepancy it is required to immediately report it to the other, and the parties agree to consult with each other to resolve the Discrepancy in a timely fashion. Either party may elect to terminate its election to reconcile against SDR Data as of the effective date of notice to the other party.
The parties may agree outside of the scope of the March 2013 Protocol to resolve a Discrepancy by means of a market poll, or other mechanism, but the March 2013 Protocol does not provide for a resolution mechanism other than consultation. Valuation disputes involving amounts in excess of $20 million that are not resolved in five business days must be reported to the CFTC.
5. The Bottom Line
End-users should carefully review and make sure they understand the March 2013 Protocol. In particular, if they do not have in place ISDA Master Agreements (or equivalent documentation) to govern future swaps they should elect to enter into the ISDA 2013 DF Protocol Master Agreement or otherwise enter into an ISDA Master Agreement (or equivalent documentation) with each relevant CFTC Swap Entity.
End-users entitled to elect the End-user Exception should be prepared to use the March 2013 Protocol as the mechanism to interface with their CFTC Swap Entity counterparties about the use of such election and the resulting reporting requirements. Non-financial end-users should consider if they wish to elect to participate in the Risk Valuation process. All end-users should consider whether they will be accorded a benefit by engaging in portfolio reconciliation.