Almost two years after the passage of the Dodd-Frank Act, the overhaul of the US derivatives market is rapidly shifting into the implementation phase. While most provisions of the Dodd-Frank Act are directed at US Swap Dealers (SDs) and Major Swap Participants (MSPs), some of the Dodd-Frank rules also affect Canadian counterparties that don't deal in or speculate with swaps but use swaps merely to hedge exposures in their business or investments (End-Users). By May 1, 2013, all End-Users must have provided their SDs with certain information and representations in order to enable SDs to comply with the Commodity Futures Trading Commission’s external business conduct rules (the Business Conduct Rules).
It is important to note that SDs will only continue offering and executing swaps with End-Users who have provided such information. As such, End-Users who have not already been contacted by their SD counterparties regarding this deadline may want to consider approaching the relevant SDs to discuss this matter, as these rules may have application for Canadian End-Users that engage in derivatives transactions with US Swap Dealers.
The Business Conduct Rules
The Business Conduct Rules generally attempt to enhance protections for swap counterparties of SDs and MSPs though due diligence, disclosure, fair dealing and anti-fraud requirements. In short, the Business Conduct Rules act like a customer protection regime for counterparties of SDs and MSPs. The rules require SDs and MSPs to apply a new “know-your-counterparty” process and collect certain information about their counterparties.
Under the Business Conduct Rules, SDs and MSPs will be subject to strict and detailed business conduct standards obligating them to undertake the following actions, among other things:
- conduct due diligence on their counterparties to verify eligibility to trade (including eligible contract participant status);
- refrain from engaging in abusive market practices;
- provide disclosure of material information about the swap to their counterparties;
- provide a daily mid-market mark for uncleared swaps;
inform their counterparties of their right to:
- clear a swap that is not required to be cleared;
- select the derivatives clearing organization through which a cleared swap is cleared; and
- request a scenario analysis and a daily mid-market mark for cleared swaps;
- provide material information sufficient to allow the counterparty to assess the swap’s material risks, characteristics, incentives and conflicts of interests; and
- when recommending a swap to a counterparty, make a determination as to the suitability of the swap for the counterparty based on reasonable diligence concerning the counterparty.
As a result, End-Users must complete the necessary amendments to their swap documentation and will be asked to provide certain information and additional representations before May 1, 2013 in order to enable SDs to comply with the new rules.
ISDA August 2012 DF Protocol Agreement
A current ISDA protocol provides a standardized process for SDs to collect know-your –counterparty information and confirm that clients are allowed to execute trades.
ISDA has launched the ISDA August 2012 DF Protocol (the Protocol), which provides for certain standardized amendments to existing ISDA documentation. The Protocol is designed to facilitate compliance with the CFTC's rules by supplementing existing master agreements or other written agreements relating to swaps. The Protocol consists of the following six main components:
- The Protocol: The main structural document;
- Adherence Letter: Evidences a party’s agreement to be bound by the Protocol;
- Questionnaire: Allows a party to provide information about itself, make certain safe-harbour elections, and identify the counterparties with whom it is willing to apply DF Supplement provisions;
- Addendum 1: Contains additional optional reps relevant to counterparties not completed when the Protocol was first launched;
- DF Supplement: Contains representations, covenants, disclosures, acknowledgements and notifications related to the Covered Rules that counterparties may apply to their swap trading relationship; and
- DF Terms Agreement: Allows parties to apply selected provisions of DF Supplement to their trading relationship in respect of swaps, whether or not they have an existing master swap agreement.
In order to accept the terms of the Protocol, a party must: (1) sign and deliver the Adherence Letter, (2) pay an adherence fee of $500 and (3) complete the Questionnaire. Once these steps have been completed, the existing master agreements between the parties would deemed to be amended based upon the election made in the Questionnaires. Practically speaking, it will take some time to adhere and complete the Questionnaire, so End-Users should being the process as soon as possible if they have not already done so.
The Protocol procedure is not required by the CFTC's rules; rather, the Protocol is a mechanism put in place by ISDA to assist swap dealers and major swap participants in complying with their responsibilities under the CFTC's Dodd-Frank regulations. It is possible for a SD or MSP, on the one hand, and an End-User counterparty, on the other, to execute a bilateral amendment agreement that addresses the Dodd-Frank requirements instead of adopting the Protocol, and some SDs and MSPs have circulated such agreements to certain of their clients.
The deadline for compliance with the Business Conduct Rules is May 1, 2013. By this date, End-users will need to have either adhered to the Protocol or entered into a bilateral agreement by that date. The Protocol is unlike previous protocol processes that ISDA has employed and End-Users will want to carefully review the documentation associated with the protocol to understand its implications.