10. Energy Commodity Exchanges, OTC Derivative

When is the Reporting Required?

Originally, all swaps were subject to reporting requirements that were to have begun on 4/10/13. This included "pre-enactment" swaps (swaps that were in effect on 7/21/10, when Dodd-Frank was enacted) and "transition" swaps (swaps that were executed after 7/21/10 but before 4/10/13). This original schedule was revised for non-financial counterparties (i.e., end-users) under a "noaction" letter issued by the CFTC during early April 2013 (Letter No. 13-10). The revised Dodd-Frank reporting schedule for end-users is now as follows (please note that the Dodd-Frank standard for reporting transaction data is generally in "real time," but this term is defined differently for different types of swap participants): • Credit/interest rate swaps entered into after 7/21/13: subject to Dodd-Frank standards • Credit/interest rate swaps entered into from 4/10/13 to 7/21/13: 8/1/13 • Equity/FX/ commodity swaps entered into after 8/19/13: subject to Dodd-Frank standards • Equity/FX/ commodity swaps entered into from 4/10/13 to 8/19/13: 9/19/13 • All historical swaps that were in existence from 7/21/10 to 4/10/13: 10/31/13 Dodd-Frank Recordkeeping for End-Users End-users must keep full, complete and systematic records of all their swap transactions. The recordkeeping requirements apply to pre-enactment, transition and post-4/10/13 records. Records should be kept in electronic format unless they were originally created in paper format and have been maintained as such. Records must be kept for five years from the termination date of the swap, with the exception of audio records, which must be kept for one year from termination date. Please note that these same recordkeeping requirements apply to certain related physical transactions. Specifically, these are the physical transactions that are the hedged items for which hedge treatment is being claimed with respect to an end-user's hedging swaps.

Summarize the steps involved in processing an OTC trade and understand the action required in each step (Trade Capture, Controls Processing, etc.).

o • 1. Trade Capture and Revisions o (a) Initial Trade Capture Once a transaction has been executed, both of the parties to the trade must enter the full terms of the transaction into their respective trade capture systems. The Trade Capture System, either independently or through a technological interface, should provide robust, accurate, reliable, real-time information related to credit risk, market risk and position exposure management, as well as provide trade support functionality to enable processes such as position verification, broker recaps, counterparty affirmations, confirmations, settlements, collateral margining, and financial control. o (b) Trade Capture Revisions Trade capture revisions can be categorized as either economic or non-economic. Economic trade capture revisions can arise from any post-trade capture control processes, including during the risk management and position verification processes, or the broker recaps, counterparty affirmation and confirmation or settlements processes. The need for these revisions may occur on or after trade date (T) according to the timeframe of the process that highlights such need. Regardless of the source of identification of the need for the revision, modifications to any existing transaction details recorded should always be done at the trade capture level, and not within the downstream processing environment. Economic trade capture revisions will typically have an impact on downstream processing, such as the need for a revised confirmation or a revised invoice being raised. Non-economic trade capture revisions can also arise from post-trade capture. Examples include an incorrectly identified broker, or a re-modeling of a transaction for internal purposes, where such re-modeling maintains the original economic intent of the transaction without altering the terms of the trade as agreed between the two parties. With the exception of electronic broker matching, Non-economic trade capture revisions will typically have minimal impact on downstream processing. • 2. Controls Processing o (a) Broker Recap For trades executed via a broker, the broker recap process typically occurs on T or T+1 for standardized vanilla trade types (but may take place on a longer time frame for the more structured trade types). Traditionally, the broker will send a written recap of the economic details of the trade to both parties involved in the transaction by either facsimile or email. However, there is now some take-up of both the ability of parties to download their own broker recaps from a web portal, and also, increasingly, the available use of electronic broker matching. This independent third-party verification of trade details is used by each of the two contracting parties to validate the accuracy of their trade capture in order to gain confidence that the economic details of the trade are correctly understood and reflected in the official records of the parties concerned. This process often serves as the earliest point of risk mitigation in correctly securing the economic details of the trade. o (b) Counterparty Affirmation Counterparty affirmation also typically occurs on T or T+1. According to a party's internal organization and processes, the counterparty affirmation process may be done (i) only for transactions that are traded direct (i.e, non brokered transactions) and which are not confirmed with the counterparty by means of electronic matching, or (ii) for non-brokered transactions irrespective of the method used for the counterparty confirmation, or (iii) brokered and non-brokered trades which are not confirmed with the Counterparty by means of electronic matching, or (iv) all trades. The process is performed between the two parties to the transaction via telephone or through the delivery of a trade summary by email. It should be noted that some parties choose not to participate in the verbal affirmation process because their internal structural organization of resources' responsibilities does not support this lifecycle event. o (c) Confirmation Confirmation is the process by which, either through electronic messaging or through the use of paper confirmations, the parties legally memorialize the terms of the trade. Confirmation is typically performed on T, or as soon as practical thereafter. Confirmation execution is the process by which the two parties confirm their agreement to the full terms of the trade as set out in the confirmation. The parties may confirm a transaction by matching electronically on a bilateral basis, or on a third-party vendor matching platform. Paper confirmations may be created manually, systemically with some user interaction, or systemically with full STP. According to the terms of any prevailing Master Agreement and/or the governing law, confirmations may be legally binding by (i) one party signing and returning the other party's confirmation, (ii) an exchange of confirmations between the parties, (iii) one party affirming their agreement to the terms of the confirmation by some means but without actually signing the confirmation, or (iv) one party implying their acceptance of the other party's confirmation by virtue of not having disputed it within a given specified timeframe. Paper confirmations that are not executed/agreed by both parties may be an indication of disagreement on the terms of the trade, and in such case a verbal counterparty affirmation of the core economic trade details should occur between the parties pending the resolution of the any legal, credit, or other provision(s) that remain in discussion. • 3. Settlements o (a) Pre-Settlement Activity Settlement prices for transactions can be obtained either electronically or manually, but in any event should be done on a timely basis, at the latest the opening of business on the day following the day, or last day, of pricing in question. When obtained electronically, the relevant prices are taken from the price source through a technological interface, most commonly by way of a Logical Information Machine (LIM) feed or a data scrape of a particular website. When obtained manually, operations personnel will consult the appropriate price source based on the relevant pricing convention for the particular trade type and commodity product to be settled and manually input the relevant price(s). Best practices dictate that settlement prices that are input by one person (Maker) should be verified by a separate person (Checker). Irrespective of whether the prices are taken by automated or manual means, they must be input into a system or format that will ultimately be used for the purposes of trade valuation, collateral margining and invoicing. Once prices are updated and available for invoicing purposes, invoices are issued, reconciliation occurs between the parties, and any discrepancies between the payment mounts calculated by each of the parties are investigated and resolved. Payment affirmation is then exchanged between the parties either in the form of affirmation of settlement amounts or an exchange of invoices, and cash movements are effected for the correct value date. o (b) Post-Settlement Activity Once cash movements are effected, operations personnel will conduct a reconciliation of ledger entries against cash movement. Discrepancies between cash and ledger entries are typically the result of failure to pay, underpayment or overpayment of agreed amounts, inadvertent payment to a different legal entity, or withholding of wire transfer fees. Operations personnel will investigate the discrepancies and resolve the matter via their individual organization's escalation controls, procedures and processes, but always with the goal of obtaining complete and accurate recording of cash movements (or exceptions) to the general ledger. o (c) Nuances to Settlements Activity in Commodities Bilateral Settlements consist of the settlement of (i) financial transactions and (ii) physical transactions for which delivery either occurs or is "booked out" by another physical transaction with similar characteristics. Financial transactions are typically settled a specific number of days after the final pricing date of the relevant pricing period, depending on the market convention for the underlying commodity product. For transactions involving calendar monthly pricing periods, this often results in a high volume of settlements on a few specific days during the early part of the following month. For financial transactions with pricing periods that comprise a single day, settlements will occur throughout the month, on the specified day after the pricing period. Option premiums are typically settled a specific number of days after the trade date, although they can also be netted with the final settlement. Precious metals and base metals settlement takes place on the day of delivery of the commodity. Transactions where physical delivery of electricity or gas occurs possess product-specific settlement conventions, where the delayed settlement provides for reconciliation of physical deliveries and book-out of transactions between counterparties at delivery points on natural gas pipelines and within electricity ISOs and RTOs, or at other regional scheduling locations on the grid. For example: North American Physical Power and European and UK Physical Natural Gas transactions settle on a monthly cycle 20 days after the end of the delivery month; UK Physical Power transactions settle on a monthly cycle 10 days after the end of the delivery month; and North American Physical Gas transactions settle 25 days after the end of the delivery month. Bilateral physical power settlements consists of the purchase and sale of electricity as it moves across one or a series of power grids from point A to point B. Often times there are "cuts" along the way as power that has been contracted is not actually delivered. Investigating these curtailments in the power flow of buyers and sellers comprises a significant portion of the settlement effort. However, each movement along the grid(s) is tracked via a "tag" that aids in the investigation of the discrepancy. Power transacted with an Independent System Operator (ISO) must be settled according to the ISO's invoice and timeline. Disputes may only be raised via the ISO's dispute resolution service. ISOs also remain risk neutral; for each settlement cycle they require that all receivable payments are made before their payables are made, and if a participant fails to make a scheduled payment, the ISO remits payment, resulting in a pro-rata shortfall to the paying participants. Physical natural gas settlement is the settlement of the purchase, sales, storage, or transportation of natural gas either between parties or via a natural gas pipeline. Since physical natural gas being delivered from point A to point B may involve various parties and/or pipelines, imbalances may occur as the result of imbalances along the path. Volume actualization between the parties in the "daisy chain" comprises a significant portion of the settlement effort. The resolution process is manual and paper intensive, and takes place using data obtained from each individual pipeline's Electronic Bulletin Board (EBB). CMD members should adhere to any Best Practice Guidelines as issued by the CMD, where applicable. As a result of the physical power curtailments and physical natural gas imbalances mentioned above, it is not atypical for portions of these invoices to have incomplete reconciliation for several months (or longer) after the initial settlement cycle. Physical oil settlements vary in frequency and process by the type of product and transportation mode on the transaction and are governed by the individual purchase/sale contract. For waterborne transactions (barges and vessels of varying sizes), payment terms generally range from prepayment based on an estimated volume or estimated price, to monthly settlements in the month following delivery. For pipeline transactions, a similar range can be seen, but with the majority of the US refined product pipeline business transacted under two-day payment terms after movement and receipt of the invoice and backing documentation from the pipeline company. Although some of the liquidly traded physical oil transactions are booked out against a chain of other counterparty trades or bilaterally with a single opposing trade with the same counterparty, most oil trades go to physical delivery and settlement. These transactions, like the power and gas transactions described above, have to be "actualized" with actual volumes, dates, and product quality measurements based on what actually occurred. Thus two settlements are often required: a Provisional settlement for the estimated quantity and quality, and a Final settlement to true up to the actual amount due. In addition, some parties participate in payment netting in those instances where different commodity products settle on the same payment date and in the same currency. o (d) Current Settlement Process (i) Over-the-Counter (OTC) Trades The OTC commodity derivatives settlement process is a date-driven process. Certain key dates each month correspond to the settlement of different products. In many cases, specific products are settled only once a month. For example: Many financial commodities (such as gas, crude and refined products) settle five business days after completion of pricing; and US financial power settles on the 10th business day of the month. Physical commodities also have different settlement conventions based on the product and region. For example: North America physical power settles on the 20th calendar day of the month following flow month; North America physical gas settles on the 25th calendar day of the month following flow month; European physical natural gas settles on the 20th calendar day of the month following flow month; and Spot precious metals trade for spot value, which is two business days after the trade date. The longer settlement times on physical energy products is reflective of the greater amount of reconciliation required in the event of a discrepancy due to the dependence upon transportation statements. Power prices are published on an hourly basis or, in some cases, every 15 minutes, which results in a large number of resets which need to be reconciled whena discrepancy arises. In the event that agreement is not reached by parties by the settlement date, the undisputed amount is often paid. The settlement calculation for physical transactions is volume multiplied by price. Prices are either agreed upon at the time of the transaction ("fixed") or settled against a published index ("floating"; ex. Platts Gas Daily).Some products require a provisional invoice since the quantity, the price or even both may not be known at the time at which a provisional payment is required. Final settlement is then performed to true-up to actuals. It is not uncommon when physical commodities are settled to see an "actualization", where the contractual quantity is updated to reflect the actual quantity delivered. In addition, physical power and gas add a level of complexity as volumetric "cuts" need to be reconciled. Cut resolution can take months as all upstream and downstream parties need to agree. Settlement calculations for financial transactions are similar, volume multiplied by price, but more than one price is involved. One price may be fixed and compared against an index price (Fixed Swap) or there may be two index prices (Float-Float Swap or Basis Swap) multiplied by the volume and settled against one another (e.g, 310,000 mmbtu * 3.50 versus 310,000 mmbtu * Gas Daily-Texok.) Swaps are always settled net; individual legs are never settled gross. There also can be multiple prices with different weightings, which comprise a basket. Typically, invoices are settled net, meaning multiple transactions settling on the same day with the same counterparty in the same currency and same legal entity are netted together, with only one party moving the cash. In some jurisdictions, such as the European markets, tax requirements require sellers of physical commodities to invoice the counterparty for delivered goods, and only sell trades are on the invoice. Invoices include such relevant information as trade date, volume, fixed price and/or floating price, and settlement amount per trade. As soon as practicable after all prices are known, counterparties issue invoices to one another—and, in the case of physical gas, either on nominated volumes or after volumes are actualized. Settlement affirmation is standard in the industry, where parties confirm cash amounts prior to the settlement date. This practice reduces settlement breaks and ensures that reconciliations are performed prior to cash moving. This is a major contributing factor to the low rate of settlement fails across commodities. According to the 2011 ISDA Operations Benchmarking Survey, the percent of monthly settlement volume resulting in nostro breaks is only 8% across the industry. There are a number of explanations for the low rate of outstanding settlement fails in commodities, partly explained by the well-controlled confirmation processes below, which allow for trade discrepancies to be remedied well in advance of settlement: The OTC commodity derivatives markets have a record of striving for electronic confirmation Matching. Vendor solutions such as ICE eConfirm, EFETnet and SWIFT have facilitated this approach. The industry continues to add both products and trade types to these electronic platforms in order to decrease the number of trades requiring paper confirmations. Additional vendors are also beginning to enter this market (e.g, Markitwire and Misys). Many transactions are brokered by a third party. A broker recap is sent out (in addition to the Confirmation) and is diligently checked to ensure that trade economics are accurately booked. A number of market participants perform verbal confirmation of trade economics should there be no type of affirmation by Trade Date + 1. Pre-settlement affirmation of cash flows identifies discrepancies early and allows for reconciliations prior to settlement date. At times, the movement of the physical commodity serves as a pre-settlement affirmation of economics, with the exception of price. Discrepancies on physical transactions relate primarily to cuts in physical power and gas, where the actual quantity of the delivered commodity is different from the contractual quantity due to operational factors, e.g., congestion on the power grid. Each organization has its own, essentially similar, process for reconciling volumes (i.e., the use of pipeline statements and OATI tags) and, in the event of a volume discrepancy, the invoicing groups work together and share support to resolve any differences. Scheduling groups, and in the case of power, real-time trading desks, may get involved as well, to resolve volumetric differences. Should a difference remain at settlement time, counterparties will advise one another as to what the payment amount will be, and agree to continue working on the disputed portion of the invoice. Counterparties typically have a shared interest in resolving these outstanding items, so cooperation between counterparties is generally good. The UK power and gas markets are structured differently from North America markets and contractual obligations are usually met in full, with the financial impact of any changes in delivered volumes often managed centrally. (ii) Listed and OTC Cleared Trades Although this Paper does not focus on the specifics of the markets for Listed Trades and cleared OTC trades, OTC settlement risk in the OTC commodity derivatives markets has to be considered in the context of the overall commodity settlement volume. A significant percentage of commodities transaction volume is traded as futures and options on regulated exchanges run by entities such as the following: the CME Group, which controls the New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME); the Intercontinental Exchange, Inc. (ICE), which controls ICE Futures US and ICE Futures Europe; Commodity Exchange (COMEX); London Metal Exchange (LME); NYSE Euronext LIFFE (LIFFE); Singapore Exchange (SGX); Dubai Mercantile Exchange (DME); European Energy Exchange (EEX); and Tokyo Commodity Exchange (TOCOM) offering commodity products globally. o The OTC commodity derivatives markets pioneered the development of central clearing of OTC transactions. In the late 1990s, NYMEX was one of the first exchanges to offer the ability to clear OTC contracts. Counterparty demand for alternate solutions to complement bilateral collateral arrangements led to the development of a platform to clear OTC as futures through NYMEX's Clearport mechanism. The subsequent growth and success of OTC clearing coincided with Enron's bankruptcy and subsequent credit instability in the energy markets. In 2001, NYMEX Clearport provided the industry with the ability to clear centrally. The continued credit instability experienced during the late 2001-2002 period re-enforced the benefit of OTC clearing and its ability to provide capital efficiencies and access to a wide range of products. Other commodity exchanges and clearing houses followed the NYMEX example with ICE Clear, CME Clearport, LCH.Clearnet, European Commodities Clearing (ECC), NOS Clearing, AsiaClear and many others offering central clearing of OTC products. o

Examples of commodity central counterparty and clearing organizations today include:

o Gas Trading: ECC / ICEClear / CME Clearport / APX Group o Base Metals Trading: LCH.Clearnet / CME Clearport o Precious Metals Trading: LCH.Clearnet / CME Clearport o Power Trading: ECC, APX Group o Plastics Products Trading: LCH.Clearnet o Oil Products Trading: ICEClear / CME Clearport (formerly NYMEX Clear) o Crude Oil Trading: ICEClear / CME Clearport o Coal Trading: CME ClearPort, ICEClear o Freight Trading: NOS Clearing / LCH.Clearnet o Agriculture Trading: CME Clearport / ICEClear US o Emissions Trading: ICEClear / NOS Clearing / ECC o Iron Ore Trading: AsiaClear, LCH Clearnet o To date, NYMEX has launched more than 650 OTC-cleared contracts,23 and ICE Clear24 more than 600. Market participants commonly use central clearing, and there is strong competition between exchanges and clearing houses to launch new products providing capital efficiencies and credit risk management. Some of the most recent examples include: o ECC clearing contracts traded on the European Energy Exchange, European Energy Derivatives Exchange and Powernext; o NASDAQ and Nordpool working together to deliver central clearing services for UK power; o launch of Iron Ore OTC clearing by SGX/AsiaClear as well as LCH.Clearnet; o launch of Coal Futures by EEX; and o planned launch of gold forwards cleared by the CME Group, with LCH.Clearnet and NYSE Euronext also offering gold clearing solutions. o Settlement risk is being reduced by the shift towards central clearing. The benefit of facing the exchange on cleared trades rather than having bilateral OTC trades on with multiple counterparts is (1) the reduction in counterparty credit risk and (2) the ability to net long and short positions across a range of different product types, which may reduce the amount of collateral that is required for posting. In December 2011, the CMD processed 443,492 commodity OTC derivatives transactions of which 68,894 (16%) were OTC-cleared.25 Central clearing combined with the ongoing efforts to increase electronic confirmation matching has led to a significant continued decline in OTC settlement risk and a low number of aging fails amongst the CMD group. •

Compare the regulatory requirements and regulatory authority in the United States, European Union, and Singapore with respect to: the central clearing of OTC derivatives, requirements of central counterparties, margin requirements for uncleared OTC derivatives, trading, and back-loading of existing OTC contracts.

o A. Central Clearing 1. United States All swaps, regardless of their asset class, need to be centrally cleared. There is a possibility that the Treasury Secretary may exempt foreign exchange swaps and forwards from central clearing. However, the latest clarification from the CFTC (2012) indicated that even if such an exemption from the swap regulation were to be granted by the Treasury Secretary, the swaps would still be subject to reporting requirements under the CEA. Certain insurance products and commodity forward contracts are not required to be centrally cleared. Additionally, the Federal Energy Regulatory Commission regulates instruments or electricity transactions that the CFTC finds to be in the public interest are exempt from central clearing. End users of derivatives are exempt from central clearing. Additionally, the definition of end user is expanded to include small financial institutions (with assets of $10 billion or less) (CFTC and SEC 2012) to be exempt from the regulation. Cooperatives such as farm credit unions and credit unions are also exempt from clearing requirements. 2. European Union All standardized OTC derivatives that have met predetermined criteria need to be centrally cleared. All firms, financial and nonfinancial, that have substantial OTC derivatives contracts need to use central counterparty clearing houses. Nonfinancial firms below a certain "clearing threshold" are exempt from clearing through a CCP. Any OTC contract that is considered to be a hedge is exempt from clearing and as such does not even count toward the total clearing threshold. The threshold has yet to be set by the ESMA and the European Systemic Risk Board. The "European System of Central Banks, public bodies charged with or intervening in the public debt, and the Bank for International Settlements" (EURLex 2010) are not subject to clearing. There is a temporary exemption from clearing through the CCP for pension funds. There is also an exemption for intragroup transactions subject to higher bilateral collateralization by the EMIR. 3. Singapore All standardized OTC derivatives need to be centrally cleared. Singapore dollars interest rate swaps and US dollar interest rate swaps, and nondeliverable forwards (NDFs) denominated in certain Asian currencies have been prioritized for mandatory clearing followed by other asset classes in the future. The MAS exempts foreign exchange forwards and swaps from the clearing obligation. However, currency options, NDFs, and currency swaps are not exempt. They identify the Dodd-Frank Act in the United States for such exemptions or nonexemptions. Clearing is required when at least one leg of the OTC contract is booked in Singapore and if either one of the parties is a resident or has a presence in Singapore and has a clearing mandate. o B. Requirements of CCPs The CFTC may exempt a foreign CCP from registration if it determines that the CCP is regulated and supervised by an appropriate authority in its home country with regulations comparable to those of the United States. A CCP is required to maintain adequate capital to cover at a minimum a loss by a defaulting member and one year's operations. It is required to have sufficient liquidity arrangements to settle claims in a timely manner. Organizationally, the board needs to have market participants as its members. The CCP should have fitness standards for its board, members of a disciplinary committee should reduce (mitigate) any conflicts of interest, and it should maintain segregation of client funds. The CCP should be able to measure and manage risks. The European Union recognizes a third country CCP if the ESMA is satisfied that the regulations in that third country are equivalent to that of the EU. Further, the CCP should be regulated in that third country and that third country regulator must have cooperation arrangements with the ESMA. The ESMA is responsible for the identification of contracts that need to be centrally cleared (Europa.eu 2012). A competent authority in a member state can authorize a CCP; as such, it will then be recognized and can operate in the entire EU. There are permanent capital requirements for CCPs of €5 million. A CCP is required to maintain sufficient funds to cover losses by a defaulting clearing member in excess of the margin posted and default funds. These funds include insurance arrangements, additional funds by other nondefaulting clearing members, and loss sharing arrangements. Additionally, a CCP should have appropriate liquidity arrangements (EUR-Lex 2010). There are specific organizational and governance requirements for CCPs. These include separation of risk management and operations, remuneration policies to encourage risk management, and frequent and independent audits. Additionally, CCPs must have independent board members and a risk committee chaired by an independent board member. Finally, there are specific guidelines to avoid a conflict of interest and maintain segregation of client funds (EUR-Lex 2010). Singapore has no requirement of clearing through only domestic CCPs. Singapore-based corporations can act as clearing houses if they are approved. Foreign clearing houses can operate in Singapore if they are recognized. There are no specific requirements of the central counterparties in relation to the amount of capital required. The only presumption is that the clearing house needs to have sufficient financial, human, and system resources (MAS 2012). The MAS requires segregation of client funds. o C. Margin Requirement for Noncleared OTC Derivatives In the United States, the CFTC (2011) proposes rulemaking for initial margin and variation margin for swap dealers (SD) and major swap participants (MSP) for which there is no "prudential regulator" on swaps that are not centrally cleared through a derivative clearing organization. The proposal allows for netting of legally enforceable positive and negative marking to market swaps and reduction in margin requirements with off-setting risk characteristics. Only swaps entered after the effective date of the regulation are covered. The forthcoming capital rules will encompass existing swaps. There are no margin requirements on nonfinancial end users. Initial and variation margin requirements would not be required if payments are below the "minimum transfer amount" of $100,000. SD, MSP, or financial entities can post initial margins in the form of cash; US government or agency securities; senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, or the Federal Agricultural Mortgage Corporation; or any "insured obligation of a farm" credit system bank. A variation margin has to be posted in cash or US Treasury securities. For nonfinancial entities, there is flexibility about assets that could be used as long as their value can be easily assessed on a periodic basis. Those SD and MSP that have a "prudential regulator" are required to meet the margin requirements of that regulator. A prudential regulator is the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, or the Federal Housing Finance Agency. These commissions will propose capital requirements and financial condition reporting for SD and MSP at a later date. In the EU, financial and nonfinancial firms that enter into OTC contracts that are not centrally cleared through a CCP have to adopt procedures to measure, monitor, and mitigate both operational and credit risk including timely electronic confirmation of contract terms and early dispute resolution. Additionally, the contracts have to be marked to market on a daily basis. Finally, there should be appropriate exchange of segregated collateral or appropriate and proportionate holding of capital. These rules are applicable only to market participants subject to central clearing obligations (Herbert Smith LLP 2012). Singapore recommends financial buffers of capital and margins to mitigate the risk of OTC derivatives that are not centrally cleared. The amount of capital and margin should reflect and be proportionate to the risk of noncentrally cleared OTC contracts. The MAS will be implementing the Basel III requirements of capital for banks and will seek to align capital requirements of other regulated financial institutions with Basel III. The MAS will seek to align margin requirements on non-centrally cleared derivatives in accordance with the recommendations of the working group made up of representatives from the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, and the International Organization of Securities Commissions. o D. Trading All centrally cleared swaps in the United States are required to trade on a swap execution facility unless the swap execution facility or exchange does not accept the swaps. In the EU, all cleared OTC derivatives have trading requirements mandated by the Markets in Financial Instruments Directive. The MAS does not require trading of centrally cleared OTC derivatives in Singapore. o E. Backloading of Existing OTC Contracts In the United States, the Dodd-Frank Act applies to swaps entered only after the mandatory clearing requirement. However, this exemption is not applicable for reporting. The EU has proposed to require backloading of outstanding contracts with remaining maturities over a certain threshold (MAS 2012). In Singapore, a contract for a product subject to mandatory central clearing and having more than a year left before maturity is backloaded. Table 1 summarizes the regulatory requirements for these three jurisdictions. o •

Describe the function and benefits of a trade repository as it relates to OTC market participants.

o B. Trade Repositories o In addition to central clearing, regulators across jurisdictions have proposed trade repositories. It has been contended by studies such as Wilkins and Woodman (2010) that there was not enough information about the OTC trades before the crisis. Regulators lacked information about the size of trades and the volume of trades linked to a counterparty. Hence, they were not in a position to identify concentration of risk in a contract or an institution. There was no central database where regulators could gather and analyze OTC information. Studies have suggested that a trade repository (TR) would help reduce this opacity. Trade repositories can disseminate trade data to the public and help increase market transparency. They can help OTC market participants ascertain the deal on their trades. A trade repository is an institution that maintains a centralized database that records details about OTC derivatives contracts. The purpose of a trade repository is to increase pre-trade (quotes) and post-trade (information on executed trades) transparency. It is a single place where regulators can access data about the entire OTC market, a single trade, or any institution. The objective of a TR is to provide a centralized location where regulators can access data to monitor the OTC market. Regulators can identify concentrations of risk in a trade or with an institution before such concentration becomes destabilizing for the market. They can perform post-mortems on trades and identify guilty parties or aspects that are suspicious or illegal. Trade repositories can help manage trade life cycle events (Hollanders 2012). o Russo (2010) thinks that reporting of OTC trades should be mandatory. Additionally, TRs should give free access to regulators to the information stored in the registry (Wilkins and Woodman 2010). By disseminating trade information to market participants, TRs can improve market transparency and confidence in market participants. This dissemination of information will strengthen OTC markets. o Wilkins and Woodman (2010) advocate exchange trading of standardized and liquid OTC derivatives to improve transparency. Market participants can access firm quotes and see trade prices. This information will help level the playing field for both sophisticated and unsophisticated market participants. Electronic trading platforms, by providing indicative quotes, can offer limited pre-trade transparency. o Avellaneda and Cont (2010) distinguish between pre-trade and post-trade transparency of OTC derivatives data and between regulatory and public dissemination of data where participants in the interest rate swap market use these instruments to hedge the underlying interest rate risk. Standard interest rate derivatives market trades are usually large, OTC, and institutional. Pre-trade information can be disseminated among dealers using dealer networks such as ICAP, Tradition, BGC, and Tullet Prebon. Quotes from dealer networks could be used to provide aggregate indicators of market variables to the whole market. •

Understand the de minimis and major swap participant (MSP) tests, along with other financial obligations a party must meet to be considered an end-user.

o De Minimis and MSP Tests o Going forward, the de minimis and MSP tests described previously have to be run on a regular basis. A company that passes these tests today (and therefore can initially qualify for end-user status) may fail these same tests next year or the year after. So building a robust mechanism for running these tests as part of a company's base risk system is an important consideration. The de minimis calculations are run on a trailing 12-month basis in relation to the gross notional amount of a company's dealing swaps, while MSP tests are run on a quarterly basis looking at current and expected future exposures (MTMs) of the company's swaps (but only looking at the negative MTM values). The de minimis tests currently have three thresholds: an $8 billion threshold for all entities, an $800 million threshold for utility special entities and a $25 million threshold for non-utility special entities. The CFTC has indicated that these thresholds will apply during a "phase-in" period that will last about five years. At the end of the phase-in period, the CFTC may reduce its de minimis thresholds to lower levels. The MSP tests are more complicated than the de minimis tests, but they have been set at levels that should only capture the very largest swap market participants. The details of the MSP tests will be studied in more detail in a subsequent article. It is logical to anticipate that if any company expects to fail the MSP test for a quarterly period, it would probably file an election to become a swap dealer, since the MSP status carries most of the burdens with few of the benefits associated with swap dealer status. •

Understand the financial limits a party must meet to qualify for the end-user exemption.

o End-User Qualification o To begin, in order to qualify as an end-user (Category 3), a company must be neither a swap dealer nor a major swap participant (Category 1). Nor can the company be a "financial entity" (Category 2). In a subsequent article, I will provide more detail on financial entities (one of the less discussed terms in Dodd-Frank), but for present purposes, they are persons predominantly engaged in activities that are financial in nature, as defined by the Federal Reserve under the Bank Holding Company Act. With respect to the first part of the end-user requirement (i.e., being neither a swap dealer nor an MSP), this can only be determined by running the "de minimis" tests that determine whether a company is a swap dealer and the various MSP tests that determine whether a company is a major swap participant. In particular, end-users should make sure that they are not dealing in significant quantities of swaps with "special entities" (primarily government organizations) under Dodd-Frank. At a minimum, end-users should stay well under the de minimis thresholds that apply to swap trades with special entities. The $8 billion threshold that generally applies under the de minimis test drops to $800 million for special entities that engage in utility operations and to just $25 million for non-utility special entities (all calculated on gross notional amounts). One additional point for foreign companies to keep in mind is that the definition of a "financial entity" is based on the percentage of their assets and income that are derived from financial activities (sometimes called the "85/85" test). This calculation can be significantly influenced by how derivatives are treated within the company's financial statements -- U.S. Generally Accepted Accounting Principles present derivatives on a net basis while the European International Financial Reporting Standards present derivatives on a gross basis. o End-User Next Steps o Assuming a company qualifies for the end-user exemption from mandatory clearing (see above), companies that are subject to SEC reporting obligations (generally, U.S. public companies) must then adopt annual board resolutions to make this election. These resolutions can be adopted by the board itself or by a suitable committee of the board -- e.g., the audit committee or the finance committee. Though there is no statement within Dodd-Frank about companies that are not subject to SEC reporting obligations, it is a best risk practice for all companies that claim end-user status to adopt these same board resolutions. Swap dealers will probably be asking for proof of end-user status to all of their customers under Dodd-Frank's "know your counterparty" (KYC) rules that apply to swap dealers, so companies claiming end-user status should adopt appropriate board resolutions. Under CFTC rules, the annual board resolution must be filed with a swap data repository (SDR). For non-reporting end-users (i.e., end-users whose counterparties will do the swap reporting), this may be an issue if they do not have an existing relationship with an SDR. Based on recent discussions, at least one of the SDRs is working on providing a filing mechanism for the nonreporting end-users at this time. Keep in mind that the purpose of filing a board resolution with an SDR is to claim an exemption from the mandatory clearing requirement, but to date there have been few swap categories listed by the CFTC that are actually subject to mandatory clearing. In particular, the CFTC has yet to include any of the energy commodity swaps in the list of swaps subject to mandatory clearing -- so the timing for adoption of a board resolution has been extended (originally, this was due to be in place by September 2013). •

Describe the requirements for reporting derivative transactions to trade repositories in the United States, European Union and Singapore.

o F. Reporting Requirements 1. United States In the United States, swaps trade repositories are regulated by the CFTC or the SEC. TRs authorized by the CFTC (SEC) deal in swaps regulated by the CFTC (SEC). All traded or bilaterally negotiated swaps have to be reported. These swaps have to be between two unrelated parties and any changes to the swap agreement have to be reported. If a swap is executed by a swap execution facility (SEF) or designated contract market (DCM), the SEF or the CCP is required to report swap data to the TR as soon as technologically possible. For an off-facility swap, the hierarchy lies with the SD followed by MSP, followed by a non-SD or non-MSP. When the counterparties are within the same category, they have to choose which one of them will report. Both parties can choose to report and there is no condition of nonduplication. The party required to report is ultimately liable for the reported data even if that party contracts reporting to a third party (Young et al. 2012). Any swap (mandatory cleared or nonmandatory) that is cleared before the reporting deadlines for primary data can be reported by the clearing facility. Confirmation data on a cleared swap need to be reported by the clearing facility. For a noncleared swap, confirmation data need to be reported by the counterparty as soon as technologically possible. Any changes to the swap over its lifetime need to be reported by the respective parties listed above. Additionally, the state of the swap needs to be reported daily to the TR (Young et al. 2012). There is a real time public reporting obligation by a TR. Such reporting will not identify the counterparty and should be done when technologically possible. These records must be retained for the life of the swap and for five years after the termination of the swap. A TR needs to be appropriately organized and be able to perform its duties in a fair, equitable, and consistent manner. The TR should have emergency procedures and system safeguards and provide data to regulators. 2. European Union The ESMA has the regulatory power to register a trade repository in Europe. Regulators in individual countries cannot do so. Foreign authorities can deal with the ESMA for exchange of information and bilateral negotiations. Foreign TRs are recognized if regulations in the foreign country are comparable to those of the EU and there is appropriate surveillance in that third country. Additionally, there should be agreement between that country and the EU for exchange of information. Financial counterparties are required to report to a TR and to report to regulatory authorities if a TR is unable to record a contract. A counterparty required to report may delegate such reporting to another counterparty. Reporting should include the parties to the contract, the underlying type of contract, maturity, and the notional value. A nonfinancial counterparty, above the information threshold, is required to report on OTC contracts. Such reporting must be done in one business day from the execution, modification, or clearing of the contract. There should be no duplication. The regulation has proposed robust governance arrangements including organizational structure to ensure continuity, orderly functioning of the TR, quality of management, and adequate policies and procedures. Operational requirements include a secure TR with policies for business continuity and disaster recovery. Data reported to a TR should be confidential even from affiliates or the parent of the TR. A TR will share information with (a) the ESMA; (b) the competent authorities supervising undertaking subject to the reporting obligation under Article 6; (c) the competent authority supervising CCPs accessing the trade repository; and (d) the relevant central banks of the European System of Central Banks. A TR will maintain confidentiality of information and maintain records for at least 10 years after the termination of a contract. A TR will aggregate data based on both class of derivatives and reporting entity. 3. Singapore The MAS does not require reporting to a domestic TR. The MAS has proposed two types of trade repositories — approved and recognized overseas trade repositories (ATR and ROTR). Approved TRs are domestic, whereas ROTRs are foreign incorporated TRs. The MAS has not required foreign regulators to indemnify ATRs or ROTRs before obtaining data from them. The MAS has proposed reporting for all asset classes of derivatives. However, it recommends a phased implementation of the reporting requirement with a priority given to asset derivatives from a significant share of the Singapore OTC market interest rate, foreign exchange, and oil derivatives. Oil forms a significant part of the physical market during the Asian time zone, but it does not form a significant part of the Singapore derivatives market. All contracts that are booked or traded in Singapore or denominated in Singapore dollars are required to be reported. All contracts where the underlying entity or market participant is resident or has a presence in Singapore also need to be reported. Any foreign finance entities are not required to report in Singapore. However, if MAS has an interest in an entity, it will seek information from a foreign authority. All financial entities and any nonfinancial entity above a threshold (that takes into account the asset size of the entity) have to report. Additionally, group-wide reporting is required for Singapore incorporated banks. Singapore allows single-sided reporting and third-party reporting. While singlesided reporting is mandatory for financial entities, only one of the nonfinancial entities (among a group) needs to report. Foreign entities are not required to report, and public bodies are excluded from reporting. Transaction-level data, including transaction economics, counterparty, underlying entity information, and operational and event data, need to be reported. The content of the data needs to be reported in both functional and data field approaches. Any changes to the terms of the contract over its life need to be reported. The MAS has proposed a legal entity identifier and standard product classification system, but has not required it. The data need to be reported within one business day of the transaction. The MAS requires backloading of pre-existing contracts. Summary The main difference in the three regulatory jurisdictions is the nonrequirement of trading of cleared derivatives in Singapore. This difference has the potential to provide substantial choices in trading venues for market participants. •

Explain the use of swaps for hedging purposes and how this is affected under Dodd-Frank.

o Hedging o As part of this board resolution, a company claiming end-user exemption from mandatory clearing must represent that it uses swaps to hedge or mitigate commercial risk arising from its underlying physical business -- e.g., oil and gas production or gasoline refining. An important point to consider is that the board resolution itself is necessary, but not sufficient, to receive an exemption from mandatory clearing. The transactions themselves must be used for hedging purposes. What this means is that even after making an election and filing the annual board resolution with an SDR, a company can still only be exempted from mandatory clearing if its swaps are really being used for hedging purposes. Assume for a moment that a company uses swaps for two purposes within its business: to hedge its physical oil and gas production and to engage in some limited speculative trading activity. In effect, it is an end-user when it is hedging its physical transactions, but it is a trader when it engages in speculative activity (for which the exemption from mandatory clearing is not available). A company like this should still proceed to pass an appropriate board resolution claiming exemption from mandatory clearing, but only for those transactions that are being used as hedges (and not for its speculative trading activity). Remember that end-users and speculative traders are both "nons," but they have different results under Dodd-Frank with respect to the mandatory clearing exemption rules. Another point to consider is that qualifying swaps are also excluded from certain parts of the de minimis and MSP tests. In order to qualify as a hedge, swaps must come under one of the following standards: the "mitigation of commercial risk" standard (the Dodd-Frank standard), the "bona fide hedge" standard (the Commodities Exchange Act standard) or the accounting hedge standards set by FASB. •

Define the terms: swap dealers, major swap participants, and end users; understand how entities are assigned to these categories under Dodd-Frank.

o In General. Dodd-Frank regulates a variety of previously unregulated derivatives, including interest rate swaps ("IRS"); non-spot foreign exchange transactions (unless exempted as described below); currency swaps; physical commodity swaps; total return swaps; and credit default swaps ("CDS").1 Dodd- Frank divides this group of previously unregulated derivatives into two categories: "swaps" (which come under the jurisdiction of the CFTC) and "security-based swaps" (which come under the jurisdiction of the Securities and Exchange Commission ("SEC")). The SEC has not yet finalized most of its substantive rules. Accordingly, this memorandum does not address the regulation of security-based swaps. o What Is a "Swap"? The term "swap" is broadly defined and, unless an exclusion applies, includes a wide range of agreements, contracts or transactions linked to an array of underliers such as physical commodities, rates, foreign currencies, broad-based security indices or U.S. government or other exempt securities (other than municipal securities).2 OTC derivatives based on a single non-exempt security or narrow-based security index are generally security-based swaps. o • Exemption for Physically-Settled Foreign Exchange Swaps and Forwards. The U.S. Secretary of the Treasury has exempted certain physically-settled foreign exchange swaps and foreign exchange forwards from some Dodd-Frank requirements. The exemption does not apply to products such as non-deliverable foreign exchange forwards, foreign exchange options or currency swaps.3 Exempt foreign exchange swaps and foreign exchange forwards do remain subject to the regulatory reporting requirements and external business conduct standards discussed later in this memorandum. o • Excluded Instruments. Some common financial products are excluded from the new framework. These include listed futures, options on listed futures, listed and unlisted options on securities and on broad- and narrow-based security indices, commodity trade options,4 securities repurchase agreements, depository instruments, security forwards and non-financial commodity forwards intended to be physically settled. The CFTC retains anti-evasion authority with respect to the structuring of certain transactions to evade regulation. o In General. Title VII of Dodd-Frank created two new categories of registration for SDs and MSPs. SDs and MSPs are subject to comprehensive, substantive regulation, including capital, margin, documentation, reporting, recordkeeping, and internal and external business conduct requirements. o o SDs. An entity is regarded as a swap dealer if it: (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.5 Dodd-Frank provides a deminimis exception from designation as a swap dealer for a person that enters into less than $8 billion of gross notional value in swaps over the preceding twelve months.6 Under the CFTC's current cross-border proposed guidance and exemptive order (discussed further below), the calculation of the de minimis threshold excludes swaps with non-U.S. persons and foreign branches of U.S. persons that are registered as swap dealers. o o MSPs. Even if an entity is not an SD, it may still become subject to registration with the CFTC if: (i) it maintains a "substantial position" in any major category of swaps, excluding (I) positions held for hedging or mitigating commercial risk and (II) positions maintained by an employee benefit or governmental plan, as defined under the Employee Retirement Income Security Act of 1974 ("ERISA"), for the primary purpose of hedging or mitigating risks directly associated with the operation of the plan; (ii) its swaps create "substantial counterparty exposure"; or (iii) it is a private fund or other "financial entity" that is highly leveraged, is not subject to capital requirements established by an appropriate Federal banking agency and maintains a "substantial position" in a major category of swaps.7 A "substantial position" is defined (i) in the case of rate or currency swaps, as $3 billion in negative mark-to-market exposure or $6 billion in negative mark-to-market plus potential future exposure or (ii) in the case of credit, equity or commodity swaps, as $1 billion in negative mark-to-market exposure or $2 billion in negative mark-to-market plus potential future exposure. "Substantial counterparty exposure" is defined as $5 billion in negative mark-to-market exposure across all swaps or $8 billion in negative mark-to-market plus potential future exposure across allswaps. Under the CFTC's current cross-border exemptive order, the calculation of these thresholds by a non-U.S. person excludes swaps with non-U.S. persons and foreign branches of U.S. persons that are registered as swap dealers. o • End Users. Title VII of Dodd-Frank also applies to end users that do not qualify as SDs or MSPs. Dodd-Frank divides end users into two broad categories— financial and non-financial end users. o • Financial End Users. An end user is a financial end user if it is a commodity pool,8 private fund,9 employee benefit plan,10 or person that is predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956. "Predominantly Engaged in Activities that Are Financial In Nature." According to final rules under Title I of Dodd-Frank, an entity is "predominantly engaged in activities that are financial in nature"11 if in either of its last two fiscal years: the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature represents 85 percent or more of the consolidated annual gross revenues of the company; or the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature represents 85 percent or more of the consolidated assets of the company.12 o Accounting for Subsidiaries. Under this standard, an end user may take into account its own gross revenues and/or assets as well as the gross revenues and/or assets of all of its consolidated subsidiaries in determining whether it qualifies as a financial end user. This is true even if the end user is an intermediate holding company. •

Understand the role of a derivatives clearing organization and describe the process for clearing a swap.

o Overview of Clearing. To clear a swap, the counterparties to the swap that is subject to mandatory clearing will, as soon as practicable after execution, submit their respective sides of the swap to a derivatives clearing organization ("DCO") either through a clearing broker (called a futures commission merchant or "FCM") or directly (if the party is itself a member of the DCO), rather than establishing a bilateral contract with each other. Since most end users are not self-clearing members, to accomplish this, an end user will need to establish a clearing relationship with an FCM and enter into cleared derivatives execution agreements (sometimes referred to as "give up" agreements) with its counterparties. The two counterparties to a cleared swap are not required to, but may, use the same clearing broker to clear the swap. o • Margin Requirements. Cleared swaps are subject to margin requirements established by the DCO, including daily exchanges of cash variation (or mark-to-market) margin and an upfront posting of cash or securities initial margin to cover the DCO's (and FCM's) potential future exposure to the end user in the event of its default. o • End Users May Choose the DCO. Dodd-Frank provides that the counterparty to a swap transaction that is not an SD or MSP has the sole right to select the DCO for a transaction that is required to be cleared. Swap pricing may be affected by the DCO selected to clear the swap. o • End Users May Choose to Clear Swap Transactions Not Subject to Mandatory Clearing. An end user is entitled to elect to clear swap transactions that are not subject to mandatory clearing, at a DCO of such end user's choice. o Which Swaps Are Subject to Mandatory Clearing? o • In General. The Commodity Exchange Act ("CEA") authorizes the CFTC, either upon application by a DCO or upon its own initiative, to require a designated swap or category of swaps to be cleared by a DCO.13 On November 28, 2012, the CFTC issued its first mandatory clearing determination for certain IRS and CDS. o • IRS. Very generally, the following IRS are subject to mandatory clearing: o Fixed-to-floating swaps; o Floating-to-floating swaps (also known as basis swaps); Forward rate agreements; and o Overnight indexed swaps. o The mandatory clearing determination only applies to the IRS listed above in the following currencies: United States dollar, Euro, Sterling or Yen. o • CDS. Very generally, the following CDS are subject to mandatory clearing: O Untranched indices covering the CDX.NA.IG and CDX.NA.HY; and o Untranched indices covering the iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High Volatility. 14 o • The CFTC plans to make additional clearing determinations in the future. End users should consider establishing policies and procedures to monitor which swaps become subject to mandatory clearing. o What Are the Exceptions or Exemptions to Mandatory Clearing? • In General. The CFTC has issued final rules detailing (i) a limited exception to the mandatory clearing requirement for a defined category of non-financial end users and (ii) an exemption to the mandatory clearing requirement for transactions between certain affiliated entities. • Swap Terminations. In a recent no-action letter, the CFTC staff has clarified that swaps that partially or fully terminate existing uncleared swaps are not required to be cleared.15 o What Are the Criteria for the Non-Financial End-User Exception? • Eligibility. The CFTC has issued final rules outlining a limited exception to the mandatory clearing requirement for a defined category of non-financial end users.16 Both third-party and inter-affiliate trades may qualify for the exception. In order to qualify for the exception for a particular swap transaction: o The Entity Entering into the Swap Must Not Be a Financial Entity. To qualify for the exception, the particular entity entering into the swap must not be an SD, MSP or financial end user (as described above). Notably, even an entity within a corporate group that, on a group-wide basis, engages predominantly in non-financial activities may still be a financial entity depending on the activities of the particular entity in question (and those of its subsidiaries). However, there are certain cases where a financial entity is nevertheless eligible for the exception: •

Understand the key features of the OTC commodity derivatives market.

o Over‐the‐Counter (OTC): The trading of commodities, contracts, or other instruments not listed on any exchange. OTC transactions can occur electronically or over the telephone. Also referred to as Off‐Exchange. o Within the OTC commodity derivatives market there is already a high degree of standardization. o The OTC commodity derivatives market features: Well-understood product mechanics Robust, proven legal framework Standardized documentation5 Electronic trade affirmation / legal confirmation Extensive electronic execution capabilities Active clearing across a variety of central clearing counterparties (CCPs) High and improving rates of straight-through-processing (STP) Robust bilateral settlement o Almost all OTC commodity derivative trades are executed under standard legal terms. Typically, they are contained in the ISDA Master Agreement between the parties, although in a limited number of cases they are contained in the national equivalent such as Rahmenvertrag in Germany, AFB in France (or in another master agreement between the parties). At the trade level, the standard trade incorporates the ISDA definitions, supplements, protocols and other documentation as set forth for that particular product in the ISDA Commodities Documentation Matrix, all of which have been developed over the past decade. This development has included incremental modification and standardization over time in order to make trades on the same underlying, to the same maturity date fungible in order to facilitate compression and clearing, where appropriate. For trades confirmed electronically, these standard provisions are typically incorporated via the rules and procedures governing use of the platform. For trades confirmed on paper, these standard provisions are usually incorporated via the relevant standard documentation forms. It is important to note that standardized agreements still require bilateral agreement for novations. •

Explain the importance of automation (i.e. "straight-through-processing") in clearing OTC energy trades; describe the benefits and weaknesses of a settlement matching process.

o STP: The OTC commodity derivatives market has developed a very high level of straightthrough- processing (STP). From the use of electronic trade booking to central clearing counterparty (CCP) processing, the industry continues to leverage the established infrastructure to drive further efficiency in trade processing and a reduction in operational risk.11 o 8.1 Electronic Affirmation/Confirmation/STP o The markets continue to strive for further operational standardization. There is a strong industry focus on the industry utilities keeping up with developing volumes in the marketplace. This is tracked and managed via an established and mature reporting process that confirms the level of penetration of electronic versus paper confirmation. o Paper confirmations may be created manually, systemically with some user interaction, or systemically with full STP. According to the terms of any prevailing Master Agreement and/or the governing law, confirmations may be legally binding by (i) one party signing and returning the other party's confirmation, (ii) an exchange of confirmations between the parties, (iii) one party affirming their agreement to the terms of the confirmation by some means but without actually signing the confirmation, or (iv) one party implying their acceptance of the other party's confirmation by virtue of not having disputed it within a given specified timeframe. o To summarize, a list is provided of the perceived advantages and challenges of a settlement matching service: o Advantages : o Efficiency benefits o Processing would be more scalable o Increased control o Offsetting errors would be identified o Users can select different levels of service o Challenges: o Difficulty/Cost of providing granular settlement data to the platform (e.g, hourly quantities and prices as seen in the power markets). o Cost for creating an electronic settlement system would not be too beneficial given the fact that most financially settled activity is straight-through-processed (STP) for most organizations and most physical settlements will continue to need manual processing. o Matching logic has not yet been completely defined. o Parties structure trades differently (e.g, crack spreads may be booked as one trade by Party A and two trades by Party B). There is no clear solution for how this match would occur. o Unlikely to improve the physical cut reconciliation and agreement process for physical power and physical gas. o Re-publishing of settlement prices after invoice is sent or after settlement date requiring reprocessing. o There would likely be significant implementation costs - the ongoing cost as well as internal development costs to integrate with the service. These would have to be compared to proposed efficiency gains. o Difficulty of on-boarding counterparties due to the diverse range of market participants. Any benefit will be reduced unless the majority utilizes the service. •

Understand the requirements for clearing a swap transaction, including swap reporting requirements.

o See above •

Describe how OTC clearing affects market transparency.

o The OTC commodity derivatives markets have a record of striving for electronic confirmation Matching. Vendor solutions such as ICE eConfirm, EFETnet and SWIFT have facilitated this approach. The industry continues to add both products and trade types to these electronic platforms in order to decrease the number of trades requiring paper confirmations. Additional vendors are also beginning to enter this market (e.g, Markitwire and Misys). o Many transactions are brokered by a third party. A broker recap is sent out (in addition to the Confirmation) and is diligently checked to ensure that trade economics are accurately booked. o A number of market participants perform verbal confirmation of trade economics should there be no type of affirmation by Trade Date + 1. 17 o OTC Commodity Derivatives Trade Processing Lifecycle Events April 2012 o Pre-settlement affirmation of cash flows identifies discrepancies early and allows for reconciliations prior to settlement date. o At times, the movement of the physical commodity serves as a pre-settlement affirmation of economics, with the exception of price. o Internet Research The financial crisis has highlighted the risks associated with less-regulated markets, and regulatory responses - beginning with the G20 commitments - have indicated that Central Counterparty (CCP) clearing and exchange trading will be mandated for many markets. Any discussion around increased regulation of these markets and the potential for mandatory exchange-trading and CCP clearing must recognize the role of OTC markets in the global economy, and the similarities and differences between OTC and exchange-traded markets. OTC derivatives and commodity contracts are valuable, and in some instances, necessary risk transfer tools. They allow important innovation in product design, provide for the commencement and evolution of emerging markets, and enable customized solutions for the particular hedging needs of market participants. Certain markets will possess the right combination of standardization, liquidity and user characteristics to be adapted to on-exchange trading. In fact, many derivatives that are exchange-traded today have evolved from OTC products. On-exchange trading grew as users migrated to exchange-traded instruments and in some cases substituted on-exchange for OTC products. The success of government bond futures, index futures, and equity and ETF options demonstrate products and markets that have adapted well to the standardized rules and requirements of exchange trading. The impressive growth in exchange-traded derivative activity over the past decade is clear evidence that participants have valued the benefits of on-exchange anonymity and market liquidity. OTC and listed derivatives have co-existed through significant growth in both markets, and not every derivatives contract is ready or appropriate for migration to on-exchange trading. There is a wide diversity of OTC markets that bring together participants to trade specific asset classes, and each market will be characterized by its own combination of products and participants. A "one-size fits all" response will not be appropriate for all of these markets. As a result, it is necessary to determine which markets can be effectively migrated to trading on a regulated exchange and CCP clearing, and which markets will be subject to trade reporting and higher capital requirements. In looking at how the exchange-traded and OTC markets have evolved, we can make some general observations about market suitability for exchange trading and CCP clearing. A high degree of standardization is required for on-exchange trading. Futures contracts are standardized as to (1) contract underlying, (2) contract size, and (3) contract maturity. Only the price of the contract is negotiable on exchange. The utility of futures contracts for participants is dependent on the liquidity of the market - there must be a sufficient number of participants and a sufficient volume of activity in order for effective price discovery and risk transfer. Other platforms exist that allow for trades to be reported, confirmed and processed for CCP clearing, but these do not provide the degree of price-discovery and transparency that are provided by exchanges. http://www.tmx.com/en/pdf/RoleOfRegulatedExchange.pdf •

Identify the market pricing services used to settle OTC energy contracts (i.e. PlattsGas Daily) and understand how physical delivery may impact the settlement value.

o Traders are allowed to reverse ('offset') their positions, so that physical delivery is rare (futures can be used to trade in the risk, not the commodity). This is true because most hedgers are not dealing in the commodity deliverable against the futures contract. For instance, an airline company is not going to use WTI crude oil in Cushing, Oklohama, for its operation, but may use the WTI futures contract as a hedge. That is, most hedgers are "cross hedgers". Similarly, speculators are just betting on price movement, and have no interest in owning the physical oil. Therefore, most hedgers and speculators reverse their position prior to delivery. o Even though physical delivery does not occur on most contracts, delivery is important nonetheless. Delivery ties the price of the expiring futures to the price of the physical commodity at delivery. Nonetheless, cash settlement can be considered another way to tie the futures and cash markets together. In a cash‐settled contract, at expiration the buyer pays the seller the difference between the fixed price established in the contract and the reference price prevailing on payment. o Cash Settlement: A method of settling futures options and other derivatives whereby the seller (or short) pays the buyer (or long) the cash value of the underlying commodity or a cash amount based on the level of an index or price according to a procedure specified in the contract. Also called Financial Settlement. Compare to physical delivery. o Physical: A contract or derivative that provides for the physical delivery of a commodity rather than cash settlement. See Financial. o Physical Delivery: A provision in a futures contract or other derivative for delivery of the actual commodity to satisfy the contract. Compare to cash settlement. o Transactions where physical delivery of electricity or gas occurs possess product-specific settlement conventions, where the delayed settlement provides for reconciliation of physical deliveries and book-out of transactions between counterparties at delivery points on natural gas pipelines and within electricity ISOs and RTOs, or at other regional scheduling locations on the grid. For example: o North American Physical Power and European and UK Physical Natural Gas transactions settle on a monthly cycle 20 days after the end of the delivery month; o UK Physical Power transactions settle on a monthly cycle 10 days after the end of the delivery month; and o North American Physical Gas transactions settle 25 days after the end of the delivery month. o MT - physical delay payment till 25th. Physical introduce delivery risk, scheduling / cuts / actualization. Physical delivery requires dealing with physical assets like transportation, fuel etc. Banks are typically not physical players. Hold financial derivatives to take a position, but unwind before physical delivery. •

Understand the reporting process under Dodd-Frank, including which party is obligated to report a transaction to a swap data repository (SDR).

o Who Has the Reporting Obligation? In general, if a transaction is concluded on an exchange, no further reporting is required. For off-exchange (OTC) transactions, one of the two parties to a swap must report the transaction to an SDR. If a Category 3 entity (i.e., an end-user) does a swap transaction with a Category 1 entity (swap dealers and MSPs) or a Category 2 entity (a financial entity), then the Category 1 or Category 2 counterparty has the reporting obligation (and not the end-user). The question arises: what happens when two end-users do a swap with each other? The answer is that if one of the end-users is a "U.S. entity" (as that term is defined under Dodd- Frank) and the other is not a U.S. entity, then the end-user that is a U.S. entity has the reporting obligation. A second question naturally arises: what happens when both are U.S. entities or both are not U.S. entities? The answer is that the parties have to agree on who will do the reporting. The main point to keep in mind is that for all swaps, someone has to do the reporting to the SDR. There is no free lunch. o

Explain the circumstances under which an end-user exemption may be granted to a swap participant

o • End-User Exception for Affiliates Acting as Agents for Non-Financial End Users. The end-user exception provides that an affiliate of a non-financial end user may be permitted to use the exception so long as it acts "on behalf of the [non-financial end user] and as an agent."17 o o Covered Affiliates. Financial end users acting on behalf of and as an agent for the non-financial end user may make use of the end-user exception. An SD or MSP, however, even if it acts on behalf of and as an agent for a non-financial end user, may not make use of the end-user exception. o o Undefined Scope of Agency Requirement. It is unclear whether the CFTC will interpret the agency requirement narrowly (i.e., the central affiliate may not act as a riskless principal, as is usually the case with centralized hedging programs) or in a de facto manner (i.e., to permit a central affiliate to net the demand of various affiliates and act as principal with external counterparties, while at the same time entering into offsetting back-to-back swaps with those affiliates). To address this ambiguity, the Coalition of Derivatives End Users has requested an exemption from mandatory clearing for centralized treasury units.18 o o Additional Considerations. A financial end user wishing to rely on an affiliate's eligibility to elect the end-user exception may need to enter into an agency agreement to demonstrate that it is acting as an "agent for" the non-financial end user. Such an agreement may expose the non-financial end user affiliate to certain liabilities as a principal to the swap transaction. In addition, such an agency relationship may affect set-off rights as among the various parties to the swap transactions. In order to avoid unanticipated consequences, end users should take care to analyze any potential agency arrangement from the perspective of common law principles of agency and the applicable state law governing the agreement. •

Understand how Working's T-ratio can be applied to measure speculation in a commodity futures market.

· Another example of the use of COT reports of the assessment of the impact, speculators and speculative activity on commodity prices. The formula used to accomplish this is based on the contribution of Holbrook working, who came up with a measure of speculative activity (workings T index) in a futures market. The logic behind this index is very simple. In a market without speculators - it would be probably very dull market - the commercial loans and shorts would be by necessity perfectly balanced. In reality, there is never perfect balance in the speculators have to step in. · The size of the gap to have to fill can be used to measure the level speculative heat. The formulas for working's T ratio are given below: · T = 1+ (SS/(HL + HS)) if HS >HL · T = 1+ (SL/(HL + HS)) if HL >HS · SS stands for the short positions of the speculators. · SL - long positions of the speculators. · HS - short positions of the hedgers. · HL - long positions of the hedgers. · All the position levels are announced the numbers. The history of the T ratio confirm the intuitive expectations of even a casual observer of the energy markets, it have to be used with caution. CFTC data underlying the calculations are not flawless. · As mentioned above, the distinctions between speculators and hedgers are based on self classification (through the CFTC form 40) and failed to represent a very thin line separating these 2 types of trading and the fact that in any trading organization speculative and hedging activities may be combined under one common umbrella. It is also important to recognize a speculative activities typically concentrates in the 1st few most liquid contracts. Where is hedging positions may be extended over a longer range of maturities. The aggregate nature of the CFTC data does not allow for making this distinction. •

Understand the SPAN system and how it is used to assess risk factors within portfolio positions.

· Calculation of margin is based on the system, known as standard portfolio analysis of risk (SPAN) developed by the CME in 1988 and used under license by number of exchanges, including Nymex. Span represents a version of a risk management system based on enhanced stress testing, with an attempt to recognize the benefits of diversification. Due to its transparency and flexibility (it allows exchanges to adjust the parameters to the risk preferences), the span system has survived the test of time. In spite of being fairly simplistic solution by the standards of modern risk management practices. · Understanding of span system is important for a number of reasons. A portfolio manager has to understand how different marching arrangements work for different components of their portfolio. In a complex portfolio, different pieces of the same strategy may be executed across different markets and platforms and are therefore subject to different lodging arrangements. For example, the risk of an OTC transaction may be hedged using a Nymex position in the collateral received. Posted May diverge, which may stress the firm's liquidity. 2nd, the US financial markets used to marching systems based on varying philosophies in many equity and fixed income traders moving to the energy markets may sometimes ignore these differences. US securities industry has historically used the strategy-based system developed under regulation T. The term strategy-based system is not very descriptive; what it means that 2 or more positions can be seen as mutually offsetting in terms of risk only if there parts the same predefined strategy. If this is not the case. The positions are treated as if there was no diversification affect. Span system takes a portfolio approach, adding gains and losses for all the portfolio positions under different market scenario's. This reflects a policy of an exchange to liquidate the entire portfolio. If there is a default single contract held by customer. Another important difference is the treatment of the option positions under regulation T. Margin required for options is related the value of the underlying instrument, span uses the option pricing model. · The main function of span is to create a bridge the maintenance margins est. by an exchange to the estimate of the loss that may be incurred by the portfolio from one day to the next a certain probability levels ranging from 95 to 99%. Of course, the loss estimate is not a measure of maximum potential loss in both exchanges in the futures brokers can address this by assessing surcharges to their members and in excess of the guidelines under span. · The analysis is further complicated to the to the consideration of spread risk. The default assumption used in span is that the teachers price curve changes through parallel shifts. This means the spread position in the same commodity would have 0 margin requirements. Exchanges are clearinghouses using span can Forward curve reshaping risk by charging an intra-commodity spread charge. Also an additional charge they be added to position in the 1st nearby contract in order to recognize exceptionally high volatility observed to the futures price near expire ration. Span recognizes that the futures price the same underlined not correlate exactly across different months and that the forward price curves not received through parallel shifts. •

Describe the structure and function of a clearinghouse, and explain the role of clearing members.

· Clearinghouse design · clearinghouse provides a number of very important services, including the processing, matching, registering, guaranteeing and settling of trades executed on exchange. In addition, the clearinghouse performs the following functions: it replaces a web bilateral relationships between many trading counterparties into claims on a clearinghouse and liabilities to clearinghouse. This has a beneficial outcome of reducing credit risk to a very low level, and reducing the amount of working capital required for collateral management. · The regulatory developments taking place the US related to the Dodd Frank act may clearinghouses (referred to in official documentation essential clearing counterparties or CCP's), one of the critical pillars of the overhauled financial system. One of the most important and also very controversy oh provisions of the act is mandatory exchange trading and clearing of most derivatives. Specific rules defining the universe of derivatives will fall under this provision will be determined through the process of rulemaking by the SEC and the CFTC. The end-users of derivatives (the entities hedging commercial exposures) will receive exceptions (not exemptions as is usually reported by the press). From this requirement that it itself are very controversial. Understanding the economic functions in different designs of clearinghouses becomes quite important in the changing landscape of the financial industry. Historically, different models sensual CCP's. He Voll through trial and error in the replication of successful solutions implemented elsewhere. After all, imitation is subtlest form of flattery. · In the most general sense, a clearinghouse is an entity with 2 critical functions. 1 - settling trades for its customers and 2 - guaranteeing the fulfillment of contracts. · Clearinghouses can be structured is vertical or horizontal operations. Vertical structure is a clearinghouse closely associated are directly owned by an exchange, with all transactions taking place on the exchange being subject to mandatory clearing. Additionally clearinghouse excepts for clearing exclusively the transactions executed on the exchange. It is associated with. An example of such a clearinghouse Nymex prior to creation of clear poor. Horizontal structure corresponds to clearinghouse which accepts for clearing transactions from multiple trading venues (for example, wanting clearinghouse). Both solutions has some advantages. The vertical structure facilitates seamless processing of trees with each transaction execution on exchange being immediately broken up with the clearinghouse being inserted between the 2 original counterparties. Horizontal clearing just more choices the market participants and stimulates competition. · The role of clearing members: exchange safeguards · developments related to the bankruptcy of MF global focused public attention to the role played by the clearing members and illustrate the importance of careful dissection of the somewhat simplistic understanding of credit risk of exchange trading. Conventional wisdom of many practitioners is that exchange trading in clearing eliminates completely credit risk, but this is not entirely correct. Central counterparty clearing is like plumbing in a house: it usually works is taken for granted, and less it does not. It works most the time, but it always breaks of the worst possible moment and the consequences are is. Is not correct to say that central clearing reduce credit risk to very low level, but that a very low probability/very high severity exposure always exists. · There are several requirements the clearing member has to meet, including the level of capitalization. Anybody trading on exchange should be aware of the potential exposure to credit of a clearing member they use as a broker. CME representations, for example, make it perfectly clear that the clients clearing brokers are exposed to credit risk customers face credit risk in doing business to any particular clearing member. Consequently, the selection process for suitable clearing member is important. While the policies applicable to say purgation of customers monies for products traded deregulated markets are specifically designed to protect customers from the consequences clearing member's failure, they do not always provide complete protection should default because by another customer that for. · Historically, there were very few cases of clearinghouses that ran into problems are required some kind of bailout. The exchanges have developed a system of firewalls to provide protection against default resulting from the nonperformance exchange client or clearinghouse member - clearing were nonclearing. Examples of such safeguards can be found on the websites of many exchanges, including the CME. The safeguards quoted in the CME document include the following. · 1. 2 full settlement cycles marking to the market. Once in the late morning and once in the late afternoon. · 2. Performance bond requirements that are good faith deposits to guarantee performance on open positions and are often referred to as margins. · 3. Costs are joining with other clearinghouses such as OCH clearing it in the fixed income clearing Corp. · 4. Segregation of customer funds at the clearing brokers from the clearing firm's own funds. It seems at this point that MF global field 60 probably the customers funds and possibly its trading positions. · 5. Capital requirements for the clearing brokers. CME clearing members that are subject to the CFTC regulation are required to maintain adjusted net capital (ANC) Prescribed levels. Effective as of January 1, 2009 all active clearing members were required to maintain the greatest of · $5 million US. · CFTC minimum regulatory capital requirements. · SEC minimum regulatory capital requirements. · 6. Financial surveillance. The CME group audit department in conjunction with other self regulated organizations, operates a sophisticated financial surveillance program, including notification, inspection and information sharing. · 7. Intraday monitoring. · 8. Market regulation. · 9. Clearing member risk reviews •

Describe the features of Commitments of Traders (COT) reports and the advantages and disadvantages of using COT reports by energy market participants.

· Commitments of traders and related reports. · COT reports distributed weekly by the CFTC are useful window into current activity in the futures markets area. These reports have many uses, including the development of trading strategies, forecasting futures prices and academic research. · The level of activity on futures exchanges is measured using 2 statistics: open interest in volume. Open interest is the total of all futures contracts not been offset through delivery are closed. Volume is the number of transactions executed during specific time. An example may help clarify this distinction. Suppose that a new contract is open to next sells 10 contracts to Y during the 1st hour of trading. The open interest as tenant this point, and this number is the same as the long or short open interest (there is a buyer for a reseller). Before the end of the day, X and Y reverse to transaction and X buys a 10 contracts back from why. Net open interest at this point to 0 in the volume for the day was 20 contracts (assuming there were no other trades). · The outstanding positions in over 90 futures contracts are reported, but the CFTC in the COT report, in this publication is an important information source, followed by commodity traders. COT is available for Tuesday positions for contracts in which 20 or more traders hope positions exceeding the levels est. by the CFTC. These reporting levels depend on the overall maturity of given contract open interest in may vary from low tends to a few thousand. If a single trader exceeds est. limits and just one of the delivery or option expire ration months their entire position will be reported. According to CFTC 70 to 90% of outstanding positions are covered. · Limitations - it does not provide sufficient information about the activities in positions of the indexers - financial companies offering financial instruments replicating performance of a certain commodity basket. •

Compare and contrast requirements for commercial and non-commercial traders, and for speculators andhedgers, under the CFTC rules.

· Dodd Frank act requires that all standardized derivatives be traded on exchanges and clears. This happened be a very unpopular provision the point of view of the end-users of conservatives. Protests against as part of the act and objections to similar proposal in Europe led to the end-user. Exception: a waiver of the requirement for bona fide hedgers. This section explains the reason for this controversy. · The dilemma is very simple but the debate surrounding the issues quite contentious. And then you 0 derivatives a commercial Hedger has the choice of transacting on an exchange such as Nymex to the extent a contract satisfying their criteria of hedge effectiveness is available or transacting in the OTC markets with a financial institution or trading desk the big oil company, or utility acting as a counterparty. In the 1st case, the hedging entity has to post initial margin and possibly a variation margin. In the 2nd case exposures under bilateral transaction may or may not be collateralized. Under frequently used arrangement hedge provider - typically a financial institution - ways the collateral requirements (deposit of cash, letter of credit, marketable securities serving his guarantee of performance under derivative contract) by extending to the counterparty and automatic credit facility, secured with the company's assets, corporate guarantees or letters of credit. A financial institution may also except and securitized exposure up to a credit threshold negotiated with counterparty. For example, such an arrangement was provided one of the regulatory hearings on the subject: · on June 30, 2008 Chesapeake approximate 6.3 billion under OTC derivatives contract. We had pledged collateral value of more than 11,000,000,020 derivative counterparties. The collateral. We pledged included both mortgages on oil and gas properties - are underlying business assets - and letters of credit. The security is not in cash are counterparties were and continue to be well secured. This is how most 10 users utilize this market and as a result, help alleviate system risk. · Hedgers. · Many bankers. We talked to emphasize the benefits of offering hedges in the context of managing the overall business relationship with the customer. Better understanding of customers business results in better credit terms, both in terms of cost levels of credit lines. They see the importance of accepting as collateral only well-defined, specific assets the client, and avoid relying on the overall assets, which may be pledged under contracts. As mentioned above, during the political debates on reform of the financial system in the US - related to the Dodd Frank act - and in Europe or proposals floated to mandate clearing of all standardized derivatives. This provision was met with universal outcry from the end-users of derivatives, who objected to this measure in an exceptionally strong way forming a unified front preempt its passage. · End-user. · The end-users of derivatives contesting mandatory clearing of derivatives emphasize the macroeconomic consequences of the solution has explained to Mr. Deas testimony: · forcing end-users to put up cash for fluctuating derivatives valuations means less funding available to grow their businesses and expand employment. The reality treasures faces of the money to margin derivatives has to come from somewhere, and inevitably less funding will be available to operate the business. · · Accounting - another important factor beyond strong preference for bilateral hedging arrangements seems to be has always accounting. A company hedging on an exchange in clearing through a clearinghouse would have to raise additional data reduces liquid assets in order to post margins. In automatic credit facility from a hedge provider or weep margin requirement may not register on the firm's balance sheet debt. Of course, in a perfect world, a credit rated agency should see through the the accounting can recognize that the dead is a debt is a debt. We do not live in a perfect world, unfortunately. · In end-user derivatives can negotiate multiple bilateral credit arrangements. Several providers a risk management instruments and avoid posting collateral by flying below the level of threshold with each counterparty. · •

Compare and contrast the three large energy commodity exchanges: CME NYMEX, Intercontinental Exchange (ICE) and National Gas Exchange (NGX), and describe how trades are processed on each exchange.

· Energy exchanges - 3 most important exchanges with the point of view of energy trading: CME Nymex, Intercontinental exchange and in GX. These exchanges are crucial as they establish some of the most widely used price benchmarks. We review their business models and explain briefly differences in their legal status. Other exchanges that specialize in certain niche geographical commodity markets was covered in subsequent sections of this book. · CME Nymex. · The name of the exchanges changed the New York Mercantile exchange, with an expansion into additional commodities such as dried fruits, and poultry. The name of exchange shortened Nymex paren 1st informally and then is the official name) and industry veterans still use this term in spite of many organizational changes. · Energy trading and Nymex is one of the greatest success stories the history of the US markets. The 1st energy-related futures contract introduced by Nymex is one for heating oil in 1978, followed by crude oil in 1983 and gasoline in 1984. Natural gas contract was opened in April 1990. Energy-related contracts For 24% revenues of the CME group in 2012, more than any other asset class, including interest rates, which were 21%. · One important development in the US commodity markets was the development platform that allows for the transformation of bilateral OTC forward contracts into the economic equivalent of the futures contract. This platform, known as clear port was created in 2002 by Nymex in response. The credit related slumping energy trading caused by bankruptcy or near bankruptcy. Many merchants energy costs, as well as the exit of many market disciplines. Clear port philosopher breakdown of a bilateral transaction to to futures transaction through process known as novation. In novation, Nymex is substituted is a counterparty to each side of the original transaction, which is nullified. Clear port, created as a platform for energy trading, currently covers a number of different asset classes including agricultural commodities energy, green products and metals. All other asset classes covered include credit default swaps, equities, affects an interest rates instruments, with weather derivatives also expected to become available. · At the Nymex. There are 3 types of broker traders. 1st is a broker who is employed by companies execute customer orders. Brokers have more financial security is are equipped with a set salary plus commission. The 2nd type is loosely associated local professional retreats with his own money for his own account. The 3rd type is known as a market maker. The difference between locals and market makers is at the latter. Better capitalized and financed, which enables them to treat larger quantities. · Prices of natural gas. Transactions are executed on Nymex and displayed by the exchange was only a small delay. Different financial information network, such as Bloomberg tolerate CQG display the prices in real-time to their subscribers. Historical prices are available from different vendors had a relatively small charge. The daily settlement prices (the end of day prices) are most important from the point of view of margin (the calculation of margin is based on these prices) and risk management (the traders institutions use them to market positions to market for risk management and for P&L calculation.) · On Nymex settlement prices are calculated is going weighted averages of prices of transactions executed during the last 2 minutes of each trading day. For the expiring contract on the last day of trading, the settlement prices based on a 30 minutes, volume weighted average price. · Intercontinental exchange ICE · Intercontinental exchange was created in May 2000 is a joint venture of a number of financial merchants energy companies, has an answer to the electronic trading platform started by Enron. Enron online was set up as a one to many arrangement. Enron was the buyer for all sellers in the seller for all buyers. For nearly 3 years from 1999 to 2001. Enron became true dominant player in the image space - offramp of 1400 different products, was screens, documentation and technical support of multiple languages. · Have to the company's bankruptcy in 2001. Enron online became history and ice emerged as a major factor in the commodity markets in Europe and North America. The current business model price defined around for clusters closely related businesses: · futures exchanges. · OTC markets. · Clearinghouses. · Market data and processing. · Futures - ice futures Europe was created through the acquisition of the international petroleum exchange, which was founded in 1980. Ice futures Europe operates as a recognized investment exchange in the UK and is regulated by the UK financial services Authority (FSA). Exchange me a full transition to screen-based electronic trading and offers a number of very important. Energy-related contracts, including; · Brent crude. · The VTI crude. · Ice gas oil · ice ECX CFI · ice UK electricity. · Ice unleaded gasoline blend stock. · Clearing services were initially provided by L CH are not limited - lunging clearinghouse. In April 2007 ice announced a plan to establish a wholly-owned European clearing service, parallel to services. Est. in the US and Canada, where all ice futures contracts are cleared by ice clear US and ice clear Canada respectively. The establishment of the ice European clearing service means that the relationship with L CH was terminated by the end of 2008. The US-based ice clients could initially access ice futures platform under the no action letter from CFTC. This decision of the CFTC team under close scrutiny by number of the U.S. Congress, committee during the financial crisis 2007 - 08. · OTC markets · ice OTC business offers an energy trading electronic platform that allows participants to enter into transactions both cash settled and involving physical delivery, over a wide spectrum of different commodities, including natural gas power natural gas liquids, chemicals crude and refined oil products. The contracts transacted on ice can be executed is bilateral cleared transactions. The introduction of cleared OTC contracts is one of the most important innovations introduced by ice, a concept pioneered in 2002. Clearing was initially performed under an arrangement negotiated by ice with the L CH. · Electronic trade confirmation system is an extension of the OTC trading platform. Service allows reviewing of electronic trade data received from different counterparties, comparing the terms electronically and in highlighting any discrepancies in a report to the traders respective back offices. The service, available they respectable platform on which trade was executed (other exchanges, voice brokers, etc.) reduces transaction costs for the energy trading business. · Market data - the ice data business units were est. in 2002 to address the growing appetite of energy markets for transaction related data. Ice repackages data harvested from the trading activities on its platforms into price indexes and other types of information that can be used to validate internal pricing by trading company. The services provided by the market data division include: · activity reports, including reports about ice futures, indexes and contract records. · Real-time data, historical reports (OTC end of the day) market commentary and · market price valuation for contracts with no directly observable prices. · Natural gas exchange (NGX) · Canadian Calgary-based natural gas exchange (and GX) with its associated clearinghouse is wholly-owned by the TMX group. It opened for business in 1994, funded initially predicating pipeline operator West Coast energy. The platform was designed initially to treat physical natural gas in Western Canada. And GX has an alliance with ice that velocity lies the ice trading platform. In GX was a spectacular success after starting from a very low base is illustrated by its transaction volume growth. Products offer by MTX include: · physical and financial natural gas spot and forward contracts deliverable in Canada and the USA. · Financial natural gas options for Alberta. · Physical crude oil spot and forward contracts deliverable in Canada and the USA. · Financial power forward contracts for Alberta and Ontario. · Ancillary services spot in forward contracts for Alberta (via the water X subsidiary) · the highlights of in GX operations include calculation and dissemination of the price indexes for Canadian natural gas and power. In GX post feeling about 15,000 settlement price indexes covering up oh 480 forward Curtis. The main points of the index business model include one to many design (in GX is a fire to all sellers, and a seller to all buyers) and hybrid transaction design (forward contracts stone futures principles, with respect to settlement in margin). •

Compare the mechanics and credit implications of exchange-traded and OTC derivative transactions.

· The financial institution managing the collateral exposure of client in the context of an overall business relationship can be more comfortable extending credit on better terms of it understands all the balance sheet enough balance sheet liabilities. · Access to collateral funding may be obtained at short notice. Negotiations with creditors with potentially unpredictable consequences. Hello negotiated under duress is likely to be more expensive than credit extended under revolving facility. · Downside to the bilateral approach to management credit risk. · And then you 0 derivatives may become a captive customer financial institution extending to them in automatic credit in lieu of collateral collection. Trading on an exchange or relying on central CCP offers flexibility - and sometimes flexibilities worth paying the necessary price. · The benefits of automatic credit arrangements, replacing collateral collection are driven to a large extent by an accounting arbitrage. A company relying on exchange traded derivatives and central clearing and required to post initial and potential variation. Margins would have to reduce its cash holdings and/or for. A bilateral arrangement to hedge provider does not have the same accounting consequences and may not show up as a loan. It still leaves the hedging company was encumbered assets (reducing its overall boring capacity) and with the contingent liability. It is effectively way of forwarding without making it explicit on the balance sheet. At the end of the day. However, a liabilities liability - some liabilities are contingent in the fluctuating value, but they cannot be ignored. In the long run, this debate should be settled as a purely empirical study of the costs and benefits of different credit arrangements. The provisions of the Dodd Frank act that require reporting swap transactions to STRS and dissemination of this information to the public will allow end-users to assess better the true cost of hedging. Some end-users of derivatives will most likely suffer from buyers remorse. Sophisticated end-users of derivatives that are capable of negotiating favorable terms continue to rely on bilateral arrangements. •

Describe the actions a clearinghouse can take when a clearing member defaults, and explain risks related to central clearing.

· the actions a clearinghouse can take in the case of default by clearing member vary to some extent depending on the source of the problem (mismanagement by clearing member of its own business or a customer's failure), but the remedies in. Should not for both cases share many commonalities including: · 1. Transfer of all segregated and secured customer positions and monies to another clearing member · 2. Taking control of, or liquidation of the positions in the house account. · 3. Applying the clearing members guarantee fund and house performance bond deposits of the application shortfalls. · 4. Attaching all other assets of the clearing member that are available to the clearinghouse (example shares and memberships) · 5. Invoking any applicable parent guarantee. · The most important provision from the point of view clearinghouse customer is related to separation of customers funds of the host level •