ALI-CLE Webcast

Securities and Exchange Commission Clearing Agency Standards

January 23, 2013

Andrew Blake, Sidley Austin, LLP David Kaufman, Morrison & Foerster, LLP

Anna Pinedo, Morrison & Foerster, LLP

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Overview

Clearing Agency Oversight

Clearing Agencies

Dodd-Frank Act Amendments to Clearing Agency Oversight

Central Clearing

SEC Rule 17Ad-22

Remaining SEC Rulemaking

Concerns for Security-Based (“SB”) Swap Market Participants

Clearing Documentation

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Regulatory Framework SEC Oversight:

The Paperwork Crisis Principles Based Oversight, Definition of a Clearing Agency Registered Agencies

CFTC Oversight: Definition of Derivatives Clearing Organization (“DCO”) Entities Dually Registered as a Clearing Agency and DCO

The Dodd-Frank Act: Title VII – Wall Street Transparency and Accountability Act of 2010 Title VIII – Payment, Clearing, and Settlement Supervision Act of 2010

International Standards: Committee on Payment and Settlement Systems (“CPSS”) – International Organization of

Securities Commissions (“IOSCO”) Recommendations for Securities Settlement Systems 2001 Recommendations for Central Counterparties 2004 Principles for Financial Market Infrastructures 2012

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Historical Basis The Paperwork Crisis

From 1934 through 1975, state law governed clearance and settlement processes in the U.S. In the late 1960’s and early 1970’s, the U.S. securities markets experienced a

back-office crisis caused by increasing volumes and back-office inefficiencies in processing securities transactions. Post-trade processing systems designed for the three million share days of 1960

proved incapable of dealing with the volume of thirteen million share days around the end of the decade The confusion and delays in the back offices of broker-dealers were magnified by

inadequate clearance and settlement facilities, particularly in the over-the-counter area, and clogged transfer agent and registrar facilities. Losses related to the operational deficiencies caused roughly 160 NYSE member

firms in 1967 - 1968 to go out of business.

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Congressional Response Section 17A of the Securities Exchange Act of 1934 (“Exchange Act”)

The Congressional intent stated in Section 17A is for the SEC to facilitate the establishment of: A national system for the prompt and accurate clearance and settlement of

transactions in securities (other than exempt securities); and Linked or coordinated facilities for clearance and settlement of transactions in

securities, securities options, contracts of sale for future delivery and options thereon, and commodity options.

Oversight of clearing agencies through Section 17A has been a departure from the SEC’s typical oversight of registrants through rules promulgated under the Exchange Act. Section 17A has been administered as a principles-based regulatory scheme that results in oversight that is more akin to the prudential regulation of banking regulators.

Section 17A(b)(3)(A) – (I) provides the principles that must be met for a clearing agency to become registered and maintain its registration.

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Clearing Agency Standards In the initial process of creating a national system of clearance and

settlement and bringing the nation’s clearing agencies into compliance with the requirements of 17A, the SEC needed to further explain the requirements found 17A (and 17A(b)(3) in particular).

To help explain the meaning and some of the practical effects of the requirements, the SEC proposed two Commission level documents for public comment (June 1, 1977 and March 6, 1978).

Ultimately, the SEC chose not to issue Commission level guidance and instead published guidance from the staff of the Division of Market Regulation (now Trading and Markets).

This staff level guidance, published in 1980 and is titled Standards for the Registration of Clearing Agencies.

Until the recent clearing agency standards rulemaking by the SEC, it was usually referred to simply as “the standards release.”

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SEC Oversight Mechanisms The primary mechanisms used by the SEC to oversee clearing agencies: Self-Regulatory Organization (“SRO”) rule filing process under Section 19b of the Exchange Act and Rule 19b-4 thereunder.

Inspections and examinations by the SEC’s Office of Compliance Inspections and Examinations.

Voluntary participation by clearing agencies in the SEC’s automation review policy statements.

The SEC is considering the proposal of rules that would codify the automation review policy statements for securities exchanges and clearing agencies.

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Clearing Agency Defined Under Section 3(a)(23)(A) of the Exchange Act, a Clearing Agency is

any person who:

Acts as an intermediary in making payments or deliveries or both in connection with transactions in securities;

Provides facilities for the comparison of data regarding the terms of settlement of securities transactions to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities;

Acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry, without physical delivery of securities certificates (such as a securities depository); and

Otherwise permits or facilitates the settlement of securities transactions, or the hypothecation or lending of securities without physical delivery of securities certificates (such as a securities depository).

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Clearing Agency Exclusions Section 3(a)(23)(B) of the Exchange Act excludes from the definition of

clearing agency any: Federal Reserve bank, Federal home loan bank, or Federal land bank.

National securities exchange or registered securities association solely by reason of its providing facilities for comparison of data respecting the terms of settlement of securities transactions effected on such exchange or by means of any electronic system operated or controlled by such association.

Bank, broker, dealer, building and loan, savings and loan, or homestead association, or cooperative bank if such entity would be deemed to be a clearing agency solely by reason of functions performed by such institution as part of customary banking, brokerage, dealing, association, or cooperative banking activities, or solely by reason of acting on behalf of a clearing agency or a participant therein in connection with the furnishing by the clearing agency of services to its participants or the use of services of the clearing agency by its participants.

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Clearing Agency Exclusions Continued

Section 3(a)(23)(B) of the Exchange Act excludes from the definition of clearing agency any: Life insurance company, its registered separate accounts, or a subsidiary of such

insurance company solely by reason of functions commonly performed by such entities in connection with variable annuity contracts or variable life policies issued by such insurance company or its separate accounts;

Registered open-end investment company or unit investment trust solely by reason of functions commonly performed by it in connection with shares in such registered open-end investment company or unit investment trust, or

Person solely by reason of its performing functions as a transfer agent in transferring record ownership of securities certificates by bookkeeping entry without the physical issuance of securities certificates.

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Initial Approach to Registration

In light of Section 17A, the SEC needed a way to permit service providers in the securities markets to continue to provide their clearance and settlement functions while they also migrated over to the new operational and legal requirements of clearing agency registration and participation in the national system for clearance and settlement.

Accordingly, the SEC adopted Rule 17Ab2-1, and granted thirteen temporary clearing agency registrations thereunder.

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Initial Approach to Registration The thirteen regional entities that received temporary registrations

from the SEC were: The Depository Trust Company (“DTC”); Bradford Securities Processing Services, Inc.; Stock Clearing Corporation of Philadelphia; Boston Stock Exchange Clearing Corporation; Midwest Securities Trust Company; The Options Clearing Corporation (“OCC”); Midwest Clearing Corporation; Pacific Securities Depository Trust Company; Pacific Clearing Corporation; TAD Depository Corporation; New England Securities Depository Trust Company; National Securities Clearing Corporation (“NSCC”); and Philadelphia Depository Trust Company

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Current Clearing Agencies

Registered Clearing Agencies: DTC NSCC Fixed Income Clearing Corporation (“FICC”) OCC

Dormant Clearing Agencies Stock Clearing Corporation of Philadelphia Boston Stock Exchange Clearing Corporation

Deemed Registered by Section 17A(l)for SB Swaps ICE Clear Credit ICE Clear Europe Chicago Mercantile Exchange (“CME”)

Exempt Clearing Agencies: Omgeo (conditional exemptive order permits inspection) Several providers of collateral management, comparison, and tear-up/compression services for

SB swaps

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The Depository Trust Company

DTC provides depository services and book-entry transfer of interests in securities with end-of-day net funds settlement that affords its Participants netting efficiencies.

Previously operated as the Central Certificate Service of the New York Stock Exchange, DTC was founded in 1973.

Since 1999 when The Depository Trust & Clearing Corporation (“DTCC”) was formed, DTC has been a wholly-owned subsidiary of DTCC.

DTC is a limited purpose trust company, organized under the banking laws of the state of New York, a state member bank of the Federal Reserve System and a registered clearing agency under the Exchange Act.

DTC was designated by the Financial Stability Oversight Council (“FSOC”) on July 18, 2012 as a systemically important financial market (“FMU”)utility under Title VIII of the Dodd-Frank Act.

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National Securities Clearing Corporation

NSCC was established in 1976 as a New York business corporation. Since 1999, NSCC has been a wholly-owned subsidiary of DTCC.

NSCC’s core services are trade capture and reporting and clearance and settlement through its Continuous Net Settlement (“CNS”) system, which is a multilateral netting engine.

NSCC provides risk management and central counterparty services to its clearing members with respect to CNS-eligible securities (e.g., U.S. equities, corporate bonds, unit investment trusts, and municipal securities).

Securities not eligible for CNS may be eligible for processing through NSCC’s Balance Order System, where trades are guaranteed through the originally scheduled settlement date but NSCC does not become a central counterparty for such trades.

Some securities transactions of members are not eligible for CNS or the Balance Order System and therefore are processed on a trade-for-trade basis. NSCC does not act as a central counterparty to these transactions nor guarantee settlement.

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Fixed Income Clearing Corporation

FICC (Continues to operate under a temporary registration). FICC is a wholly-owned subsidiary of DTCC. It has two divisions: the Government Securities Division (“GSD”) and the Mortgage-Backed Securities Division (“MBSD”).

Government Securities Division FICC GSD brings trade comparison, netting efficiencies, risk management and

guaranteed settlement services to transactions in U.S. Treasury Bills, Notes, Bonds, Treasury Inflation Protected Securities (“TIPS”), Segregated Trading Registered Interest and Principal Securities (“STRIPS”), and notes, bonds and zero-coupon securities that are book-entry and Fedwire-eligible.

Mortgage Backed Securities Division (recently a CCP)

FICC MBSD brings trade comparison, netting efficiencies, risk management and guaranteed settlement services to the market for U.S. agency mortgage-backed securities.

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The Options Clearing Corporation

Founded in 1973.

OCC is dually registered as clearing agency with the SEC and as a DCO with the CFTC

Under SEC oversight, OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest rate composites and single stock futures.

Under CFTC oversight, OCC offers clearance and settlement services for transactions in futures and options on futures.

OCC provides central counterparty and guaranteed settlement services to the markets it serves.

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ICE Clear Credit Clearing of credit default swaps (“CDS”) began in March 2009. Formerly known as ICE Trust. On July 19, 2012, the FSOC designated ICE Clear Credit as a systemically

important FMU.

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ICE Clear Europe ICE Clear Europe is the clearing house for IntercontinentalExchange’s

energy and emissions markets.

ICE Clear Europe also provides clearing services for European CDS, with a separate clearing function, rulebook, membership and risk management model to the energy clearing function.

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Chicago Mercantile Exchange The CME Clearinghouse Division has responsibility for assuring and

maintaining the financial integrity of the exchange through a variety of functions, including matching, carrying, and guaranteeing all trades, enforcing financial safeguards and establishing and monitoring performance bond (margin) requirements.

CME provides real-time processing of trades and tracks positions continuously, in real-time. Additionally, it has the flexibility to accommodate complex new product types including combinations, options on combinations, options on options, swaps, repos, etc.

CME also supports complex, multi-party agreements for trading and clearing linkages, cross-margining and common banking, and consists of an open architecture that expands the integration between clearing member firm systems and the clearing system.

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Exempt Clearing Agencies Omgeo Formed in 2001 as a wholly owned, global joint venture between DTCC and

Thomson Reuters. Services are grouped into two categories: Information Services Centralize standard account, market and settlement information that can be

accessed by its users and used to enrich trade communications. Omgeo’s Information services are shared global databases for the maintenance and communication of standing settlement and account instructions.

Transaction Services Connect investment managers, broker-dealers and custodians and help

them to complete the trade allocation and confirmation/affirmation processes for cross-border and domestic trades.

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CFTC Oversight of Derivatives Clearing Organizations

Under Section 1a(15) of the Commodity Exchange Act, a Derivatives Clearing Organization is a clearinghouse, clearing association, clearing corporation, or similar entity, facility, system, or organization that, with respect to an agreement, contract, or transaction:

Enables each party to the agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the derivatives clearing organization for the credit of the parties; Arranges or provides, on a multilateral basis, for the settlement or netting of obligations resulting from such agreements, contracts, or transactions executed by participants in the derivatives clearing organization; or Otherwise provides clearing services or arrangements that mutualize or transfer among participants in the derivatives clearing organization the credit risk arising from such agreements, contracts, or transactions executed by the participants.

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Dually Registered Entities The following entities are dually registered with the SEC

as Clearing Agencies and with the CFTC as DCOs: OCC

ICE Clear Credit

ICE Clear Europe

CME

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Dodd Frank Title VII Amendments to Section 17A 17A(g) Registration Requirement Requires any entity performing the functions of a clearing agency to register with

the SEC.

17A(h) Voluntary Registration Those entities not required to register as a clearing agency with the SEC may still

do so.

17A(i) Standards for Clearing Agencies Clearing SB Swap Transactions Clearing agencies that clear SB swap transactions shall comply with such

standards as the SEC may establish.

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Dodd Frank Title VII Amendments to Section 17A Cont’d 17A(j) Rules The SEC shall adopt rules governing clearing agencies for SB swaps.

17A(k) Exemptions The SEC may exempt from clearing agency registration certain entities it finds to

be subject to comparable regulations under the CFTC or appropriate governmental authorities of the entity’s home country.

17A(l) Existing Depository Institutions and Derivative Clearing Organizations A depository institution or derivatives clearing organization registered with the

CFTC is deemed to be registered as a clearing agency with the SEC.

A depository institution can be converted into a State corporation if not in contravention of applicable state law.

The CFTC shall make available to the SEC, upon request, all information determined to be relevant by the CFTC regarding a DCO that is deemed registered.

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Title VIII of Dodd-Frank: Payment, Clearing and Settlement Act Systemically Important Financial Market Utilities

On July 18, 2012, the Financial Stability Oversight Council (“FSOC”) designated eight financial market utilities (“FMUs”) as systemically important under Title VIII of the Dodd-Frank Act. The designated FMUs are:

The Clearing House Payments Company (“CHIPS”) CLS Bank International CME DTC FICC (includes the GSD and the MBSD) ICE Clear Credit NSCC OCC

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Fundamentals of of Central Clearing Immobilization and Dematerialization Central Securities Depository

Clearance Novation Netting Guaranteed Settlement

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Immobilization and Dematerialization

Immobilization Refers to the placement of certificates and financial instruments in a central securities

depository to reduce the movement of physical securities in the marketplace and to facilitate book-entry transfers.

In the transition from paper-based to electronic practice, immobilization often serves as a transitional phase prior to dematerialization.

DTC is the largest immobilizer of securities in the world.

Dematerialization Process by which physical certificates are eliminated so that securities exist only as

accounting records.

Individual certificates are cancelled and replaced by a single certificate representing all of the shares or bonds.

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Clearance Comparison Section 3(a)(23)(A) of the Exchange Act requires clearing agencies to provide

facilities for the comparison of data regarding the terms of settlement of securities transactions to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities;

Matching In its 1998 interpretive release, Confirmation and Affirmation of Securities

Transactions, the SEC published its view that a “matching” service that compares securities trade information is performing a clearing agency function.

Exchange Act Release No. 34-39829 (April 6, 1998).

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Novation In the context of central counterparty clearing, novation generally is the operational

and legal process by which an initial bilateral contract between counterparties is replaced with with two contracts (one for the short (sell) leg of the trade and one for the long (buy) leg of the trade) in which the central counterparty becomes the legally recognized buyer to the seller and the seller to the buyer.

In the traditional markets for equity and debt securities, novation substitutes the creditworthiness and liquidity of a clearing agency performing central counterparty services over a relatively short settlement cycle (T+3 or T+1) compared with the risk management process associated with derivatives instruments that have a longer period of open interest.

By contrast, in futures, swaps, and options markets, novation requires that a central counterparty become a party to the long and short legs of longer dated open positions that, because of their longer tenor, can expose the central counterparty to substantial risks resulting from the volatility and changing mark-to-market values of such open positions. This in turn places greater demands on a central counterparty to implement robust risk management systems, including initial and variation margin requirements.

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Netting Netting is the process of bringing together all of the trades or transactions made by

the netting system’s participants in the same type of financial instrument. The system uses all of a participant’s purchases and sales for a specific security to offset each other, thereby creating a single net debit or net credit position at the end of the day for cash as well as for each security for each participant.

Bilateral Netting

Each participant nets all of their long and short positions with each of their counterparties. This process is generally more efficient than the trade-for-trade process, but it not as efficient as multilateral netting.

Multilateral Netting

Each participants’ trade obligations in a particular instrument with the central counterparty are simultaneously netted with the other participants’ purchase and sale obligations to result in a single dollar position and a single net position per security.

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Guaranteed Settlement Margin

Margin collateral or performance bond is collateral that participants deposit with a clearing agency that performs central counterparty services for derivatives transactions to manage the credit and market risk of positions introduced by the participant.

Initial Margin Margin deposited to open a cleared position.

For derivatives clearing (swaps, futures and options), initial margin is an amount intended to protect against potential future changes in the mark-to-market value of the relevant position over a specified number of days (determined to a statistically targeted confidence level).

Variation Margin Amount of margin calculated and either collected or credited back to a participant based on

changes in the market value of a cleared positions.

For derivatives clearing (swaps, futures, options), variation margin in effect represents a daily settlement of the amount of unrealized gain or loss on an open position resulting from its being marked to market.

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Guaranteed Settlement Guarantee/Clearing Fund In lieu of margin deposits (traditional securities markets) or in addition to margin

deposits (derivatives markets), participants in a clearing agency that performs central counterparty services typically contribute to what is known as a guarantee or clearing fund. This is a pooled amount of resources from participants, correlated to use of the clearing facility and/or potential default scenarios, that may generally be mutualized by the clearing agency to help it meet its settlement obligations in an event of default.

Lines of Credit

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Purposes of a Central Counterparty Manage Credit Risk

Manage Market Risk

Lower Transaction Costs

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International Standards

Committee on Payment and Settlement Systems (“CPSS”)

International Organization of Securities Commissions (“IOSCO”) CPSS-IOSCO Recommendations for Central Counterparties (2004)

CPSS-IOSCO Recommendations for Securities Settlement Systems (2001)

Financial Market Infrastructures (2012)

Was not relied on to help formulate the standards in 17Ad-22.

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SEC Rule 17Ad-22 Effective Jan. 2, 2013

Definitions Risk Management Requirements Participant Access Standards Record of Financial Resources Annual Audited Financial Statements Minimum Standards for Clearing Agencies

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Definitions, Rule 17Ad-22(a) (1) Central counterparty means a clearing agency that interposes itself between the

counterparties to securities transactions, acting functionally as the buyer to every seller and the seller to every buyer.

(2) Central securities depository services means services of a clearing agency that is a securities depository as described in Section 3(a)(23) of the Exchange Act.

(3) Participant family means that if a participant directly, or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with, another participant, then the affiliated participants shall be collectively deemed to be a single participant family for purposes of paragraphs (b)(3) and (d)(14) of Rule 17Ad-22.

(4) Normal market conditions as used in paragraphs (b)(1) and (2) of Rule 17Ad-22 means conditions in which the expected movement of the price of cleared securities would produce changes in a clearing agency’s exposures to its participants that would be expected to breach margin requirements or other risk control mechanisms only one percent of the time.

(5) Net capital as used in paragraph (b)(7) of Rule 17Ad-22 means net capital as defined in SEC Rule15c3–1 for broker- dealers or any similar risk adjusted capital calculation for all other prospective clearing members

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Risk Management Requirements For Clearing Agencies in Rule 17Ad-22(b)(1)-(4) A clearing agency shall establish, implement, maintain, and enforce policies and procedures reasonably designed to: (b)(1) Measurement and Management of Credit Exposures

Measure its credit exposures to its participants at least once a day and limit its exposures to potential losses from defaults by its participants under normal market conditions so that the operations of the clearing agency would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control.

(b)(2) Margin Requirements

Use margin requirements to limit its credit exposures to participants under normal market conditions and use risk-based models and parameters to set margin requirements and review such margin requirements and the related risk-based models and parameters at least monthly.

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Risk Management Requirements For Clearing Agencies in Rule 17Ad-22(b)(1)-(4) Cont’d

(b)(3) Financial Resources Maintain sufficient financial resources to withstand, at a minimum, a default by the

participant family to which it has the largest exposure in extreme but plausible market conditions; provided that a registered clearing agency acting as a central counterparty for security-based swaps shall maintain additional financial resources sufficient to withstand, at a minimum, a default by the two participant families to which it has the largest exposures in extreme but plausible market conditions, in its capacity as a central counterparty for security-based swaps. Such policies and procedures may provide that the additional financial resources may be maintained by the security-based swap clearing agency generally or in separately maintained funds.

(b)(4) Model Validation Provide for an annual model validation consisting of evaluating the performance of

the clearing agency’s margin models and the related parameters and assumptions associated with such models by a qualified person who is free from influence from the persons responsible for the development or operation of the models being validated.

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Interpreting the Risk Management Requirements For Clearing Agencies in Rule 17Ad-22(b)(1)-(4)

To comply: Clearing agencies must adopt margin requirements designed to cover potential losses under “normal market conditions” (as defined in 17Ad-22(a)(4)) to:

Help ensure the financial safety of the enterprise;

Protect the interests of clearing members; and

meet or exceed standards of risk management best practices recognized in the financial services industry.

Flexible minimum standard:

At least once per day, calculate daily margin requirements using risk-based models to ensure coverage at a 99% confidence interval over a designated time horizon.

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Participant Access Standards in Rule 17Ad-22(b)(5)-(7) Purpose is to ensure risk-based access standards at SB swap clearing

agencies.

17Ad-22(b)(5) - Non-Dealer Member Access

Provide the opportunity for a person that does not perform any dealer or security-based swap dealer services to obtain membership on fair and reasonable terms at the clearing agency to clear securities for itself or on behalf of other persons.

17Ad-22(b)(6) - Portfolio Size and Transaction Volume Restrictions

Have membership standards that do not require that participants maintain a portfolio of any minimum size or that participants maintain a minimum transaction volume.

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Participant Access Standards in Rule 17Ad-22(b)(5)-(7)

17Ad-22(b)(7) - Net Capital Restrictions

Provide a person that maintains net capital equal to or greater than $50 million with the ability to obtain membership at the clearing agency, provided that such persons are able to comply with other reasonable membership standards.

Any net capital requirements would be scalable so that they are proportional to the risks posed by the participant’s activities to the clearing agency.

The clearing agency may provide for a higher net capital requirement as a condition for membership at the clearing agency if the clearing agency demonstrates to the Commission that such a requirement is necessary to mitigate risks that could not otherwise be effectively managed by other measures, and the Commission approves the higher net capital requirement as part of a rule filing or clearing agency registration application.

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Record of Financial Resources, Rule 17Ad-22(c)(1)

Each fiscal quarter (based on calculations made as of the last business day of the clearing agency’s fiscal quarter), or at any time upon Commission request, a registered clearing agency that performs central counterparty services shall calculate and maintain a record, in accordance with § 240.17a–1 of this chapter, of the financial resources necessary to meet the requirements of paragraph (b)(3) of this section, and sufficient documentation to explain the methodology it uses to compute such financial resource requirement.

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Annual Audited Financial Statements Rule 17Ad-22(c)(2)

Within 60 days after the end of its fiscal year, each registered clearing agency shall post on its Web site its annual audited financial statements. Such financial statements shall: (i) Include, for the clearing agency and its subsidiaries, consolidated balance

sheets as of the end of the two most recent fiscal years and statements of income, changes in stockholders’ equity and other comprehensive income and cash flows for each of the two most recent fiscal years; (ii) Be prepared in accordance with U.S. generally accepted accounting

principles, except that for a clearing agency that is a corporation or other organization incorporated or organized under the laws of any foreign country the consolidated financial statements may be prepared in accordance with U.S. generally accepted accounting principles or International Financial Reporting Standards as issued by the International Accounting Standards Board; (iii) Be audited in accordance with standards of the Public Company

Accounting Oversight Board by a registered public accounting firm that is qualified and independent in accordance with 17 CFR 210.2–01; and (iv) Include a report of the registered public accounting firm that complies with

paragraphs (a) through (d) of 17 CFR 210.2–02.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Based on the CPSS-IOSCO Recommendations for Central Counterparties

and Recommendations for Securities Settlement Systems

The registered clearing agency must establish, implement, maintain and enforce written policies and procedures reasonably designed to: (1) Provide for a well-founded, transparent, and enforceable legal framework for

each aspect of its activities in all relevant jurisdictions.

To comply, a clearing agency must have written policies in place that, at a minimum, address the significant aspects of a clearing agency’s operations and risk management to provide a well-founded legal framework, and must be clear, internally consistent, and readily accessible by the public in order to provide a transparent legal framework.

In addition, the clearing agency must be able to enforce its policies and procedures that contemplate enforcement by the clearing agency.

Policies and procedures that govern or create remedial measures that a party other than the clearing agency (such as a clearing member) can undertake to seek redress or to promote compliance with applicable rules must be enforceable.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d

(2) Require participants to have sufficient financial resources and robust operational capacity to meet obligations arising form participation in the clearing agency; have procedures in place to monitor that participation requirements are met on an ongoing basis; and have participation requirements that are objective and publicly disclosed and permit fair and open access. Intended to reduce the likelihood of defaults by participants, while also providing flexibility

for clearing agencies to tailor standards that are linked to the obligations of the participant.

(3) Hold assets in a manner that minimizes risk of loss or of delay in its access to them; and invest assets in instruments with minimal credit, market and liquidity risks. May not apply to the assets of a participant’s customer depending on how a clearing

agency’s operations are structured.

The SEC does not expect that registered clearing agencies would need to rely on their physical assets, such as computers, furniture and buildings, to cover a participant default under the rule.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d

(4) Identify sources of operational risk and minimize them through the development of appropriate systems, controls, and procedures; implement systems that are reliable, resilient and secure, and have adequate, scalable capacity; and have business continuity plans that allow for timely recovery of operations and fulfillment of a clearing agency’s obligations.

Does not require clearing agencies to eliminate all operational risks.

Allows clearing agencies, subject to SEC oversight, to develop systems, controls, and procedures that are “appropriate” in response to the identified risks.

(5) Employ money settlement arrangements that eliminate or strictly limit the clearing agency’s settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants; and require funds transfers to the clearing agency to be final when effected.

Clearing agency must establish implement, maintain and enforce written policies and procedures reasonably designed to employ money settlement arrangements that eliminate or strictly limit the clearing agency’s settlement bank risks.

(6) Be cost-effective in meeting the requirements of participants while maintaining safe and secure operations.

Seeks to help reduce the costs incurred for clearing agency services by requiring registered clearing agencies to be mindful of costs incurred by their participants, which may include keeping fees lower for participants, while also requiring that registered clearing agencies maintain safe and secure operations.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d (7) Evaluate the potential sources of risks that can arise when the clearing agency

establishes links either cross- border or domestically to clear or settle trades, and ensure that the risks are managed prudently on an ongoing basis

(8) Have governance arrangements that are clear and transparent to fulfill the public interest requirements in Section 17A of the Exchange Act applicable to clearing agencies, to support the objectives of owners and participants, and to promote the effectiveness of the clearing agency’s risk management procedures.

Designed to promote the ability of a clearing agency to serve the interests of its general constituents and the general public while maintaining prudent risk-management processes to promote prompt and accurate clearance and settlement

The policies and procedures should necessarily reflect the unique relationships at that agency between the scope of its operations and its governance and risk management needs.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d (9) Provide market participants with sufficient information for them to identify and

evaluate the risks and costs associated with using its services.

Among the categories of information that participants could use to identify and evaluate risks and costs associated with use of the clearing agency are:

Disclosure of the clearing agency rulebook, the costs of its services, a description of netting and settlement activities it provides, participants’ rights and obligations, information regarding its margin methodology, and information regarding the extreme but plausible scenarios that the clearing

agency uses to stress test its margin requirements. (10) Immobilize or dematerialize securities certificates and transfer them by book

entry to the greatest extent possible when the clearing agency provides central securities depository services.

Does not require clearing agencies to take actions beyond the scope of their rules, procedures, and operations.

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d

(11) Make key aspects of the clearing agency’s default procedures publicly available and establish default procedures that ensure that the clearing agency can take timely action to contain losses and liquidity pressures and to continue meeting its obligations in the event of a participant default.

Frequency and design of default management tests should be determined by each individual agency, in consultation with, and subject to, oversight by, the SEC.

Clearing agencies should consider concentration risk in margin practices, and if certain concentrations indicate that liquidation of the concentrated positions could not be performed within the parameters of the clearing agency’s default management plan, then the clearing agency should consider extra initial margin charges to account for that occurrence.

(12) Ensure that final settlement occurs no later than the end of the settlement day; and require that intraday or real-time finality be provided where necessary to reduce risks.

Rule must be must be reasonably construed to provide that in extreme circumstances same-date settlement may be impossible to achieve (i.e., due to natural disasters, terrorist acts, and major communications breakdowns).

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Minimum Standards for Clearing Agencies in Rule 17Ad-22(d)(1)-(15) Cont’d

(13) Eliminate principal risk by linking securities transfers to funds transfers in a way that achieves delivery versus payment.

The elimination by a clearing agency of its right to reject matched trades and subsequently relying on mutualization of resources to make settlement if necessary does not violate Rule 17Ad–22(d)(13), as mutualization of risk by participants is an acceptable means of eliminating principal risk that would otherwise exist for a clearing agency. The rule requires a clearing agency to establish policies and procedures to link the transfer of securities and funds in a manner that mitigates principal risk in the event of a participant default.

The rule does not govern when a clearing agency guarantees a transaction or the clearing agency’s loss allocation procedures in the event of a default.

(14) Institute risk controls, including collateral requirements and limits to cover the clearing agency’s credit exposure to each participant family exposure fully, that ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle when the clearing agency provides central securities depository services and extends intraday credit to participants.

Only applies to entities that perform CCP or CSD services and does not apply to entities exempt from registration as a clearing agency, unless the terms of future exemptions specifically contemplate its application, in whole or in part.

(15) State to its participants the clearing agency’s obligations with respect to physical deliveries and identify and manage the risks from these obligations.

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Mandatory Clearing Determinations Clearing Requirements for SB Swaps SB Swap Submissions Commission Initiated Review Criteria Used in Mandatory Clearing Determinations

53 53

Remaining SEC Rulemaking Remaining SEC rulemaking pertaining to Clearing Agencies

SBS Reporting Requirements

End-User Clearing Exception

Conflicts of Interest Rules

Designation of SBSs for Mandatory Clearing

SEF Requirements

Cross-border rules

SEC has issued a “roadmap” in summer 2012 outlining SEC’s approach to Title VII implementation

54 54

Reporting Requirements The SEC’s SBS reporting requirements are to be provided for under

Reg SBSR, which was proposed in late 2010, but is yet to be finalized

All cleared SBSs, whether cleared on a mandatory or voluntary basis, will be subject to this reporting regime, which calls for both real-time and additional data reporting The additional data reporting will consist of additional execution data and

subsequent lifecycle data

In general, this structure mirrors that reporting requirements imposed under the CFTC’s final regulations under Parts 43, 45 and 46, though the CFTC regulations are considerably more complex and involved than those proposed by the SEC

SEC intends to propose “block trade” thresholds at the time it finalizes Reg SBSR

Block trades are subject to delayed reporting and public dissemination

55 55

Reporting Requirements Not clear whether Reg SBSR will impose a reporting duty directly on

clearing agencies Under the CFTC’s reporting rules, a clearinghouse is expressly responsible for

reporting for a cleared swap all Part 45 information (which covers data relating to execution and ongoing lifecycle events), but not real-time data Reg SBSR does not contain a similar express allocation of reporting responsibility

to a clearing agency in connection a cleared SBS As the SEC moves to finalize Reg SBSR, it will be worth noting whether a more

explicit reporting obligation is mandated for clearing agencies

Final jurisdictional reach of Reg SBSR remains relevant for clearing agencies As proposed, Reg SBSR attempts to define the cross-border jurisdictional scope

of SBS reporting obligations (proposed rule 24.908) This proposal as drafted could require US Persons to report SBSs executed and

cleared offshore Also, given the evolving state of the CFTC’s cross-border guidance, it is

impossible to evaluate whether these two regimes are in alignment or conflict

56 56

End-User Clearing Exception End-User clearing exception is another major piece of unfinished

SEC rulemaking that will affect SB swap clearing SEC’s proposed rule (§240.3Cg-1) follows the same contours as the final rule

adopted by the CFTC, which were largely dictated by the Title VII wording To use this exception, a party:

Cannot be a financial entity; Must use swap or SB swap to “hedge or mitigate commercial risk”; Must notify the CFTC or SEC (as applicable) of how the entity meets its

financial obligations associated with entering into non-cleared swaps or SB swaps; and If a public company, must have appropriate board or committee approval to

use this clearing exception

Both CFTC rule and SEC proposed rule have been criticized because relief is limited to “non-financial entities” However, statutory language does not give regulators much flexibility on this point

57 57

End-User Clearing Exception While this exception is likely to be widely used in the CFTC regulated

swaps market, its utility for purposes of the SEC regulated SB swaps market is far less certain This uncertainty stems from the requirement that end-user must be “hedging or

mitigating commercial risk”

CFTC has adopted a “commercial risk” definition as part of MSP rulemaking and has applied that same definition to its end-user exception

SEC had proposed a “commercial risk” definition, which presumably it will adopt when it finalizes this rule

These definitions are focused on hedging risks arising from a change in: assets that the person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; liabilities that the person owns or anticipates incurring; or services that the person provides, purchases, or anticipates providing or purchasing

Unlike with many CFTC regulated swaps, it is difficult to see how SB swaps will be able to satisfy this condition

58 58

End-User Clearing Exception CFTC simplified the process for claiming its end-user exception by

permitting annual filings of certain information SEC’s proposed rule does not provide for annual filing.

This represents another issue that the SEC might address in its final rule.

59 59

Conflicts of Interest Rules SEC’s proposed rules to prevent conflicts of interest resulting from

market participants owning and controlling SB swap clearing agencies as well as other intermediary entities such as swap execution facilities Rules, proposed in March 2011, provide for two alternative ownership structures

for SB swap clearing agencies that focus on limiting the ownership and control of “participants”, i.e., clearing members. The concern is to prevent such participants, especially those that are major

dealers or participants in the SB swaps market, from having undue influence over the clearing agency. One approach limits each participant (and its related persons) to 20% ownership

and voting power and all participants (and their related persons) in the aggregate to 40% ownership and voting power Other approach limits each participant (and its related persons) to 5% ownership

and voting power. Both approaches impose certain (not identical) requirements for independent

members of the board and key committees, and other governance standards.

60 60

Conflicts of Interest Rules Proposed rules raise serious questions

How compelling is the need for this regulatory action? Is this a solution in search of a problem

Could this rule, if implemented, have a counterproductive effect, particularly on the ability of a clearing agency to maintain a robust capital base and a highly sophisticated risk management structure

61 61

SB Swap Clearing Designations While some SB Swaps are already cleared, such as certain single name

CDS that are traded and cleared on ICE, no formal determination mandating clearing for any SB swap has been made by the SEC CFTC made its initial designation of mandatorily cleared swaps in November 2012

by designating certain categories of basic interest rate swaps and index-based credit default swaps

As expected, CFTC designated categories of swaps that were already being traded on exchanges or trading platforms and subject to clearing

The first mandatory clearing of CFTC designated swaps will start in March 2013, but will not affect end-users until September 2013

In its Roadmap, SEC indicates no clearing determinations will be made until it has finalized clearing agency rules, end-user exception rules and capital and customer protection rules Thereafter, bilateral process with clearing agencies will be initiated to make initial

determinations.

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Mandatory Clearing Determinations Clearing Requirement for SB Swaps

Section 3C(a) – Standard for Clearing: “It shall be unlawful for any person to engage in a security-based swap unless that person submits such security-based swap for clearing to a clearing agency that is registered under [the Exchange Act] or a clearing agency that is exempt from registration [under the Exchange Act] if the security-based swap is required to be cleared.”

SB Swap Submissions A clearing agency shall submit to the SEC each security-based swap, or any group,

category, type, or class of security-based swaps that it plans to accept for clearing and provide notice to its members of such submission Any security-based swap or group, category, type, or class of security-based swaps

listed for clearing by a clearing agency as of July 21, 2010 (the date of enactment of Dodd-Frank) was considered submitted to the SEC for a mandatory clearing determination.

Commission Initiated Review The SEC on an ongoing basis shall review each security-based swap, or any group,

category, type, or class of security-based swaps to make a determination that such security-based swap, or group, category, type, or class of security-based swaps should be required to be cleared.

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Criteria Used in Mandatory Clearing Determinations

Security-Based Swap Submissions and Commission Initiated Review In reviewing an SB swap, group of SB swaps or class of SB swaps as part of either

a submission by a clearing agency or a Commission initiated review, the Commission must take into account the following factors: The existence of significant outstanding notional exposures, trading liquidity and

adequate pricing data. The availability of rule framework, capacity, operational expertise and resources, and

credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded. The effect on the mitigation of systemic risk, taking into account the size of the market

for such contract and the resources of the clearing agency available to clear the contract. The effect on competition, including appropriate fees and charges applied to clearing. The existence of reasonable legal certainty in the event of the insolvency of the

relevant clearing agency or one or more of its clearing members with regard to the treatment of customer and security-based swap counterparty positions, funds, and property.

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Criteria Used in Mandatory Clearing Determinations SB Swap Submissions The Commission must review whether the submission is consistent with Section

17A of the Exchange Act in addition to factors below that apply to both Security-Based Swap Submissions and Commission Initiated Review

65 65

SB Swap Clearing Designations What should market participants expect?

Given status of SEC rulemaking, doubtful that any mandatory clearing

determinations will be made and finalized by the SEC until later in 2013.

Any determinations made by the SEC are likely to be product specific rather than based on product types or categories as was the case with the initial swap designations made by the CFTC.

This reflects that different nature of the swaps market and the SB swap market.

Fewer SB swaps exist that are “ready-made” for clearing.

For example, some single name CDS may have the liquidity to justify such a designation, but a categorical designation for all single name CDS would not be warranted and could even present a risk management issue for clearing agencies.

66 66

Other Rules to be Completed Other significant rules that are yet to be addressed or finalized by the

SEC include Requirements for SB swap execution facilities have been proposed but not

finalized. Rules governing cross-border activities are yet to be proposed.

Though the CFTC has proposed rules for each of these areas, it has not yet finalized them.

Each of these areas can have significant implications for the clearing of swaps and SB swaps.

67 67

Other Rules to be Completed SEF rules will establish the non-exchange multi-lateral trading

environments on which SB swaps and swaps can trade Title VII creates a linkage between clearing and trading: if a swap is mandatorily

cleared, it must be traded on an exchange or a SEF (unless a clearing exemption is available, such as the end-user exception, or such swap is “not available to trade”)

Final structure of SEF is therefore closely connected to the expansion of clearing

If clear less liquid and more complex products are to be cleared, flexible SEF platforms may be necessary to accommodate the trading requirement

Significant issues as to nature of SEF trading environments (such as “request for quote” requirements) and the definition of “available to trade” remain to be addressed by both the SEC and the CFTC

68 68

Other Rules to be Completed Cross Border rules may represent the single greatest challenge to

completing the regulatory implementation of Title VII. CFTC has engaged in significant actions relating to the cross border regulation of

the swaps market, including issuing controversial proposed guidance in July 2012, interim no-action relief in October 2012 and a final exemptive order in December 2012. The final exemptive order is intended to address the cross border area until

the CFTC is able to finalize its guidance which it is now discussing with other international regulators.

SEC in its Roadmap has promised to propose Cross-Border Rules, but is yet to do so SEC’s approach to this entire area remains one of major missing pieces of

the Title VII puzzle How the SEC addresses cross-border activities and whether its approach will

be consistent with the CFTC’s approach are major concerns for market participant Offshore clearing will be one key element of this topic area

69 69

Customer Clearing and Portfolio Margining On December 16, 2012, the SEC issued conditional exemptive relief to permit the

establishment of programs to commingle and portfolio margin cleared customer positions in CDS that are both swaps and SB swaps.

The conditional exemptive relief is available to entities that are dually registered as a clearing agency and a DCO.

The conditions of the order seek to preserve the ability of customers to select between the segregation requirements and customer protections afforded a securities account subject to the Exchange Act and the requirements and protections afforded a swap account subject to the Commodity Exchange Act.

70 70

Concerns for SB Swap Parties Timing: When will the SB swap regime be implemented and mandatory clearing of SB swaps

become a reality?

Scope: Which SB swaps will be designated for mandatory clearing and how broadly will the commercial risk requirement be interpreted under the end-user exception.

SEFs: How much flexibility will SEFs afford parties to execute SB swaps that are subject to a clearing requirement?

Customer Clearing and Portfolio Margining: Will recent exemptive relief issued by the SEC make central clearing of CDS easier to access and less expensive for customers of broker-dealer/futures commission merchants?

Documentation: What additional documentation will parties need to execute to be able to clear SB swaps For swaps, substantial progress has been made (primarily by ISDA and the FIA) in developing

standard form industry documentation for swap clearing, which is described in the following slides. No similar forms have yet been proposed for the SB swap side of the market

71 71

Swap Clearing Documentation As swap clearing becomes a reality, additional or modified

documentation will be required The ISDA Master Agreement may serve a lesser or different role for cleared OTC

swaps CFTC regulations place certain constraints on clearing-related documentation

Clearing firms currently are proposing the following three types of documents: Futures Account Agreement (“FAA”)

Governs the relationship between the parties to the swap and their regulated clearing members

Cleared OTC Derivatives Addendum to FAA Necessary because FAAs do not address swaps or close-out rights in relation

to cleared swaps Execution Agreement

New documentation must address consequences if a transaction that is expected to clear is not accepted for clearing

72 72

Swap Clearing Documentation Futures Account Agreement (“FAA”)

Sets out the bilateral relationship between the clearing member and its customer Not standardized, differs among dealers Historically used as contract to trade futures Sell-side friendly and, in relation to futures, not highly negotiated

Unilateral hair trigger defaults Discretion of dealer to charge whatever margin dealer believes is required to

protect its interests In negotiations to clear derivatives under the FAA, buy side typically attempts to

make FAA more like an ISDA Master Agreement by Limiting defaults against buy side Including cure periods for defaults Limiting the amount of margin that dealer may require its counterparty to post

(for example, by requiring dealer to rely on DCO margin calculations) In addition, buy side often attempts to negotiate for a commitment to clear (a

“committed facility”)

73 73

Swap Clearing Documentation Cleared OTC Derivatives Addendum to FAA

Addendum makes FAA applicable to cleared swaps Not standardized, differs among dealers Market standard Addendum was thought to be close to final in March 2011 However, dealers determined that they needed a legal opinion in relation to netting for

regulatory cap purposes The most significant unresolved issue, which relates to the required netting opinion, is close

out rights upon termination Some market participants want to follow futures model (menu of broad rights upon

termination, not especially transparent) Others want to follow an ISDA-like model (market quotation or similar, greater

transparency) A revised standardized document was published by ISDA and the FIA in early August 2012 In addition to addressing close out rights, Addendum forms used in the market typically also:

Contain representations as to authority, non-reliance language and tax provisions Require a clearing member to transfer (“port”) the customer’s trades to another clearing

member upon client’s request in accordance with a National Futures Association rule

74 74

Swap Clearing Documentation Most market participants will need to negotiate the Cleared OTC

Swaps Addendum Many have already negotiated and agreed to the prior version and will likely need

to renegotiate based on the August version Under phase-in rules, most end users will have until either 180 or 270 days after

swaps are designated for clearing until they are required to comply with mandatory clearing regime Swap dealers, MSPs and certain active funds have a shorter 90 day period Comment period on first proposes set of cleared swaps ends September 6, 2012

so final CFTC action on those swaps is unlikely to be completed and published until some in October 2012 As a result, mandatory clearing for most end-users will not become a reality until

well into 2013

75 75

Swap Clearing Documentation As compared to its earlier version, the newly published Cleared OTC

Swaps Addendum has the following significant features: Covers all derivatives transactions amenable to clearing (including forwards and

options), not just swaps Liquidation provision (Section 7) have been dramatically expanded

Provides detailed liquidation and close out methodology for clearing members Following a “Close-out Event” a clearing member may execute “Close-out

Transactions”, but also may execute “Risk-reducing Transactions” and “Mitigation Transactions” All such close out activity is to occur in accordance with a defined Liquidation

Standard that based on good faith and commercially reasonable procedures, though also recognizes that a clearing member may have to effect a close out in circumstances where no prevailing market prices or bona fide quotations are available However, if despite its commercially reasonable efforts, a clearing member

determines it cannot satisfy the Liquidation Standard based on quotations, prices and other market data, then it may base its valuation on internal sources

76 76

Swap Clearing Documentation Another significant changed feature of the new Addendum is an

expanded set of tax provisions (Section 8), including references to FATCA gross up and indemnity provisions tax liquidation event provisions and tax documentation requirements

77 77

Cleared Swaps Execution Agreement This agreement sets out the procedure for trade affirmation or rejection and states what

happens if a transaction that is expected to clear is not accepted for clearing Document is not yet final, ISDA in discussions with its membership to update its draft in

view of recent CFTC final rules (see next page) Each of the parties to the original transaction (dealer and client) represents that it has a

clearing agreement with a clearing member Once a transaction is accepted for clearing, neither dealer nor client has any obligation

to the other (DCO becomes a party to both sides of transaction) If a trade does not clear, then unless otherwise agreed, at the option of the dealer:

The dealer (if it a clearing member) may elect to accept the transaction in its capacity as clearing member, or have a clearing member affiliate do so If the transaction is not legally required to be cleared, the dealer may enter into the transaction on

a bilateral (uncleared) basis or The transaction may be terminated

at the dealer’s side of the market if the transaction’s failure to clear is caused by the client or its clearing member (including the client’s clearing member breaching a position limit imposed by the relevant DCO) at the client’s side of the market if the transaction’s failure to clear is caused by the dealer or its clearing

member (including the dealer’s clearing member breaching a position limit imposed by the relevant DCO)

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Swap Clearing Documentation In accordance with recently released CFTC rules, Execution Agreement will likely be

bilateral only, between dealer and client As proposed by the Futures Industry Association and ISDA, the Execution Agreement

could be trilateral, with optional annexes under which either party’s clearing member could become a party to the agreement

Trilateral arrangement provided for limits notices, in which a clearing member would specify the transactions it would commit to accept under the Execution Agreement

If a transaction that a party’s clearing member committed to clear did not clear because of an issue caused by that clearing member, and an early termination amount was payable by that party, then the party and its clearing member were to be jointly liable for such early termination amount

Triparty arrangement was a major point of contention with the buy side, which was concerned that clearing members would steer trades to their own affiliates and restrict the dealers with which the buy side could transact

Market consensus is that recent final rules released by CFTC effectively prohibit a trilateral agreement

Under those rules, among many other restrictions, clearing members may not enter into any arrangement that discloses to the clearing member the identity of the member’s customer’s original executing

counterparty or restricts the size of the position a member’s customer may take with any individual

counterparty, apart from an overall limit for all positions held by the customer at the clearing member