The Swap Report : Derivatives Lawyers & Attorneys: Reed Smith Law Firm: Investment & Commodity Laws

By Todd Zerega

On February 13, 2014 the Federal Reserve Bank of New York ("NY Fed") issued an update on Tri-Party repo infrastructure reform. The update can be found here.

In its update the NY Fed commended the industry for the reduction of intraday credit provided by the tri-party clearing banks. It indicated that the amount of intraday credit provided was down to 20% of daily repo volume. The NY Fed expects that intraday credit usage will reach the Task Force's benchmark of 10% of daily tri-party repo volume by the end of 2014. The NY Fed indicated that in order to further reduce intra-day credit cash investors will need to fund their trades before 3:30 p.m. This may entail changes to the cash investor's cast netting arrangements. Cash investors should consider whether these changes will push the intraday credit to the investor's custodian. The NY Fed also noted progress on collateral optimization and allocation processes at the clearing banks.

The Update noted that industry participants are not addressing the risk of destabilizing sales of repo collateral by cash investors following a default by a repo dealer. The NY Fed notes that while fire sales are not unique to the repo market it is a "a particular concern in the tri-party repo market given the composition of its investor base." The NY Fed notes many tri-party repo investors are "highly vulnerable to liquidity pressures and credit losses that may cause them to liquidate the collateral of a defaulted counterparty very quickly, even if they must do so at a loss." This seems like a clear reference to money market mutual funds which are large players in the tri-party repo market. The NY Fed went on to indicate that fire sale risk "remains a critical policy concern" and in the "absence of a market-based solution" it may forced to use regulatory tools to reduce the risk of fire sales. No timetable was given on the proposed regulatory action.

Good day. Good brainstorming. TSR

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For those of you living the dream of MSFTA papering (not re-papering, but papering) and collateralization of TBA trades...we draw your attention to the following article from Chris Kentouris at FinOps Report

FINRA: Even Tougher Margining Rules

In short, the article discusses current events surrounding a January 2014 Regulatory Notice from FINRA seeking comments on the agency's new margin proposal for TBA trades on MBS.  That notice is available here.  And, the comment period on the notice closes on February 26th.

Good day.  Good clicking, even better commenting. TSR

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INTRODUCTION

On February 11, 2014, the Office of the Chief Counsel ("Chief Counsel") of the SEC's Division of Investment Management issued No-Action Relief to The Brink's Company ("Brink's"), a company that provides gold bullion and other precious metals ("Precious Metals") vault services to a wide range of institutional customers. 

The No-Action Letter,  which is available here, is likely to be of interest to any registered investment company (a "Fund") that now or in the future invests in Precious Metals. 

AN OVERVIEW OF THE NO-ACTION RELIEF

The relief permits Brink's to provide vault services to a registered investment company (a "Fund"), notwithstanding the fact that Brink's is not a bank, a member of a national securities exchange or one of the other types of qualified custodians under Section 17(f) of the Investment Company Act of 1940 (the "1940 Act") and the rules thereunder.  As background, that statutory provision and the related rules govern the safekeeping of Fund assets and is frequently referred to as the "custody requirement" of the 1940 Act, since it requires a Fund to place and maintain its assets with a qualified custodian. 

CONDITIONS UPON WHICH THE RELIEF WAS GRANTED

Chief Counsel conditioned the relief, in part, on the prominent role of Brink's in the regulated Precious Metals derivatives markets in both the United States and the United Kingdom.  Specifically, Chief Counsel noted that Brink's is subject to regulatory oversight:

1) In the United States, as a "Licensed Depository" for Precious Metals supporting transactions that occur over the New York Mercantile Exchange and the Commodity and Metals Exchanges ("NYMEX" and "COMEX," respectively); and

2) In the United Kingdom, as a member of the London Bullion Market Association ("LBMA").

In both cases, Chief Counsel credited these oversight programs as helping to ensure that Brink's maintains "state-of-the-art secure" vault facilities for Precious Metals. In addition, Chief Counsel noted that as a reporting company under the Securities and Exchange Act of 1934, Brink's is subject to a wide range disclosure obligations about its business activities and related risks.  Finally, Chief Counsel commented on the level of insurance coverage carried by Brink's and, more generally, observed that Brink's vaults provide reasonable protections again misappropriation of the Precious Metals kept in them. 

Good day.  Good vaults, apparently. TSR

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Every customer of a futures commission merchant (or "FCM") should become familiar with the series of "customer protection rules" finalized by the United States Commodity Futures Trading Commission in November 2013.  While some of these rules went into effect in mid-January, many of them will be implemented over the next several months.

In short, these rules will require your FCM to provide you with new information about its business and risk management processes.  Understanding what information will be available to you is the first step in the process of using the information to lower risk faced by your organization.

We have been meeting our clients and friends in order to help them understand how to use the new information as part of their internal risk management and broker monitoring programs. 

To that end, we have prepared a relatively short presentation that is available for your review and download.  

Download file

Significantly, the same customer protection rules are likely to be of interest to all customers of an FCM - those who trade financial products, those who trade energy products or physical commodities, those who trade cleared swaps, as well as U.S. exchange-traded and foreign futures contracts, etc.  So, if you have a trading relationship with an FCM, then you should become familiar with these rules.

If you would like to learn more about the CFTC's customer protection rules, please contact Andrew Cross ( across@reedsmith.com ) or the Reed Smith attorney with whom you regularly work.

Good day.  Good download. TSR

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On February 10th, the CFTC granted time-limited no-action relief for so-called "Package Transactions".  The relief expires at 11:59 p.m. (eastern time) on May 15, 2014.

QUESTION:  What is a Package Transaction?

ANSWER:   A Package Transaction is a transaction involving two or more instruments:

(1) that is executed between two counterparties;

(2) that is priced or quoted as one economic transaction with simultaneous execution of all components;

(3) that has at least one component that is a swap that is subject to the mandatory SEF trading requirement (i.e., a swap that has been made available to trade or "MATTED"); and

(4) where the execution of each component is contingent upon the execution of all other components.

So, by way of non-limiting example, here are some package transactions:

Treasury note or Treasury futures vs. interest rate swaps (commonly called an "invoice spread");

Swaption vs. an interest rate swap (commonly called a "swap spread");

TBA MBS vs.. swap spread (commonly called an MBS basis trade);

A single-name credit default swap vs. a credit default index swap or "CDX"; and

A package of two interest rate swaps of differing tenors (a so-called "swap curve").

What about a package of a CDX and a Treasury security, like a TIP (i.e., a synthetic corporate inflation protected bond)?  (And, if you are a mutual fund, then you solved your section 18 asset segregation issues all at once.)

Not mentioned...but, if it is a package, then it qualifies for the recent no-action relief.  (No promise of liquidity, of course.  But, it does illustrate the point...at least we hope.

Good day.  Good relief.  TSR

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By Todd Zerega and Cátia Kossovsky

The Federal Reserve Bank of NY released their monthly statistics of the U.S. tri-party repo market for December.

For the month ending December 10, 2013, the total collateral in the U.S. tri-party repo market decreased by $21.6 billion, a decrease of less than 0.015%.　Corporates Investment Grade  and Money Market led the increases of $5.8 billion (an increase of 12.6%) and $1.18 billion (an increase of 6%) respectively, while US Treasury Strips lead the decrease by $3.15 billion, or 7.10%.　

Haircuts remained relatively stable with the median haircut remaining constant for all collateral types except for ABS Investment Grade, which increased from 5% to 5.2%.

The statistics are available here.　

Good day. Good statistics. TSR

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By Todd Zerega and Cátia Kossovsky

Effective Thursday, January 30, 2014, the Federal Reserve Bank of New York (FRBNY) revised the terms of its daily, overnight fixed-rate reverse repurchase operational exercise, to increase the maximum allotment cap from $3 billion per counterparty per day to $5 billion per counterparty per day.  In addition, the fixed rate for these auctions will continue to be between 0 and 5 basis points.　 The current fixed rate for the operations will be maintained at 3 basis points.  Additionally, since January 15, the timing of the operations moved an hour and half later in the day, to 12:45 – 1:15 pm ( Eastern Time).  All other terms of the exercise will remain the same.

Since 2009, the Open Market Trading Desk (the Desk) of the FRBNY has been working with market participants on operational aspects of tri-party reverse repurchase agreements (RRPs) to ensure that this tool will be ready to support the monetary policy objectives of the Federal Open Market Committee (Committee).  The Committee also authorized the Desk to extend the conduct of a series of daily overnight, fixed-rate RRP operations through the end of January 2015. The operations will remain open to all eligible RRP counterparties, will use Treasury collateral, will settle same-day, and will have an overnight tenor.

The FRBNY is interested in running these exercises with larger transactional flows to view what effect such operations would have on interest rate control.　 The FRBNY has stated that this is only intended as an operational exercise as part of advance planning and is not intended to materially affect the current level of short-term interest rates. 

You can see the latest FRBNY statement here.

Good Day.  Good Exercise.  TSR

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By Andrew Cross and Tom Watterson

We are asked this question with increasing frequency, so we thought that we would provide the answer in an easy to find location.

We provided the initial list of interest rate swaps that will be subject to the SEF trading mandate in our previous post. However, with each "Made Available to Trade" submission ("MAT Submission") that the CFTC certifies (or is deemed to be certified), additional swaps will become subject to the SEF trading mandate. Since the first MAT submission was certified, additional interest rate swaps and credit default index swaps have been added to the list of swaps that will be subject to the SEF trading mandate.

Fortunately, the CFTC has been providing cumulative charts of the swaps subject to the SEF trading mandate in each press release announcing the certification of another MAT Submission. The most recent press release (as of the of this posting) is available here and you can find any new CFTC press releases here.

Of course, the start dates for the SEF trading mandate will vary slightly by the type of swap, but the first interest rate swaps will be required to be traded on a SEF beginning on February 15 (note that this is a Saturday).

Good day. Good trading. TSR

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By Andrew Cross and Tom Watterson

In our post from last week, we described which interest swaps will be covered by the SEF trading mandate which will come into effect February 15, 2014. This post will lay out some steps that you should be taking to prepare to trade on SEFs.

As an initial matter, when the concept of SEFs arose during the Dodd-Frank discussions and rulemakings, most observers (including TSR) believed that participants would access their SEFs through an agent, such as an FCMs, much like the futures market (at some points called the "sponsored access model" and now considered the "non-participant access model"). However, as far as we have seen, the models allowing for participants to access SEF platforms through their FCMs are still under development and will not be finished before February 15, 2014. As a result, in order  to enter into most interest rate swaps (see the list of Covered Swaps in our prior post), an entity will have to become a participant on a SEF.

Now, you may be thinking that certainly the CFTC would not impose a trading mandate before the market has figured out how to provide what was once thought to be the primary access model for SEFs? Unfortunately, it does not appear that the CFTC is willing to slow down the mandate.

So, what do you have to do over the next several weeks to make sure that you can trade interest rate swaps on February 15?

January 21-24 

• Identify how you are currently trading pre trade allocation, post trade allocation, or trade by trade; how the traders access their trading platforms (voice, GUI); packaged trades or single trades
• Contact SEFs - request paperwork to become a participant
• Contact your FCM (FCM must be set up with the SEF)
• Have legal team begin review of documents, rulebooks
• Contact traders to begin to determine how much trading can be done by February 14 before the trading requirement, this could by you some time if you do not have to enter into any trade right away
• Contact operations and technology departments regarding order processing and system requirements (based on information from your FCM and SEF)

January 27-31

• Connect operations/technology with appropriate persons at SEFs and FCMs - the operations and technical set-up may be the most difficult part of this process
• Identify who will be the SEF participant (each client/fund, the asset manager) this will depend on how you trade and which SEFs you are accessing
• Begin onboarding process for SEFs - Operations and legal

February 3-7

• Finish operation/technology set-up
• Begin to submit test trades

February 10-14

• Continue testing the trading systems
• Transfer all trade order flow onto SEF platforms

February 15 (Well, February 18th, after giving effect to weekends and holidays) 

• Hope the market and liquidity remains in tact enough to continue trading

Good day. Good luck! TSR

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By Andrew Cross and Tom Watterson

Attention investment managers, banks, CPOs, insurance companies and anyone who currently must clear their interest rate swaps, the requirement to trade interest rate swaps on a swap execution facility ("SEF") will come into force on February 15, 2014.

Part 1: What will be covered by the trading mandate?

The CFTC certified Javelin SEF's "Made Available to Trade" submission (the "MAT Submission") (for a summary of the submission see our earlier post "CFTC Taking Comments on Requiring Interest Rate Swaps to be Executed on SEFs or DCMs"). Javelin's initial MAT Submission covered interest rate swaps across the curve, but revised its MAT Submission to limit the scope to interest rate swaps with the benchmark tenors. The swaps that are subject to Javelin's MAT Submission ("Covered Swaps"), whether listed or offered by Javelin or any other SEF will become subject to the trading requirement beginning on February 15, 2014. As a result, unless exempted from the trading requirement (such as through the end-user exception) transactions involving Covered Swaps must be traded on a SEF or a designated contract market .

The Press Release is available here.

 Covered Swaps include the following fixed for floating interest rate swaps:

Covered Swaps do not include interest rate swaps with optionality or multiple currencies.

However, the CFTC Division of Market Oversight ("DMO") clarified that status of “package transactions” or "multi-legged transaction," transactions involving more than one swap or financial instrument. According to the DMO, the inclusion of a Covered Swap in a package transaction "would not per se relieve market participants" from the trading requirement for that Covered Swap.

Because the market does not currently facilitate trading package transactions on SEFs,the DMO will be holding a public roundtable to discuss "whether and under what conditions to grant limited relief for package transactions to ensure proper implementation of the execution mandate."

"Part 2 Countdown to the trading mandate -- what to do now" will be arriving shortly.

Good day. Good certification? TSR

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On January 15th, the SEC's Division of Investment Management ("IM") issued a Guidance Update entitled, "Risk Management in Changing Fixed Income Market Conditions" (available here). 

In the piece, IM raises questions as to whether volatility in the fixed income markets would be materially increased by an uptick in bond fund outflows in the face of decreased dealer inventories.

While assets in bond mutual funds and ETFs have grown rapidly in recent years, dealer capacity in the fixed income markets appears to have undergone fundamental changes.  Today, primary dealer capacity is at similar levels to 2001, while bond mutual fund and ETF assets have grown by a factor of four since that time...A significant reduction in dealer market-making capacity has the potential to decrease liquidity and increase volatility in the fixed income markets. [Pages 3-4 of the Guidance Update, Footnotes Omitted]

Mention is not made of whether alternative liquidity sources (i.e., other than primary dealers) exist that could have a mitigating effect on volatility.  

SO, WHAT'S AN INVESTMENT ADVISER TO DO?

According to IM, investment advisers can consider at least four possible actions.

1) Assess and Stress Test Liquidity 

Advisers may consider assessing fund liquidity needs during both normal and stressed environments for varying time periods - 1 day, 5 days, 30 days and potentially longer.

2) Conduct More General Stress-Tests/Scenario Analysis

Advisers may consider assessing the impact (beyond just liquidity) of various "stress-tests and/or other scenarios on funds".  Specific examples provided by IM included interest rate hikes, widening spreads, price shocks to fixed income products, and increased volatility and reduced liquidity.

3) Risk Management Evaluation

Advisers may consider using the outcomes of any assets to evaluate what risk management strategies and actions are most appropriate at the fund and complex level, in light of changing fixed income market conditions.  Specific decisions cited by IM related to portfolio composition, concentrations, diversification and liquidity.

4) Communicate with Fund Boards

Advisers may consider whether additional information could be provided to fund boards, so that directors are informed of a fund's liquidity positions, risk exposures, and ability to manage through potential volatile interest rate conditions.

And, last but certainly not least, the adequacy of existing mutual fund disclosures should be considered. Specific consideration could be given to whether existing disclosures adequately address additional risks due to changes and recent events in the fixed income markets, such as the effect of a tapering of quantitative easing and rising interest rates (perhaps even decreased dealer inventories, although there is no mention of this factor in the enumerated list provided by IM in the Guidance Update).

Good day.  Good guidance? TSR 

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By Todd Zerega and Luke Sizemore

CASE SNAPSHOT

Prior to filing for bankruptcy, a debtor entered into a repurchase agreement with an investment bank and a swap agreement with an affiliate of the investment bank. Following commencement of the debtor’s bankruptcy case, the investment bank and its affiliate effectuated a triangular setoff whereby the banks offset monies owed to the debtor under the swap agreement against funds owed to the investment bank under the repurchase agreement. The United States Bankruptcy Court for the District of Delaware (the “Court”) determined that the banks’ contractual right to a triangular setoff was not protected by the safe harbor provisions of sections 559-561 of the Bankruptcy Code and, consequently, the exercise of such right constituted a violation of the automatic stay.

FACTUAL AND PROCEDURAL BACKGROUND

In February 2006, an investment bank (the “Investment Bank”) entered into a Master Repurchase Agreement (the “Repurchase Agreement”) with a retail mortgage lender (“Debtor”). In March 2006, Debtor entered into a series of interest rate cap transactions governed by the ISDA Master Agreement (the “Swap Agreement”) with an affiliate (the “Affiliated Bank”) of the Investment Bank. The Swap Agreement contained a broad setoff provision that purported to authorize the Affiliated Bank to perform cross-obligation and cross-affiliate setoffs, including a “triangular setoff” of the Affiliated Bank’s obligations to Debtor under the Swap Agreement against amounts that Debtor owes to the Investment Bank under the Repurchase Agreement.

On August 2-3, 2007, the Investment Bank and the Affiliated Bank (together, “Defendants”) declared events of default and exercised their termination rights under the Repurchase Agreement and the Swap Agreement. The Affiliated Bank notified Debtor of its intent to setoff any amounts payable by the Affiliated Bank to Debtor under the Swap Agreement against Debtor’s unsatisfied obligations to the Investment Bank under the Repurchase Agreement. On August 6, 2007, Debtor and its affiliates filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. Thereafter, Defendants effectuated a triangular setoff by applying the excess collateral under the Swap Agreement to amounts owed by Debtor to the Investment Bank under the Repurchase Agreement.

In April 2011, Debtor filed a complaint against Defendants requesting a declaratory judgment as to whether the triangular setoff effectuated by Defendants constituted a violation of the automatic stay. Defendants filed a motion to dismiss, arguing that the Bankruptcy Code and the Swap Agreement permit triangular setoffs under these circumstances.

COURT ANALYSIS

The issue before the Court was whether an agreement to permit triangular setoffs is enforceable under the safe harbor provisions in sections 559-561 of the Bankruptcy Code. The Court held that a contractual right of setoff that permits netting by multiple affiliates of the contract-counterparty outside of bankruptcy may not be enforced after the commencement of the debtor’s bankruptcy case. The safe harbor provisions provide no exception.

Section 553 of the Bankruptcy Code imposes restrictions on a creditor’s right of setoff against a debtor in bankruptcy. Among other things, the debtor’s claim against the creditor and the debt owed the creditor must be mutual. Debts are considered “mutual” only when they are due to and from the same persons in the same capacity. Because of the mutuality requirement, courts routinely hold that triangular setoffs are impermissible in bankruptcy.

Defendants acknowledged the mutuality requirement, but argued that the safe harbor provisions of sections 559-561 of the Bankruptcy Code exempt triangular setoffs in swap and repurchase agreements from its application. The Court disagreed. Relying upon two recent decisions from the United States Bankruptcy Court for the Southern District of New York, the Court determined that the safe harbor provisions could not be interpreted as implicitly doing away with the mutuality requirement. The safe harbor provisions permit the exercise of a contractual right to offset any termination values or payment amounts arising under certain financial contracts. However, as a result of section 553 and the mutuality requirement, the right to a triangular offset does not exist after commencement of a bankruptcy case. Nothing in the safe harbors can be read to protect a right that does not exist.

PRACTICAL CONSIDERATIONS

The safe harbor exceptions to the automatic stay embodied in sections 559-561 of the Bankruptcy Code cannot be interpreted as providing an implicit exception to the mutuality requirement for setoffs exercised after commencement of the debtor’s bankruptcy case. As a result, non-debtor counterparties to swap and repurchase agreements must move for relief from the automatic stay before exercising control over property of the estate by retaining funds in exercise of their alleged triangular setoff rights.

The case may be found here.

Good day. Good stay. TSR

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On January 10th, the SEC released a 19 page FAQ (available here) on the new municipal advisor rule. 

We focus your attention to the last sentence of the answer to Question 4.1

Therefore, the Staff would not object if those SEC registered investment advisers that provide advice on municipal derivatives in an investment portfolio for clients that are municipal entities or obligated persons do not register with the Commission as municipal advisors.

Good day.  GOOD, NO GREAT, interpretation.  TSR

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On December 26, 2013, the Securities and Exchange Commission's Division of Investment Management ("IM") issued No-Action Letters to the Chicago Mercantile Exchange, ICE Clear Credit and LCH Clearnet.  The letters can be accessed by clicking here and looking for the letters under the "Chronological List of No Action Letters".

In effect, these no-action letters extended relief from section 17(f) of the Investment Company Act of 1940 (the "1940 Act") for certain interest rate and credit default swaps cleared at these three derivatives clearing organizations (commonly called, CCPs, clearinghouses or central counterparties).   The original relief has now been extended through December 31, 2014.  For a March 2011 posting from The Swap Report on the topic of the application of the custody rules to section 17, you can go here - once at that site, you can access another posting from March 2011** that will provide you with more information about the interplay of the 1940 Act custody rules and initial margin on cleared swaps. 

**One caveat, in case you do decide to read the 2011 posting, it appears that IM is following the path of renewing No-Action Relief, instead of issuing a final rule - so, disregard any suggestion from the earlier pieces to the contrary. 

Good night. Good extension. TSR

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