Otc Drugs Regulation

Reval's End-User's Guide to

Preparing for Dodd-Frank

Derivative Regulation

Confidential

Copyright 2011 Reval. All rights reserved.

The enclosed material is confidential and proprietary to Reval, and is therefore copyrighted. This document may not be disclosed in any manner to anyone other than the addressee and the employees of the addressed firm who are directly responsible for the evaluation of its contents. This document may not be used in any manner other than for the purpose that it was distributed. Any unauthorized use, reproduction or transmission in any form is strictly prohibited. The recipient of this document should not construe any information furnished herein as any legal, tax, accounting, investment or riskmanagement opinion, recommendation, strategy or advice.

Disclaimer

This information is for illustrative purposes only and not intended to replace your own internal business and legal review processes to comply with any law or regulation related to the content provided. You should seek your own independent legal advice regarding compliance with the DoddFrank Wall Street Reform and Consumer Protection Act and any regulation passed by the Commodities Futures Trading Commission, Securities Exchange Commission or any Prudential Regulator.

Table of Contents

1 Introduction .............................................................................................................................................................. 4

2 Definitions: Under Which Category Do You Fall? ...................................................................................................... 4

2.1 Definition Risk ................................................................................................................................................. 5

2.2 Preparation: Get to know your regulator! .......................................................................................................... 6

3 Clearing .................................................................................................................................................................... 7

3.1 End-User Clearing Exemption ......................................................................................................................... 7

3.2 Preparation for End-User Clearing Exemption ................................................................................................. 7

3.2.1 Documentation ................................................................................................................................... 7

3.3 No End-User Clearing Exemption: What Does It Mean To Clear A Trade? ...................................................... 9

3.4 Preparation for Clearing ................................................................................................................................ 11

4 Margining for Un-Cleared Trades ............................................................................................................................ 11

4.1 Key Definitions for Margin .............................................................................................................................. 11

4.2 Important Differences of D-F Margin Rules vs Current CSAs ......................................................................... 13

4.3 Pre-enactment Swap Treatment .................................................................................................................... 14

4.4 Preparing for Margin Requirements ............................................................................................................... 15

5 Business Conduct................................................................................................................................................... 16

5.1 Documentation .............................................................................................................................................. 16

5.2 Affirmation and Confirmation ......................................................................................................................... 16

5.3 Portfolio Reconciliation .................................................................................................................................. 17

5.4 Preparing For Business Conduct Rules ......................................................................................................... 17

6 Swap Data Repository ............................................................................................................................................ 17

6.1 Preparation for the SDR ................................................................................................................................ 18

7 People & Process ................................................................................................................................................... 18

8 Further Reading ..................................................................................................................................................... 19

Confidential

Reval - 2011 Page 4

1 Introduction

This document is intended to help End-Users of OTC derivatives prepare for the pending regulation issued by the Commodity Futures Trading Commission (CFTC) required under the Dodd-Frank Wall Street and Consumer Protection Act of 2010 ("Dodd-Frank", "The Act"). Under Dodd-Frank, users of OTC derivatives will face sweeping new regulation around trading, clearing, margin, capital, reporting, business conduct and other requirements intended to help reduce systemic risk by promoting better transparency, efficiency and risk management around the use of derivatives. Not only will pending regulations directly impact End-Users, but they will also indirectly impact these market participants as Swap DealersEnd-User counterpartiesalso face more stringent requirements.

The big question of course is the effective date for compliance. A majority of the CFTC rules have been out for comment, and it is anticipated that there will be a strong push to get as many passed before the end of 2011, focusing on the key definitional rules (what is a Swap Dealer) in some areas that require as much time to get ready (SDR rules). No matter which pass first, all of the rules in the U.S. are expected to be finalized by the end of 2012, which currently coincides with the original G-20 timeframe.

While the basis for this End-User's guide is the current draft rules proposed by the CFTC, which are not yet finalized, the intent is to help you think about areas where you may need to start preparing. This guide will make the key assumption that the core principles and rules will be close to what is currently being proposed.

2 Definitions: Under Which Category Do You Fall?

Technically there is no defined End-User category under Dodd-Frank. The primary definitions to describe user categories are Swap Dealer (S-D), Major Swap Participant (MSP) and Financial Entities (FE). If you do not fall under any of those definitions, then you are most likely a non-financial End User or exempted Financial Entity (i.e. Farm Credit Banks). If you do fall under the definition of an S-D or MSP, then you will face the most stringent regulation with little or no exemptions. If you are a Financial Entity, while not as stringent as being classified as an S-D or MSP, you will not benefit from any clearing exemptions and will have more restrictive margin requirements for trades that do not clear.

2.1 Definition Risk

There are gray areas in how you may be defined, which may concern you:

Swap Dealer Definitional Risk: For most non-financial companies it should be pretty obvious that you are not a Swap Dealer, but one area that raises concern is the lack of clarity around those corporates that have separate legal entities that engage in centralized treasury or hedging activities, especially if you are active in commodities "trading" through these vehicles. Technically you could be making markets to affiliate entities of your parent holding company by acting on their behalf to face the Swap Dealers. Many hedging centers are also created by companies that are active in commodity procurement, and if they specialize in a commodity (coffee, cocoa, metals), many of these entities also engage in trading the underlying, given their expertise in the commodity and their position in knowing the supply and demand factors. If you function in this manner, you may need to curtail trading activity or trade as the parent or holding company, and not as a separate legal entity, if the final rules do not carve you out of being defined as a Swap Dealer.

Major Swap Participant Definitional Risk: It is unlikely that many companies would exceed the first threshold of bn (credit, equity or commodity Swaps) or bn (Fx and interest rates) in uncollateralized positions net of commercial risk hedges, which would then classify them as an MSP. For example, assuming you had a bn notional 5 year interest rate Swap at par (i.e. [POSTCONTENT] NPV today), rates would have to rise over 600 basis points for your Swap to exceed bn. Furthermore, most End-Users would not trade a Swap of that notional size without underlying debt to hedge, which should qualify as a mitigation of commercial risk and would not go towards calculating the position against the first threshold.

This definition of commercial risk, and having hedges qualify against it, is critical if you are at all active, or as you will see later, if you are trying to claim an End-User exemption from clearing. Similar to the Swap Dealer issue of having treasury hedging centers as separate legal entities, there is also a concern that treasury center hedges are not hedging their own commercial risk, but the commercial risk of an affiliate, which would not qualify as a commercial risk hedge. If this issue isn't clarified in the final rules, then many large multi-national corporates would either have to start entering into Swaps in the parent's or affiliate's name or figure out a way to put the risk at the treasury center hedge level.

If there is any risk that your hedges will fail being designated a commercial risk hedge and/or you are simply an active user of derivatives for trading, but not at the current first threshold level, you should still measure and monitor both your current position and the rules around the second test against potential future exposure (e.g., daily average potential future exposure of bn in uncollateralized positions net of commercial risk for equity or commodity derivatives and bn for FX and Interest Rate derivatives). In other words, you can pass the first test but fail the potential future exposure calculation and then be deemed an MSP.

Financial Entity Definitional Risk: For most non-financial companies it should be clear that you would not fall under the definition of being categorized as a Financial Entity, which would not be eligible for the end-user clearing exemption. However, there are corporations who may offer banking type services to their clients, vendors or affiliates, for example retail stores that have their own banking or credit card services.

If you are a small Financial Entity or an exempted Financial Entity, there may be the possibility of a clearing exemption. The CFTC has left this an open comment question and hopefully they will carve out banks below a certain size, which would probably be around billion in assets. If you do qualify, then you would still have to meet the other end-user clearing exemption requirements.

2.2 Preparation: Get to know your regulator!

If you are a non-bank Swap Dealer or MSP, then you will need to register with the CFTC and or the SEC. This guide is not intended for Swap Dealers or MSPs, which should refer to the CFTC and SEC websites to start reviewing the many proposed rules that will affect these groups of market participants. If you fall into these categories, it will be beneficial to establish a relationship with the Commissions if you have never met with them or have never commented on any proposed rules.

Financial Entities should already be under one or more Prudential Regulators (Fed, FDIC, OCC, etc.) and you may be subject to different or additional requirements, so don't forget to review any of their new regulations, especially pertaining to capital and margin requirements.

For End-Users that would not be defined as a Financial Entity, the good news is you do not have to register with a regulator. However, if you are using any OTC derivatives, you will have to be in compliance with the regulations, and the Swap Dealers selling you the Swaps will have regulatory requirements that may impact you. The following sections address these considerations.

3 Clearing

3.1 End-User Clearing Exemption

In response to concerns from companies that use derivatives tailored to hedge their business risks, Dodd-Frank allowed for certain companies to not be required to clear their Swap transactions. Cleared OTC derivatives are expected to be standardized trades that trade on a Designated Contract Market (DCM) or Swap Execution Facility (SEF) or cleared by a Derivative Clearing Organization (DCO), even if they do not trade on a DCM or SEF. As a cleared transaction would have initial and variation margin requirements, these transactions are viewed to have less credit risk and therefore would reduce the risk of systemic failure. As a clearing firm would need enough liquidity to justify the costs associated with clearing a transaction, it would also be expected that cleared trades would have to be fairly plain vanilla in nature or fungible and commonly traded. Both standardization and any margin costs associated with cleared trades would be detrimental to the End-User as their hedges require customization to meet specific business risks and are therefore difficult to standardize for exchange trading or clearing. Funding costs to meet the margin requirements through exchange trading or clearing have also been another central issue for End-Users who mostly do not have this requirement today.

In order to qualify for the end-user clearing exemption, you would essentially need to do the following with the Swap

Dealer:

Declare that you do not want the transaction to clear.

Confirm that neither you nor an affiliate is a Financial Entity.

Demonstrate that you are hedging commercial risk and not speculating or investing.

Prove that you can meet the financial obligation of the Swap.

Have board approval to enter into Swaps.

File the appropriate documentation if you are an SEC filer.

Currently, the above actions are proposed as check-list items that must be reported to the SDR by the Swap Dealer or other reporting entity, but some of the substantive issues are addressed in more detail in the section that follows.

3.2 Preparation for End-User Clearing Exemption

3.2.1 Documentation

The first step is to ensure that you have the documentation in place in the event that you would need to verify that you qualify for the End-User clearing exemption.

Commercial Risk Hedge Documentation. For those of you that have FAS 133 (also known as ASC 815) compliant hedges, the good news is that you can use this method to show that you are hedging commercial risk. However, you should consider modifying language that can refer to specific language in Dodd-Frank or the specific CFTC regulation. For example, in your hedge designation under FAS 133, you may also want to add wording to the effect of, "This cash flow hedge also qualifies as a hedge to commercial risk as defined by the CFTC under the Commodities Exchange Act and is therefore exempt from the clearing requirements."

If you mark to market your derivatives or do not try to achieve hedge accounting under FAS 133, you would need to document how your derivative is hedging commercial risk. You may want to consider following some of the hedge designation documentation that you would need for FAS 133, without running any effectiveness testing or measuring ineffectiveness. Essentially you would want to link your derivative to a specific exposure or risk and clarify that the derivative is not for trading or speculative purposes and reference where possible Dodd-Frank or the CFTC regulations.

Board Approval Documentation. The current draft rules imply that the Board is required to approve each transaction for clearing exemption, which clearly would not be practical, so hopefully the rules are amended accordingly. The intent is to make sure that the Board is aware that your organization is entering into OTC derivatives and can meet the End-User exemption requirements, for example the ability to meet the financial obligations of the Swap. Hopefully you already have a Board-approved risk management policy in place. If so, it should be amended to include procedures and policies that allow you to claim the clearing exemption under the regulatory guidelines (e.g., up to a certain amount, as long as it is approved by the CFO). If you do not currently have a risk management policy, and you enter into OTC derivatives today, then you will want to put a solid risk management policy in place, regardless.

SEC Filings. If you are publicly traded in the U.S. or issue public debt and want to claim the End-User clearing exemption, then you must:

a) Specify your company's SEC Central Index Key number so the CFTC can better analyze un-cleared trades reported to the SDR, and

b) Demonstrate in accordance with the related Board approval section that an appropriately authorized committee member of the Board of Directors has reviewed and approved the clearing exemption.

Whether you are an SEC filer or not, it may also be advisable to set up a Risk Committee or Regulatory Committee at the Board level to ensure that your company's fiduciary responsibilities will be met.

Meeting the financial obligations of the Swap. There are a few examples described in the CFTC rules on the End-User clearing exemption that would meet this requirement:

c) Credit Support: You may have a Credit Support Annex (CSA) in place with the Swap Dealer that provides the collateral arrangement to reduce the credit risk of the Swap. A CSA is a legal document under an ISDA master agreement between the counterparties of an OTC derivative trade, specifying the agreed upon collateral terms. Please refer to the section, "Margin for Un-Cleared Trades," for definitions and terms found within most CSAs. CSA documentation may be a potential requirement under the Business

Conduct Rule for Swap Dealers, which may result in any counterparty to a Swap meeting the financial obligations of the Swap.

d) Pledged or Segregated Assets: Typically one would expect pledged assets to be tied to a CSA, but for commodity and loan-based Swaps, they could be tied to less liquid assets. However, the margin rules do not allow for



otc drugs regulation