Important Note: the deadline for compliance with certain rules is May 1, 2013
The International Swaps and Derivatives Association (“ISDA”) released the August 2012 Dodd-Frank Protocol (the "August Protocol") in the fall of 2012, followed this year by the March 2013 Dodd-Frank Protocol (the “March Protocol”, and together with the August Protocol, the “DF Protocols”). Introduction of the DF Protocols has left many Canadian swap market participants wondering what the Protocols are, how they work, what the impact is on them, and whether they should (or are required to) adhere to the DF Protocols. This bulletin addresses these questions in an introductory fashion while also addressing the looming May 1, 2013 compliance deadline for certain external business conduct rules in further detail.
What are the DF Protocols and What do they Intend to Address?
An ISDA protocol is a multilateral contractual amendment mechanism that allows for various standardized amendments to be deemed to be made to the relevant agreements of any two adhering parties. This is based on the principle that a party may agree with one or more other parties that certain terms and provisions will apply to their respective relationships. Such a mechanism is aimed at providing industry with a solution to the need for regular amendments to existing swap agreements between a large number of bilateral counterparties.
The DF Protocols are designed to allow swap market participants to apply selected compliance provisions from Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) to their swaps trading relationship. The DF Protocols add notices, representations and covenants responsive to Dodd-Frank requirements that must be satisfied at or prior to the time that swap transactions are offered and executed. The DF Protocols are not limited to ISDA Master Agreements, and may be used to amend all agreements between a pair of market participants pursuant to which they enter into swaps.
The August Protocol was the first protocol published by ISDA to assist swap market participants in complying with the rules adopted by the Commodity Futures Trading Commission (“CFTC”) in order to implement the swap market regulatory reforms mandated by Dodd-Frank. The August Protocol is designed to assist compliance by market participants with the documentation requirements of seven CFTC rules, including external business conduct rules (the “Business Conduct Rules”) which require swap dealers ("SDs") and major swap participants ("MSPs") to obtain certain information from their counterparties, such as, for SDs, certain "know your counterparty" information as well as verifications that counterparties qualify as "eligible contract participants". Both SDs and MSPs must provide certain information, give notices and make certain disclosures to their counterparties, which differ depending on the legal status of the counterparty. Since the deadline for compliance with the Business Conduct Rules is May 1, 2013, this bulletin addresses those rules and related compliance in more detail under To Whom do the DF Protocols Apply? and What are, and how do I Comply with, the Business Conduct Rules?
Like the August Protocol, the March Protocol is intended to facilitate compliance with CFTC rules based on Dodd-Frank by providing an efficient and standardized way of amending swap agreements. The March Protocol (also known as DF Protocol 2.0) is intended to address the requirements of three rules that were finalized too late to be covered by the August Protocol, namely: (i) the end-user exception to the clearing requirement for swaps, (ii) the clearing requirement determination that mandates clearing for certain classes of interest rate swaps and credit default swaps, and (iii) a rule for SDs and MSPs that governs confirmation, portfolio reconciliation, portfolio compression, and swap trading relationship documentation requirements.
ISDA has indicated that it may publish further protocols to assist swap market participants with Dodd-Frank compliance.
How do the DF Protocols Work?
Market participants adhere to the DF Protocols by following the instructions posted on the ISDA website, which includes the submission of an Adherence Letter, evidencing agreement to be bound by a specific DF Protocol, and the payment of a US$500 fee. Each party submitting an Adherence Letter and paying the related fee is an adhering party. A list of adhering parties is posted on the ISDA website in relation to each of the DF Protocols. Each adhering party (also called a protocol participant) must also complete a Questionnaire, allowing that party to provide information about itself and make certain elections. Delivery of a completed Questionnaire to another adhering party allows for the addition of supplemental terms to be effective for that adhering party. To address such bilateral delivery requirements, ISDA has partnered with the Markit Group Limited to create “ISDA Amend,” an automated information-gathering process to provide the sharing of submitted data and documents to counterparties for which permission has been granted. This system of bilateral delivery requirements differs from previous ISDA protocols.
In addition to an Adherence Letter and a Questionnaire, the basic architecture of the DF Protocols includes a Protocol Agreement and a DF Supplement. The Protocol Agreement is the base document that establishes an agreed process for amending swaps agreements between permitted adhering parties, or, in the case of the August Protocol, entering into a DF Terms Agreement (described below). The DF Supplement sets out certain standardized representations, acknowledgements, notifications and agreements relating to the relevant regulatory rules. For the August Protocol, a DF Terms Agreement may be used in cases where participants wish to apply certain provisions of the DF Supplement to their swaps transactions without necessarily having a pre-executed ISDA Master Agreement between them.
As noted above, the DF Protocols are not limited to ISDA Master Agreements and therefore can be used to amend all swap agreements between an SD or MSP and a counterparty. The August Protocol is limited to existing written agreements between the parties, but parties can elect to have it apply to undocumented swaps by entering into a DF Terms Agreement. The March Protocol allows parties to enter into an agreement to apply selected compliance provisions to their trading relationship for swaps that are not (i) governed by a written agreement, which provides for, among other things, the terms governing the payment obligations of the parties, or (ii) agreed by the parties to be cleared by a clearing organization.
The architecture and process described above is intended to address two fundamental objectives: firstly, selective access to information (which is effected by limiting access to certain documents such as Questionnaires), and secondly, flexibility (which is achieved by allowing participants to specify any relevant special status and to selectively choose which provisions they wish to have applied). Note, however, that conformed copies of Adherence Letters (though in a standard form) are uploaded and available for public viewing on the ISDA website.
The March Protocol is independent of the August Protocol and therefore adherence to one DF Protocol does not imply or require adherence to the other.
Though most of the rules enacted as a result of Dodd-Frank apply to U.S. SDs and MSPs (and are in fact intended to be of benefit to, and not impose direct administrative burdens on, their counterparties), certain rules also affect Canadian market participants that don't necessarily deal in or speculate with swaps, but rather are counterparties to swap agreements as a means to hedge business or investment exposures. In order for SDs to comply with the Business Conduct Rules under the August Protocol, including confirming counterparty eligibility standards and determining the availability of “safe harbors”, SDs require that all Canadian counterparties provide them with certain information and representations by May 1, 2013. In order to comply with the Business Conduct Rules, SDs will only be able to enter into swaps transactions with those counterparties who have provided the required information and representations. Consequently, Schedules to ISDA Master Agreements furnished by SDs have increasingly contained provisions such as the following:
No Effective Date with respect to any Transaction under this Agreement may occur until such time as (i) both parties have adhered to the ISDA August 2012 DF Protocol Agreement by delivery to ISDA of an Adherence Letter and (ii) each party has delivered to the other party a Questionnaire.
As touched on above, the Questionnaire is the document that permits a pair of adhering parties to amend a written swap agreement between them. In order for a DF Protocol to be effective for that agreement, both parties must complete and submit a Questionnaire and stipulate that the other may have access to its Questionnaire. When Questionnaires have been exchanged between the parties, the relevant agreement will be deemed to have been amended by the terms of that DF Protocol. It is possible for an adhering party to deliver different Questionnaires to different counterparties, but only one Questionnaire may be delivered to any particular party.
It is of note, however, that the relevant regulatory requirements do not mandate that affected parties comply with a particular DF Protocol. Rather, the DF Protocols are mechanisms created by ISDA to assist relevant parties in complying with the regulations; compliance may also be achieved through executing bilateral amendment agreements that comply with regulatory requirements. Some SDs and MSPs have created and distributed such agreements to relevant counterparties.
There is currently no cut-off date for adherence with the March Protocol. However, ISDA has reserved the right to designate a closing date on 30 days’ written notice posted on its website.
The Business Conduct Rules aim to enhance protections for swap counterparties through due diligence, disclosure, fair dealing and anti-fraud requirements. The rules require SDs and MSPs to utilize a new “know your counterparty” process and obtain certain information about their counterparties.
The Business Conduct Rules obligate SDs and MSPs to comply with business conduct standards, which include the following:
(a) undertaking due diligence on counterparties to verify eligibility to trade;
(b) refraining from engaging in abusive market practices;
(c) providing disclosure of material information about the swap to their counterparties;
(d) providing a daily mid-market mark for uncleared swaps;
(e) informing their counterparties of certain rights;
(f) providing sufficient material information to allow a counterparty to assess the swap’s material risks, characteristics, incentives and conflicts of interests; and
(g) making a determination as to the suitability of the swap for a counterparty based on reasonable diligence concerning the counterparty.
In order to allow compliance by SDs, counterparties will be asked to make amendments to their swap agreements and to provide certain information and additional representations. As noted above, compliance may be achieved through adherence with the August Protocol or by executing bilateral amendment agreements that comply with regulatory requirements. If a counterparty chooses to adhere to the August Protocol, the Questionnaire required as part of the process includes representations by the relevant adhering party as to its legal status (e.g., eligible contract participant, SD, MSP, special entity, commodity pool, etc.) and certain “know your counterparty” information. The Questionnaire also enables the relevant adhering party to elect which of the six Schedules contained in the August Protocol DF Supplement will be incorporated into the relevant agreement. Given the May 1, 2013 deadline, and anticipating that it will take some time for a party to review and complete the Questionnaire, interested parties are encouraged to complete the adherence process as soon as possible.
Take the following steps to adhere to the August Protocol:
(a) obtain a CICI (CFTC Interim Compliant Identifier) from the Depository Trust & Clearing Corporation, if required;
(b) complete and submit an Adherence Letter and the US$500 adherence fee to ISDA;
(c) complete a Questionnaire; and
(d) deliver a completed Questionnaire to SD counterparties via ISDA Amend or other means available (which includes email).
Please feel free to contact the authors if you have any questions about this bulletin.