Executive  Summary

For market participants to comply with three new U.S. Commodity Futures Trading Commission (“CFTC”) rules, a new process must be completed by  no later than July 1, 2013. These are the practical recommendations relating to this new development:

  • Inventory over-the-counter (OTC) derivatives (“Swaps”) trading with counterparties, as well as the documentation evidencing Swaps to determine, now and going forward, to what extent the final CFTC rules apply to existing and future Swaps;
  • With respect to those Swaps within the CFTC’s jurisdiction, which will again be clarified by that regulator in coming weeks: (a) “adhere” to the ISDA March 2013 DF Protocol; (b) adhere and then adjust your Swap documentation to fit your needs accordingly; or (c) negotiate Swap documentation to incorporate the rights and responsibilities of three CFTC rules by July 1, 2013; and
  • Confer with Swap counterparties to come within portfolio reconciliation requirements, put in place specific dispute resolution programs to resolve valuation and other disputes that may surface and proactively undertake other measures to make the three final CFTC rules meaningful before, or as soon after July 1, 2013, as possible.


Despite the publication by the International Swaps and Derivatives Association, Inc. (“ISDA”) of two sets of master agreements, multiple credit support annexes and a wide range of definitions to streamline Swap trading since the 1980s, market participants have not developed a single, standard practice for evidencing critically-important legal terms for Swaps – and documentation challenges continue. Some Swaps are processed through electronic platforms in the absence of legal documentation. Swaps have been assigned or “novated” at times without any written, executed and delivered agreement. Parties to Swaps have failed to reach a “meeting of the minds” with respect to key Swap terms and there is no single accepted method for resolving disputes in this documentation. Over the years, disputes have contributed to the failure of at least one of the largest financial firms in the world and countless others in the market have been engaged in costly litigation.

One trade illustrates on a smaller scale why proper documentation of legal terms is important. In early June 2013, the author resolved a transaction that a client entered into through a Lehman Brothers affiliate nearly five years ago. The transaction was, unlike many derivatives, exceedingly straightforward, yet there was no documentation that evidenced the trade and before the transaction was scheduled to settle, Lehman Brothers and its affiliates filed for bankruptcy in September and October 2008.

In that trade, from the settlement date of September 16, 2008, nearly everything (e.g., the rights and obligations of the parties to that trade, the application of exchange rules and the amounts owing) was in dispute. It is likely that the nearly five-year dispute would have been prevented if proper legal documentation (an agreement that would have ordered rights and responsibilities and directed the parties to the transaction to resolve the trade break within a manageable period of time) would have been executed. Almost five years later, the trade dispute has been resolved. Smooth, efficient trading and dispute resolution depends on proper trade documentation and dispute resolution processes. A key component part of the three CFTC rules discussed here deals with Swap documentation and dispute resolution. This is not the first time that a regulator has attempted to impose rules on the market relating to documentation.

Over the years, regulators in leading markets became acutely aware of the problems associated with poor or non-existent transaction documentation, not only in the OTC derivatives market, but in repo and other markets.

The New York Federal Reserve Bank, led by its then-President and Chief Executive Officer Timothy F. Geithner began, years before the 2008 market crises, a process whereby confirmations evidencing OTC transactions are required to be properly executed and delivered. In a 2006 speech to the Global Association of Risk Professionals, Mr. Geithner remarked, prophetically:

The post-trade processing and settlement infrastructure, particularly in credit derivatives, is still quite weak relative to the significance of these markets, although the major dealers and buy-side investors are making a substantial effort to address these problems. The total stock of unconfirmed trades is large and until recently was growing considerably faster than the total volume of new trades. The time between trade and confirmation is still quite long for a large share of the transactions. The share of trades done on the available automated platforms is still substantially short of what is possible. Until the adoption of the new protocol last fall, firms were typically assigning trades without the knowledge or consent of the original counterparties. Nostro breaks, which are errors in payments discovered by counterparties at the time of the quarterly flows, rose to a significant share of the total trades. Efforts to standardize documentation and provide automated confirmation services have lagged behind product development and growth in volume. Although the risk controls seem to have done a pretty good job of capturing the economic terms of the trades, the assignment problems create uncertainly about the actual size of exposures to individual counterparties that could exacerbate market liquidity problems in the event of stress.1

Geithner was prescient. In particular, valuation disputes over credit derivatives and collateral – and the documentation that evidenced the rights and obligations of parties to those trades– played an important role in the demise of A.I.G. and resulted in market disputes elsewhere.

Only a few months after Mr. Geithner’s remarks in late 2006, Goldman Sachs begun to make credit derivative trades involving massive notional values (in, specifically, credit default swaps with residential mortgage securities as underliers) with international insurance giant A.I.G. that would result in enormous payouts by A.I.G. in the event that the residential mortgage-backed securities (“RMBS”) declined in value. It did.

A dispute over the course of several years after 2006 developed between Goldman and A.I.G. concerning these trades and related collateral which A.I.G. was contractually obligated to
post in a falling housing market. A major complicating factor was the seizure in the market for RMBS and resulting lack of depth of liquidity for calculating RMBS values. The RMBS posted as collateral by A.I.G. in support of credit default Swaps where A.I.G. was obliged to provide protection for credit events, and the Swaps themselves was, according to industry sources, valued by Goldman “consistently lower than third-party prices,” leading to a series of disputes involving margin calls by Goldman. This contributed to A.I.G.’s eventual demise. Goldman made a $1.8 billion margin call in connection with the RMBS-related credit default swaps in one instance in July 2007. A.I.G. pledged collateral but A.I.G. subsequently countered in November 2007 that the insurer is entitled to a return from Goldman of $1.56 billion (all in dispute by the two parties to the Swaps). Pulitzer-Prize winning financial reporter Gretchen Morgenson, writing for the New York Times, suggested with support from industry sources that the ongoing derivatives and collateral valuation disputes with Goldman Sachs contributed to the financial destabilization and eventual recapitalization of A.I.G.2

In the years leading up to the 2008 market crises and years before the A.I.G. – Goldman dispute, the sell side began to undertake documentation initiatives but valuation and dispute resolution remedies were not among them. In response to Mr. Geithner’s work to improve back-office procedures for documenting trades, by November 21, 2006 (after a September 27 meeting with Geithner), seventeen major Swap dealers committed over the next two years to make back-office improvements. These commitments included the dealers’ efforts to do the following:

  • Evidence frequently traded products by master confirmation agreements or “MCAs”; and
  • Bring about the electronic confirmation and processing of paper confirmations and execute confirmations on a timely basis, by T+5 business days, on electronic platforms and by T+30 calendar days for new or more bespoke transactions relying on long-form confirmations.

Members of working groups within ISDA, including the author, collaborated to design a dispute resolution procedure that may have ameliorated several of the key problems which resulted in the recapitalization of A.I.G., or at least prevented some litigious disputes elsewhere in the market.

On September 30, 2009, ISDA published the 2009 ISDA Collateral Dispute Resolution Procedure, a method for resolving the kind of disputed collateral calls that were the focus of the Goldman – A.I.G. dispute. This procedure, which began as a protocol, may be useful today in preventing disputes and resolving documentation problems involving collateral or possibly other Swap-related issues.

Dodd-Frank Mandates and the Three New CFTC Rules

While Giethner’s and ISDA’s efforts to implement procedures led to improvements in some segments of the market, widespread market adoption of these procedures did not take place before the passage of Title VII of the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).

The CFTC was directed by provisions within Title VII to require that certain back office employees and other market participants meet and confer to reconcile differences in pools of Swaps, timely confirm trades, agree to resolve disputes and bring about portfolio compression.

According to the CFTC, “[t]he Commission believes that the statutory requirement that the Commission adopt rules governing documentation standards relating to confirmation, processing, netting, documentation, and valuation of all swaps reflects the intent of Congress to have the Commission adopt rules that necessarily effect [Swap Dealers such as Goldman Sachs and all other Swap providers, Major Swap Participants] and their swap counterparties.”

However, existing terms within executed or boilerplate Swap documentation are either at odds with or do not “pick up” the new regulatory mandates within CFTC regulations that become effective on July 1, 2013. The CFTC understood this. End users and others submitting comments to the CFTC asked the U.S. regulator to, in essence, approve existing derivatives documentation by the sweep of a regulatory  pen. The CFTC declined: “the Commission does not believe that the standard ISDA Agreements address the swap valuation requirements of Sec. 23.504(b)(4), the orderly liquidation termination provisions of Sec. 23.504(b)(5), or the clearing records required by Sec. 23.504(b)(6). Given the foregoing, the Commission declines to endorse the ISDA Agreements as meeting the requirements of the rules in all instances.”

The March 2013 Dodd-Frank Protocol

As a result, in order for existing Swap documentation (and new documentation going forward) to comply with Dodd Frank and new CFTC rules, amendments are required. This led to the March 22, 2013 publication by ISDA of yet another protocol, separate and distinct from the August 2012 DF Protocol on business conduct rules: the March 2013 Dodd-Frank Protocol.

A “protocol” is a process whereby parties “adhering” (or agreeing to the text of the protocol) may integrate into existing derivatives documentation new rules, rights and obligations under three new and final CFTC rules3 by submitting to ISDA an adherence letter, and completing and distributing a questionnaire to existing (or new) counterparties to OTC derivatives under the jurisdiction of the CFTC. Parties under the jurisdiction of the CFTC (which is expected to be clarified within weeks and which is subject to another client briefing on cross-border regulations) are required to either adhere to Dodd Frank protocols or enter into, execute and deliver documentation that integrates new CFTC rules.

The March 2013 DF Protocol is just the second of what is expected to be several protocols within ISDA’s Dodd-Frank Documentation Initiative. Each protocol was drafted by leading market participants and practitioners, the majority of which were sell-side Swap Dealers. As long as all market participants agree with the terms of each protocol (protocol terms cannot be negotiated), the adherence to the protocols may save resources and more efficiently amend existing documentation to enable parties to come within regulatory requirements imposed under Title VII of Dodd–Frank.  Many market participants have not yet adhered to protocols and many in fact disagree with the terms of the protocol text and therefore are currently individually negotiating adjustments to existing documentation by the latest effective date of CFTC rules: July 1, 2013 (or are adhering to this latest protocol and then further amending their documentation).

There continues to be confusion as to the subject of the latest protocol. Whereas the prior Dodd Frank protocol (the August 2013 Dodd Frank Protocol) dealt with business conduct rules which became effective on May 1, 2013, the March 2013 Dodd Frank Protocol is designed to help the OTC derivatives industry comply with three rules having nothing to do with business conduct but everything to do with the documentation of derivatives (“Swaps”), the clearing mandate for certain Swaps, resolution of disputes, the generation of confirmations evidencing trades and portfolio reconciliation and compression, among other trade practices. Specifically, the three new CFTC rules address and cause market participants to shift their focus to the following:

  • The manner in which confirmations evidencing Swaps are issued and executed;
  • The identification of parties for clearing purposes as Category 1 Entities (i.e., Swap Dealers, Major Swap Participants Active Funds), Category 2 Entities (e.g., many market participants that are neither Swap Dealer or Major Swap Participants), or neither;
  • Once Swaps are executed and “taken up” for clearing, the extinguishment and replacement of Swaps through the doctrine of novation;
  • In the event that market participants are not required to settle trades through a
  • clearinghouse, certain notification procedures for those parties that are making use of an end-user exception;
  • Other notifications, such as notice whether a market participant is covered under
  • Dodd Frank’s Orderly Liquidation Authority’s “living  will” regulations;
  • Orderly management of portfolios of Swaps to obviate disputes by requiring parties to meet to confer and reconcile portfolios4;
  • Agreements with respect to the valuation of transactions; and
  • A mutual understanding of how certain disputes will be resolved.

Action Items

Like the August 2013 Dodd Frank Protocol, the DF Protocol 2.0 provides a standard set of amendments (to existing documentation covered by the protocol) which counterparties “adhering” or agreeing with the protocol text automatically integrate into their documentation, as well as elective provisions which the parties may select. In order to adhere, each party on its own submits an adherence letter to ISDA, and then directs completed questionnaires with elections to each of its counterparties. Protocol adherence is not effective until questionnaires are properly completed and received and the adherence letter is accepted by ISDA.

For those market participants that do not currently have derivatives documentation covering Swaps in place, it is also possible to “deem” a standard 2002 ISDA Master Agreement to exist, however, this agreement is not customized to include many of the protections that were needed during the 2008 market crises and the new “deemed ISDA” does not fit the unique trading practices and credit profiles of either party.

For market participants to comply with the three CFTC rules this process must be completed no later than July 1, 2013 and, in addition to adhering, market participants are to agree on the following:

  1. A specific process for determining the value of each Swap at any time5;
  2. A method for determining, or a dispute resolution process regarding, Swap valuations6; and
  3. A portfolio reconciliation process.

New Rights, Privileges, Obligations And  Shortcomings

Whereas sending ISDA an adherence letter is straightforward, extra care is needed to complete a Protocol Questionnaire (either bilaterally or through the “ISDA Amend” system hosted by Markit) in such a way as to agree to required rules and take advantage of new rights and privileges bestowed by the three CFTC rules that become effective on July 1, 2013. Adherence will result in numerous back-office and trading practice undertakings, including, specifically:

  • Parties adhering and making certain elections — without reading the protocol text — need to understand that they will only have one business day to make objections upon receiving Swap valuations.
  • Those who are not Swap Dealers will have only two business days to review data and make objections in the course of the portfolio reconciliation process.
  • During market stress, there may not be sources for Swap pricing (as was the case in the Goldman-A.I.G. dispute highlighted above) and where there are no quotes available to recalculate the value of a Swap following notice of a valuation dispute, then frequently the Swap Dealer’s or the “Risk Valuations Agent’s” calculations will be used.

It is important to note that while the CFTC mandates that OTC derivative market participants enter into dispute resolution arrangements, parties that merely adhere to the protocol to not actually put in place a specific procedure for resolving disputes (there is no procedure that is put in place for resolving disputes over Swap collateral).

Adherence to the protocol does not establish a customized method for resolving Swap valuation disputes. In fact, the protocol text specifically disclaims any obligation by a Swap Dealer to follow a specific procedure for resolving such disputes. The protocol text simply requires adhering parties to have an agreed-upon process that includes either a dispute resolution mechanism or an agreement as to which primary and back-up inputs will be used in the event that the primary inputs for Swap valuation are not available (such as during a market crises). So, unless adhering parties further amend their Swap documentation after adherence to require the use of a certain method for resolving disputes (e.g., the 2009 ISDA Collateral Dispute Resolution Procedure, or parts of that procedure which could be used to help resolve Swap valuation disputes, for example), arguably the market could again experience valuation disputes, conceivably, similar to the Goldman — A.I.G. dispute.

Market participants are encouraged to confer with qualified counsel to determine whether the details of any protocol are consistent with CFTC rules and actually “work” with their existing trading practices.

1 Timothy F. Geithner, “Risk Management Challenges in the U.S. Financial System,” Remarks by Mr. Timothy F. Geithner, President and   Chief Executive Officer of the Federal Reserve Bank of New York, at the Global Association of Risk Professionals (GARP) Seventh Annual Risk Management Convention and Exhibition in New York City, February 28, 2006 (available at http://www.bis.org/review/r060303a.pdf on June 18, 2013).

2 See, e.g., Gretchen Morgenson, “Conflict with Goldman Helped Push A.I.G. to the Edge,” “The Reckoning: Behind Insurer’s Crisis, Blind Eye to a Web of Risk,” New York Times (Sept. 27, 2008).

3 The three final CFTC rules are published in the Federal Register and available upon request, at 77 Fed. Reg. 55904 (Sept. 11, 2012); 77 Fed. Reg. 42559 (July 19, 2012); 77 Fed. Reg. 74284 (Dec. 13, 2012).

4 Swap Dealers and Major Swap Participants (a category of high-volume Swap users established and defined in Title VII of Dodd-Frank) are required by CFTC Regulation 23.502 to conduct portfolio reconciliations when they face other Swap Dealers and Major Swap Participants in Swaps. This is the subject of Schedule 4 of the protocol text. Swap Dealers and Major Swap Participants are also required by this regulation to have policies and procedures designed to ensure the carrying out of portfolio reconciliations with other Swap counterparties. Depending on the counterparties to the Swap and the size of their books, reconciliation must take place in frequencies mandated by the regulation, and, just as the protocol text does not specify the exact terms or     methods for resolving discrepancies in valuations or Swap terms, the protocol text in Schedule 4 provides the basic outlines of an agreement to confer and consult to resolve differences in a timely manner. During reconciliation, valuation differences in excess          of $20 million that cannot be resolved in certain timelines are to be reported to the CFTC.

5 Swap Dealers and Major Swap Participants are required under CFTC Regulation 23.504(b) to agree with financial entities on a process and methods for determining the value of each Swap on a daily basis. Other counterparties may pursue agreements with Swap Dealers on daily Swap valuation processes or methods; so accordingly, mere adherence to the protocol does not ensure all of the valuation protections that the CFTC envisioned.

6 The protocol does not directly address or proscribe the manner in which market participants are to resolve disputes over Swap collateral. The CFTC continues to develop final rules on collateral requirements relating to Swaps.

Other Author

Gordon F. Peery


Banking and Financial Services