The document discusses the risks of derivatives and recent high-profile losses from various institutions. It outlines regulatory reforms aimed at increasing transparency, improving market efficiency, and reducing systemic risk through centralized clearing, electronic trading, and reporting of over-the-counter derivative contracts. The reforms will significantly change the derivatives market through increased costs, collateral requirements, and regulatory complexity.

1. Stephen Thompson CFA
Manager of Derivatives and Quantitative Evaluation
Province of Nova Scotia
Liability Management and Treasury Services

2. Occupational Hazard

3.  Allied Irish Bank ($700 million)
 Amaranth ($6 billion)
 Barings ($1 billion)
 Daiwa ($1 billion)
 Enron Counterparties (Several over $1 billion)
 Kidder Peabody ($350 million)
 LTCM ($4 billion)
 Midland Bank ($500 million)
 Société Générale ($7 billion)
 Subprime Mortgages & Lehman (up to $40 billion)

4. “The derivatives genie is now well out of the bottle, and
these instruments will almost certainly multiply in variety
and number until some event makes their toxicity clear.
Central banks and governments have so far found no
effective way to control, or even monitor, the risks posed by
these contracts. In my view, derivatives are financial
weapons of mass destruction, carrying dangers that, while
now latent, are potentially lethal.”
Warren Buffett 2002

7.  All standardized OTC derivative contracts should be
traded on exchanges or electronic trading
platforms, where appropriate,
 And cleared through central counterparties by
end-2012 at the latest.
 OTC derivative contracts should be reported to
trade repositories.
 Non-centrally cleared contracts should be subject to
higher capital requirements.

8.  Increase transparency
 Improve market efficiency
 Reduce systemic risk

9.  No Reforms for Exchange Traded Derivatives
 Over the Counter trades seem the sole focus
of International Scrutiny
 Push is to limit, or eliminate Bilateral Trading

10.  Any discussion about OTC derivatives is now
necessarily a discussion about Legislation and
Regulations
 Driven by;
 Optics, we must be seen doing something
 Politics, both global and domestic (be ahead of
the US or be subject to their rules)

11.  Federal Reserve Act of 1913: 32 pages
 Glass-Steagall act: 37 pages
 Sarbanes Oxley: 66 pages
 Dodd-Frank: 848 pages
 Franken Dodd, Dodd Frankenstein…

12.  Canada's G20 commitment of clearing over-the-
counter (OTC) derivatives by December 31st, 2012
 Canada is moving faster than most to enact both G20
commitments and Basel III Requirements.
 Canadian OTC Working Group Recommendations
provide clues to framework.
 Look for Canadian CCP’s, SDR proposals
 No National Securities Regulator but Expanded Federal
Roles in Derivatives Markets

13.  CCP  CVA
 SEF  DVA
 SDR or TDR  Basel III
 SEC  ISDA
 CFTC  CSA
 EMIR  CSA
 MiFid  OTCDWG
 LCH  CMIC
 BCBS  CPSS
 IOSCO  OMG, LOL, WT…

15.  CFTC (or SEC), CCP and SEF determine which swaps
must trade exclusively on a Swap Execution Facility
(“SEF”)
 Must be executed on a SEF if;
 transaction falls with the “swap” definition in the Act; and
 the swap type is mandated by the CFTC (or SEC) to be
cleared on a CCP; and
 the client is not exempt from the requirement to clear
 Block trades: CFTC vs SEC rules
 Block trade definition

16.  Clearing and electronic trading will be mandated for
many products and users
 Multilateral trading most likely prominent
 Increased capital charges for uncleared trades and
possibly minimum margin requirements
 Liquidity will be affected by the changes in style of
trading, margin requirements, reporting
requirements, costs
 Collateral requirements will increase for most
whether cleared or not
 Counterparty risks may be reduced

18.  Asset-Liability matching
 Asset Allocation
 Diversification
 Leverage
 LDI Strategies
 Alternative Investments
 Innovation and Risk Management

19.  Prepare for new cost structures
 Increased Capital Costs for Non-cleared trades
 Increased transaction costs for cleared trades
 Prepare for Collateral Management either
in-house or through intermediaries
 Prepare for increased legal costs
 ISDA / CSA
 Prepare for increased transaction Reporting
and associated costs

20.  Look back to cash market mandates
 Is cash more effective than swaps + Collateral?
 Sit down with Managers whose mandates
have derivative heavy strategies.
 Strategies should already be in place
 Operational costs may become a pressure

21.  Will increased complexity push Buy-side
investors from bilateral markets?
▪ Maybe, but these are the testing ground for innovation
 Is this the end for the OTC Market?
▪ Remains to be seen. Likely be a smaller club with more
agency relationships. Bilateral trading will become
highly scrutinized
 Does any of this satisfy the G20 goals?
▪ Not on its own but stay tuned