Getting Ready for Changes In the Regulation of Derivatives Under The Dodd- Frank Act

1. Getting Ready for Changes In the Regulation of Derivatives Under The Dodd- Frank Act NEPOOL Meeting Boston, MA Matthew Picardi Vice President

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3. Agenda • Key Definitions • To Clear or not to Clear? – The End-User Exception • Proposed Margin Requirements For Market Participants • Positions Limits • Market Implications • Schedule For Implementation of Rules

4. Critical Definitions • Swap – includes exchange-traded swaps, bilateral swaps (like those done under ISDA agreements) and puts, calls, caps, floors, collars or other options that are based on the value of interest rates, commodities, currencies, securities, etc., but does not include transactions intended to go to physical delivery • Swap Dealer – regularly enters into bilateral swaps for purposes other than hedging, in particular entering into swaps as a regular business activity • Major Swap Participant (MSP) – holds a substantial position in swaps other than positions used for hedging • End-User – not a MSP or swap dealer, only uses swaps to hedge

5. Key Issues Related To CFTC’s Proposed Definitions • Definition of swap is broad, includes any financially settled options. • CFTC developing understanding of physical option products. • Under its proposed definition of swap, CFTC makes the following assessment to determine if option embedded in a physical transaction should be excluded: • It should just impact price, not overall nature of contract • It should not impact delivery terms • Cannot be severed from the contract* • * Further Definition of “Swap,” “Security-Based Swap” and “Security-Based Swap Agreement;” Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 76 Fed. Reg. 29,818 (May 23, 2011).

6. Key definition Issues Con’t. • Definition of Swap Dealer is broad and could pick-up commercial energy firms not historically engaged in dealing activity. • Remember, Swap Dealers will be required to clear their swaps and will face a number of additional obligations. • CFTC rulemaking considerations: • “accommodating demand” • de minimis exception • Dodd-Lincoln Letter clarifying intent of Congress not to include gas utilities

7. Understand Your Transaction • Financial products allow for efficient hedging but: • Discrepancies can create open positions – make sure intent is to hedge or mitigate commercial risk. • Rules create new players – know your counterparties. • Understand how options in a physical forward contract work.

8. To clear or not to clear ?-end-user exception • Section 2(h)(1) of the Commodity Exchange Act (“CEA”) requires swaps to be cleared though a derivatives clearing organization if they are of the type the CFTC determines must be cleared. • Section 2(h)(7) of the CEA provides an exception if one party to the swap is (i) not a financial entity, (ii) using swaps to hedge or mitigate commercial risk, and (iii) notifies the CFTC how it generally meets its financial obligations for non-cleared swaps. • CFTC proposed rules for taking advantage of the End-User Exception require that the “reporting counterparty” provide certain information to a Swap Data Repository (“SDR”), or if none is available to the CFTC. . Source: www.cftc.gov/LawRegulation/DoddFrankAct

9. To clear or not to clear? -end-user exception (CONT.) • Reporting counterparty is the financial entity, but if both counterparties are End-Users, they must choose • Information required by the CFTC to qualify for End-User Hedge Exception • Identity of electing counterparty and whether it is a financial entity. • Whether hedge is used for “hedging or mitigating commercial risk” • To qualify must be “economically appropriate” to the reduction of risks in the conduct or management of a commercial enterprise; and • CFTC will look at totality of circumstances and where the risks to be hedged arise from. • Might not include risk reducing transactions associated with speculation or trading transactions – all hedges are not equal! Source: www.cftc.gov/LawRegulation/DoddFrankAct

10. Proposed Margin Requirements – Uncleared Swaps *For exposures above thresholds Note: Margins must be cash or government-backed instruments and are to be calculated in the form of initial and variation margin, with initial margin held by third party custodian.

11. To clear or not to clear? -end-user exception (CONT.) • Indentify if End-User will meet financial obligations using (i) credit support agreement, (ii), pledged or segregated assets, (iii) third party guarantee, (iv) own financial resources, (v) other. • If an SEC filer, proposed rules say Board of Directors or committee of board approval for every swap being entered into under the End-User Exception is required. Source: www.cftc.gov/LawRegulation/DoddFrankAct

12. Key Issues—Margin Requirements • Issue • Margin requirements on cleared swaps • Collateral on non-cleared swaps • Greater need for working capital? • Inability to use unsecured lines of credit to support swap positions? • Inability of some parties to transact? • Use of non-cash collateral with exchanges? • Shift towards physical transactions? • Imbed financial features in physical contracts? • Potential Consequences • Some • Possible Responses

13. Margin Requirements Proposal---Concerns • Disregards letters of credit and liens on physical resources • End –User transactions with bank Swap Dealers will require margin • Imposes “exchange concepts” on bilateral credit arrangements • Initial margin • Variation margin • Requirement for third party custodian adds costs • Reliance on models to determine creditworthiness

14. Key Issues—Position Limits • Aggregate Position Limits -- across exchanges and OTC transactions • (Applied to 4 types of energy contracts: WTI, Henry Hub, RBOB and Heating Oil) • Issue • Uncertainties about Hedge Exemptions • Reduced capability to hedge physical positions? • Loss of liquidity (especially in out months)? • Less speculative activity? • Shift in activity to foreign boards of trade? • Potential Consequences • Potential Consequences • Related Issues and Concerns • Overall complexity – compliance risk • Systems to link physical positions with hedges • Systems to track swap and futures positions intraday

15. Bona-Fide hedge Limitations • The definition of bona-fide hedge has been narrowed under Proposed Position Limit Rule • CFTC may not maintain a flexible process to allow market participants to obtain exemptions for unforeseen bona-fide hedging strategies and daily reporting of cash positions will be burdensome • It may not include certain risk reducing transactions for which market participants applied and obtained exemptions, a/k/a “non-enumerated hedges”

16. Bona-fide hedge limitations (cont.) • Hedges on the value of services may no longer be covered • A bona-fide hedge exemption may no longer apply to the following transaction: • LDC wants to enter into a basis hedge to protect the value of a proposed purchase of firm transportation for $.30/mmbtu • LDC enters into a $4.00/mmbtu swap at receipt point and sells a strip of NYMEX gas futures at the delivery point at for $4.33/mmbtu • Not actually purchasing or selling gas at the time it enters into two separate transactions

17. other End-User Issues • Reporting and Recordkeeping Obligations • Existing Swaps • Swaps entered into after rule implementation date • Potential obligation via SEF/DCM membership to keep records of telephone, voicemail, IM, electronic mail, etc… communications that lead to the execution of transactions in a commodity interest or cash commodity • Documentation Requirements—Credit Support Agreements? • Complications for “Special Entities” • New provisions on market manipulation and disruptive trading practices

18. Potential Market Implications for End-Users • Higher costs to hedge? • Inability of some parties to enter into swaps? • Smaller market –less liquidity? • Shift towards physical transactions? • More regulatory requirements and compliance risk? • Uncertainty about regulation of related markets such as power, carbon and environmental product markets.

19. The Schedule For Implementation • Few rules were final by the July 16, 2011 deadline • Deadline now targeted for December 31, 2011 • CFTC has finalized some rules, such as those covering market manipulation, SDRs, whistleblowers, and large trader position reporting but the rules critical to overall implementation are still pending. • Proposed legislation to delay Dodd-Frank Act implementation is unlikely to be passed. • Attention is being given to sequencing implementation and on workable compliance deadlines. • Implementation expected to occur through the end of 2011 and into 2012.

20. Q & A