Legal and Regulatory Framework in the Global Derivatives Market Derivatives and Risk Management in Mexico, May 7, 2001

1. Legal and Regulatory Framework in the Global Derivatives MarketDerivatives and Risk Management in Mexico, May 7, 2001Diane Genova, Managing Director, JPMorgan

2. 1 A robust legal framework is essential for the development of an OTC derivatives market Parties need assurance that transaction is enforceable as written involves long-term payment obligations contract may be relied on as a hedge Parties need to be comfortable that they are in compliance with applicable regulatory guidance

3. 2 Legal Framework must deal with a number of legal and regulatory issues Contract Enforceability Sales Liability Standard Documentation Netting and Collateral Illegality, Force Majeure, Impossibility Regulatory Considerations

4. 3 Contract Enforceability OTC Derivatives are bilateral contracts they are not securities or futures governed by general principles of contract law general contract law must recognize that derivatives are like any other contract Recent amendments to US commodities laws clarify that swaps are legally enforceable contracts and not off-exchange futures Counterparty must have capacity and authority to enter into transactions Some counterparties may need specific statutory or regulatory authority to enter into derivatives Evidence of authority of counterparty’s representative is important, but possible to rely on doctrine of apparent authority

5. 4 Contract Enforceability (cont’d.) Hazell vs. Hammersmith: local authorities in the UK were found to have exceeded their authority by entering into swaps Lehman vs. Minmetals (Chinese corporations): court found Lehman could not rely on trader’s apparent authority if Lehman knew or suspected that agreements were illegal under Chinese law Contract Formation transactions usually executed by telephone subsequently confirmed in writing Statute of Frauds issues: in some jurisdictions, certain types of contracts must be in writing New York State solution: explicitly recognizes transactions executed by telephone Australian case (Powercor Australia): transactions were binding notwithstanding the absence of signed confirmations

6. 5 Sales Liability Appropriateness regulators may require dealers to ensure that its customers have the capability of understanding the terms and risks of transactions and that sufficient information given to customers to understand risks Existence of Duties as a general rule, in order for fiduciary relationship to exist, one party must explicitly agree to undertake a duty of care parties need to be clear as to the nature of their relationship: is it a fiduciary relationship or an arms length principal-to-principal relationship Duty of good faith and fair dealing: each party to a contract must refrain from making misrepresentations to the the other Superior Knowledge: duty to disclose may arise where party has superior knowledge of information, the information is not readily available to the other party and the first party knows that the other party is acting on basis of mistaken knowledge

7. 6 Standard Documentation Standard Master Agreements are essential for contracts created in a trading environment Industry standardization allows parties to focus on the important economic and credit terms rather than on legal boilerplate Master Agreements create consistent contractual rights applicable across the whole book of derivatives business with a counterparty Permits a party to terminate and close-out exposures in a declining credit situation Allows all transactions to be netted for credit, financial reporting and collateral calculation purposes

8. 7 Standard Documentation (cont’d) ISDA Master is the standard master agreement accepted globally Utilizes a flexible architecture: a modular approach Master Agreement printed form with representation, events of default/termination events, early termination mechanics Schedule with specific terms tailored to the counterparty Definitions booklets incorporating standard definitions and market conventions tailored to particular products Credit Support Documents Confirmations

9. Modular approach in action

10. Netting Types of Netting Payment netting Close-out netting

11. Payment netting

12. Close out netting

13. 12 Netting (cont’d) Benefit of close out netting Exposure reduction--enables parties to do more business with each other Balance sheet impact Regulatory capital benefits Enforceability of close out netting Recognition of close-out netting is key to legal derivatives infrastructure Netting legislation adopted in 22 countries

14. Collateral --Two approaches Security Interest Approach Requires pledge and perfection Ownership of asset remains with Counterparty Relies on enforcement of security interest theory Use of collateral by secured party is an issue Most common structure in OTC derivatives markets Title Transfer Approach Outright transfer of assets Relies on set-off theory Most common structure in repo markets

15. Legal issues of security interest approach Issues revolve around “creation” and “perfection” of security interests Procedural requirements Filing or notice requirements Possession requirements Choice of law/multi-jurisdiction issues Continuation requirements Substitution of collateral “After acquired property” “In flight” securities Rehypothecation or “use and abuse”

16. Legal issues of title transfer Recharacterization risk “Fallback” grant of security interest Used in repo documentation Not used in UK Credit Support Annex

17. Enforcement of remedies Bankruptcy/insolvency impediments to enforceability Stays Preferences Superpriorities or “priming” Procedural requirements Grace periods and notice requirements Prior notice of liquidation Liquidation mechanics - can the secured party buy the collateral? Requirement of “commercial reasonableness” Significant variables Type of debtor Type of transaction Type of insolvency proceeding

18.  Operational Risks May not call for collateral Risks in substitution may mis-mark collateral, swaps, etc. Legal Risks Preferences Stays Priorities over secured creditors

19. 18 Illegality, Force Majeure, Impossibility Off-exchange futures prohibited in some jurisdictions Law in US recently amended to clarify that OTC swaps are not illegal off exchange futures Gaming/gambling laws--should provide exception for bona fide commercial transactions Registration requirements for certain currency transactions--failure to register may result in lack of enforceability of transaction

20. 19 Illegality, Force Majeure, Impossibility (cont’d) Force majeure and impossibility range of actions may affect parties ability to perform, e.g. civil unrest (Indonesia), imposition of exchange controls (Malaysia) need to have a roadmap as to what happens to the contracts ISDA force majeure/impossibility provisions

21. 20 Regulatory Considerations Safety and soundness of regulated entities Banco de Mexico 31 points Federal Reserve derivatives guidelines