Details of Re-proposed Uncleared Swaps Margin Rules for Banks

Practical Law Legal Update 1-582-2605 (Approx. 13 pages)

Details of Re-proposed Uncleared Swaps Margin Rules for Banks

by Practical Law Finance

Overview of the Re-proposed Rules

The re-proposed rules impose requirements on swap entities that are prudentially regulated by one of the five prudential regulators ("covered swap entities" or "CSEs"; also, in certain capacities under the rules, referred to simply as "swap entities"). CSEs include banks and financial institutions that are registered SDs, MSPs, security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) under Title VII that are subject to regulation by the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency (OCC), the Farm Credit Administration or the Federal Housing Finance Agency.

The revised proposal is margin-collection-based. That is. the revised proposal focuses on the margin collection responsibilities of CSEs with respect to their uncleared swaps rather than on the margin posting obligations of their counterparties.

The re-proposed rules list four general margin collateral requirements for uncleared swaps entered into by CSEs:

If the counterparty is a swap entity, the CSE must collect and post both initial and variation margin.
If the counterparty is a financial end user with "material swaps exposure" (see Material Swaps Exposure), the CSE must collect and post both initial and variation margin.
If the counterparty is a financial end user without material swaps exposure, the CSE must collect and post initial margin as determined appropriate by the CSE and must collect and post variation margin.
If the counterparty is any other counterparty, the CSE must collect and post both initial and variation margin as determined appropriate by the CSE.

For details on the updated definition of "financial end user" in the revised proposal, see Revised Definition of Financial End Users.

A CSE's collection of margin from “other counterparties” that are not swap entities or financial end users (for example, nonfinancial commercial end users that generally engage in swaps to hedge commercial risk, sovereigns and multilateral development banks) is subject to the judgment of the CSE. CSEs are encouraged to continue to collect initial and variation margin from these counterparties when and how they determine in their best interest, based on their management of their overall credit exposure to the customer. Nothing in the re-proposed rules is intended to prevent or discourage a CSE from collecting (or posting ) margin in amounts greater than required under the re-proposed rules.

Unlike the initial proposal, the revised proposal requires two-way collateral posting. That is, the CSE must post margin to its uncleared swap counterparty rather than just collecting margin collateral from its counterparty. Since uncleared swaps are generally less liquid than cleared swaps, the proposed rule requires that posted initial margin cover a ten-day close-out period rather than the five-day period required for cleared swaps. This aspect of the proposed rule would likely increase the cost of uncleared swaps.

Initial Margin Collateral Collection under the Revised Proposal

Subject to certain thresholds and minimum transfer amounts (see Thresholds and Minimum Transfer Amounts under the Revised Proposal), the revised proposal would require CSEs that are transacting in uncleared swaps with one another or with financial end users with material swaps exposure (see Material Swaps Exposure) to collect and post initial margin with respect to those swaps in an amount that may be calculated by using either:

An internally created risk-based model that would establish initial and variation margin requirements for CSEs. The model must satisfy certain requirements set out on page 174 of the proposed rule and must be approved by the relevant prudential regulator.
A standardized margin schedule where initial margin would be calculated according to a table that requires initial margin posting based on type and duration of swap (see Standardized Initial Margin Schedule) found in Appendix A of the rules.

In either case, the amount of initial margin collateral required to be posted under an uncleared swap transaction would vary depending on the relative risk of the counterparty and of the uncleared swap or uncleared SBS.

The amount of initial margin required to be collected is the amount determined under either of these two methods less any initial margin threshold amount established by the swap entity, which cannot exceed $65 million. The initial margin threshold is applied on a consolidated-entity basis.

The revised proposal requires that initial margin be posted and collected on a daily basis for a period beginning on or before the business day following the date it enters into the non-cleared swap or non-cleared SBS and ending on the date the non-cleared swap or non-cleared SBS is terminated or expires. Posting and collecting initial margin must be made on at least a daily basis to reflect changes in portfolio composition or any other factors that would change the required initial margin amounts.

Initial margin requirements are subject to a phase-in period from December 1, 2015 to December 1, 2019.

Standardized Initial Margin Schedule

Appendix A: Standardized Minimum Gross Initial Margin Requirements for Non-cleared Swaps and Non-cleared Security-Based Swaps¹
Asset Class (type of swap)	Initial Margin Requirement (% of Notional Exposure)
Credit: 0-2 year duration	2%
Credit: 2-5 year duration	5%
Credit: 5+ year duration	10%
Commodity	15%
Equity	15%
Foreign Exchange/Currency	6%
Cross-Currency Swaps: 0-2 year duration	1%
Cross-Currency Swaps: 2-5 year duration	2%
Cross-Currency Swaps: 5+ year duration	4%
Interest Rate: 0-2 year duration	1%
Interest Rate: 2-5 year duration	2%
Interest Rate: 5+ year duration	4%
Other	15%

¹The initial margin amount applicable to multiple uncleared swaps or uncleared SBS subject to an eligible master netting agreement that is calculated according to Appendix A of the rules s computed as follows: Initial Margin = 0.4 x Gross Initial Margin + 0.6 x NGR x Gross Initial Margin where Gross Initial Margin = the sum of the product of each non-cleared swap's or non-cleared SBS's effective notional amount and the gross initial margin requirement for all non-cleared swaps and non-cleared security-based swaps subject to the eligible master netting agreement and NGR = the net-to-gross ratio (that is, the ratio of the net current replacement cost to the gross current replacement cost). In calculating NGR, the gross current replacement cost = the sum of the replacement cost for each non-cleared swap and non-cleared security-based swap subject to the eligible master netting agreement for which the cost is positive. The net current replacement cost = the total replacement cost for all non-cleared swaps and non-cleared security-based swaps subject to the eligible master netting agreement.

Variation Margin Collateral Collection under the Revised Proposal

Variation margin is posted to cover mark-to-market changes in the value of:

The parties' positions under the swap since it was executed or last marked to market.
Any posted margin already posted to collateralize the swap.

Under the re-proposed rules, a CSE is generally required to collect and post variation margin collateral in transactions where a CSE trades with either:

Another swap entity.
A financial end user (regardless of whether the financial end user has material swaps exposure).

The revised rules would establish minimum requirements for variation margin collection in connection with these transactions. Variation margin must be collected/posted in an amount that is at least equal to the difference in the value of the swap since the counterparties' previous exchange of variation margin. The re-proposed rules would not permit a CSE to adopt a threshold amount below which it need not collect or post variation margin on uncleared swaps with swap-entity and financial end-user counterparties. Nothing in the re-proposed rules is intended to prevent or discourage a CSE from collecting or posting variation margin in amounts greater than required under the re-proposed rules.

Positions across all uncleared swaps between two parties may be netted for the purposes of determining variation margin collection and posting obligations under the revised proposal, to the extent that a "qualifying" master netting agreement is in place between the CSE and its counterparty. Although the re-proposed rules generally do not apply to uncleared swaps that were entered into prior to the applicable compliance date, all swaps that are included in an eligible master netting agreement must be included in the calculation and compliance with variation margin requirements if the CSE chooses to calculate in that manner.

Under the revised proposal, a CSE must recalculate and collect or post (as applicable) variation margin on a daily basis. Most swaps market makers that would be CSEs under these rules already make daily mark-to-market calculations and daily variation margin calls.

The re-proposed rules do not require variation margin to be segregated with an independent third-party custodian. This was expected, as such segregation is cumbersome and expensive, and was not part of the initial proposal.

Thresholds and Minimum Transfer Amounts under the Revised Proposal

Both initial margin and variation margin collection under uncleared swaps with CSEs are subject to separate:

Minimum transfer amounts (MTAs). Under the re-proposed rules, margin collateral collection and posting by CSEs would be subject to a proposed minimum transfer amount (MTA). This means that both initial and variation margin collateral need not be collected or posted unless and until the total amount of initial or variation margin required to be collected from a counterparty under an uncleared swap, but which has not been collected, exceeds $650,000. (The parties may also negotiate a lower MTA, the rules would simply establish a maximum.) A separate MTA applies for initial and variation margin collateral collection. This change from a $100,000 MTA under the original proposal reflects concerns expressed by market participants that the originally proposed amount was too low and inconsistent with market practice. Note that an MTA only affects the timing of margin collection, it does not change the amount of margin that must be collected once the MTA is reached. For example, with a $100,000 MTA, the initial margin requirement under an uncleared swap with a CSE increases from $50,000 (which has not been collected) to $110,000. The CSE would be required to collect the entire $110,000.
Threshold amounts. Thresholds operate like collateral thresholds that have traditionally been negotiated for uncleared swaps under a standard ISDA CSA. Below these thresholds, the CSE would not be required to collect margin collateral from its uncleared swap counterparty. There is no threshold for variation margin, but, as noted above, there is a maximum threshold of $65 million for initial margin. The parties may also negotiate lower thresholds, the rules would simply establish a maximum exception from the collection rules.

Material Swaps Exposure

The original proposal differentiated between low-risk financial end users and high-risk financial end users and imposed different margin requirements on each category. The re-proposed rules differentiate between swaps with financial end-user counterparties that either have or do not have material swaps exposure. "Material swaps exposure" is defined under the rules as "an average daily notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps [Covered Swaps] with all counterparties for June, July and August of the previous year that exceeds $3 billion, where such amount is calculated only for business days." This amount differs from that set forth in the 2013 international framework, which defines smaller financial end users as those counterparties that have a gross aggregate amount of covered swaps below 8 billion euro, which, at current exchange rates, is approximately equal to $11 billion.

To illustrate the calculation for material swaps exposure, consider a financial end user (together with its affiliates) with a portfolio consisting of two non-cleared swaps (such as an equity swap and an interest rate swap) and one non-cleared security-based credit swap. The notional value of each swap is exactly $10 billion on each business day of June, July, and August of 2015, and a foreign exchange forward with a notional value of $10 billion on every business day of August 2015 is added to the entity’s portfolio at the end of the day on July 31, 2015. On each business day of June and July 2015, the aggregate notional amount of non-cleared swaps, security-based swaps and foreign exchange forwards and swaps is $30 billion. Beginning on August 1, 2015 the aggregate notional amount of non-cleared swaps, security-based swaps and foreign exchange forwards and swaps is $40 billion. The daily average aggregate notional value for June, July and August of 2015 is then (22 x $30 billion + 23 x $30 billion + 21 x $40 billion) / (22 + 23 + 21) = $33.18 billion, in which case this entity would be considered to have a material swaps exposure for every date in 2016.

Under the material swaps exposure threshold, CSEs would not be required to collect any margin from financial end users, if they do not exceed the material swaps exposure amount of $3 billion. Note that this is a high threshold that would require collection of margin collateral on very few financial commercial end users. Of course, CSEs would be free to, and in many cases likely would continue to, negotiate margin requirements for these parties under their bilateral swap agreements and CSAs. However, such arrangements would not be required under the rules.

Revised Definition of Financial End User

The re-proposed rules include an overhaul of the definition of "financial end user" from the original proposal. The re-proposed rules seek to provide certainty and clarity to counterparties as to whether they would be financial end users for purposes of this proposal, and therefore provided a list of entities that would be financial end users as well as a list of entities excluded from the definition.

Under the proposal, a financial end user includes any counterparty that is not a swap entity and that is any of the following:

A bank holding company or an affiliate thereof, a savings and loan holding company or a nonbank financial institution supervised by the Board of Governors of the Federal Reserve System under Title I of the Dodd-Frank Act (12 U.S.C. 5323).
A depository institution, a foreign bank, a federal credit union or a state credit union as defined in section 2 of the Federal Credit Union Act (12 U.S.C. 1752(1) & (6)), an institution that functions solely in a trust or fiduciary capacity as described in section 2(c)(2)(D) of the Bank Holding Company Act (12 U.S.C. 1841(c)(2)(D)), an industrial loan company, an industrial bank or other similar institution described in section 2(c)(2)(H) of the Bank Holding Company Act (12 U.S.C. 1841(c)(2)(H)).
An entity that is state licensed or registered as a credit or lending entity, including a finance company, money lender, installment lender, consumer lender or lending company, mortgage lender, broker, or bank; motor vehicle title pledge lender, payday or deferred deposit lender, premium finance company, commercial finance or lending company or commercial mortgage company. However, excluded are entities registered or licensed solely on account of financing the entity’s direct sales of goods or services to customers, money services businesses including check cashers, money transmitters, currency dealers and exchanges and money order or traveler’s check issuers.
A regulated entity as defined in section 1303(20) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C. 4502(20)) and any entity for which the Federal Housing Finance Agency or its successor is the primary federal regulator.
Any institution chartered and regulated by the Farm Credit Administration in accordance with the Farm Credit Act of 1971, as amended, 12 U.S.C. § 2001 et seq.
A securities holding company, a broker or dealer, an investment adviser as defined in section 202(a) of the Investment Advisers Act of 1940 ('40 Act) (15 U.S.C. 80b-2(a)), an investment company registered with the SEC under the '40 Act (15 U.S.C. 80a-1 et seq.) or a company that has elected to be regulated as a business development company pursuant to section 54(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-53).
A private fund as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)), an entity that would be an investment company under section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3) but for section 3(c)(5)(C) or an entity that is deemed not to be an investment company under section 3 of the Investment Company Act of 1940 pursuant to Investment Company Act Rule 3a-7 of the Securities and Exchange Commission (17 CFR 270.3a-7).
A commodity pool, a commodity pool operator (CPO) or a commodity trading advisor (CTA) as defined in, respectively, Sections 1a(10), 1a(11), and 1a(12) of the CEA (7 U.S.C. 1a(10), 7 U.S.C. 1a(11), 7 U.S.C 1a(12)).
A futures commission merchant (FCM).
An employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974 (29 U.S.C. 1002), an entity that is organized as an insurance company that is primarily engaged in writing insurance or reinsuring risks underwritten by insurance companies, or which is subject to supervision as such by a state insurance regulator or foreign insurance regulator.
An entity that is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets.
An entity that would be a financial end user or a swap entity if it were organized under the laws of the United States or any state thereof.
Any other entity that a prudential bank regulator determines should be treated as a financial end user.

The term “financial end user” under the revised proposal does not include any counterparty that is any of the following:

A sovereign entity.
A multilateral development bank.
The Bank for International Settlements.
An entity that is excluded from the definition of "financial entity" under CEA Section 2(h)(7)(C)(iii) (7 U.S.C. 2(h)(7)(C)(iii)) and implementing regulations (see Practice Note, The Dodd-Frank Act: The Commercial End-user Exception to the Mandatory Swap Clearing Requirement: Exempt Financial Entities).
An affiliate that qualifies for the exception from mandatory Title VII swap clearing under CEA Section 2(h)(7)(D) (7 U.S.C. 2(h)(7)(D)) or section 3C(g)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 78c-3(g)(4)) and implementing regulations.

The re-proposed rules classify entities that are neither financial end users nor swap entities as “other counterparties.”

Eligible Collateral under the Revised Proposal

The re-proposed rules limit the types of collateral that are eligible to be used to satisfy both initial and variation margin requirements. Eligible collateral is generally limited to high-quality, liquid assets that are expected to remain liquid and retain their value, after accounting for an appropriate risk-based haircut.

For variation margin, eligible collateral is limited to cash which can be denominated in either US dollars or the currency in which the payment obligations under the swap are required to be settled.

Eligible collateral for initial margin includes:

Cash.
Debt.
Securities that are issued or guaranteed by either:
- the U.S. Department of Treasury;
- another U.S. government agency;
- the Bank for International Settlements;
- the International Monetary Fund;
- the European Central Bank; or
- multilateral development banks.
Certain U.S. government-sponsored enterprise (“GSE”) debt securities (see Article, Summary of the Government Sponsored Enterprise (GSE) Related Program).
Certain foreign government debt securities.
Certain corporate debt securities.
Certain listed equities.
Gold.

For purposes of the initial margin requirements, non-cash collateral or cash collateral denominated in a currency other than US dollars or the currency in which payment obligations under the swap are required to be settled are subject to additional haircuts. The collateral haircuts are designed to guard against the possibility that the value of posted initial margin collateral could decline during the period that a defaulted swap position is being closed out by a CSE.

Appendix B of the revised proposal specifies applicable initial margin collateral haircuts. The value of initial margin collateral that is calculated according to Appendix B would be calculated as follows: The value of initial margin collateral for any collateral asset class is equal to the product of the total value of collateral in any asset class and one minus the applicable haircut expressed in percentage terms. The total value of all initial margin collateral is calculated as the sum of the value of each type of collateral asset.

Appendix B: Initial Margin Haircuts
Asset Class	Haircut (% of market value)
Cash in same currency as swap obligation	0
Eligible government and related (e.g., central bank, multilateral development bank, GSE securities identified in §_.6(a)(2)(iii)) debt: residual maturity less than one year	0.5
Eligible government and related (e.g., central bank, multilateral development bank, GSE securities identified in §_.6(a)(2)(iii)) debt: residual maturity between one and five years	2
Eligible government and related (e.g., central bank, multilateral development bank, GSE securities identified in §_.6(a)(2)(iii)) debt: residual maturity greater than five years	4
Eligible corporate (including eligible GSE debt securities not identified in §_.6(a)(2)(iii)) debt: residual maturity less than one year	1
Eligible corporate (including eligible GSE debt securities not identified in §_.6(a)(2)(iii)) debt: residual maturity between one and five years	4
Eligible corporate (including eligible GSE debt securities not identified in §_.6(a)(2)(iii)) debt: residual maturity greater than five years	8
Equities included in S&P 500 or related index	15
Equities included in S&P 500 Composite or related index but not S&P 500 or related index	25
Gold	15
Additional (additive) haircut on asset in which the currency of the swap obligation differs from that of the collateral asset	8

Margin Collection from Nonfinancial Commercial End Users under the Revised Proposal

In accordance with Title VII and international requirements to establish uncleared swap margin requirements regardless of counterparty type, the revised proposal would, technically, require CSEs to collect and post margin in connection with any uncleared swaps they enter into with nonfinancial commercial end users. These requirements, however, are quantitatively and qualitatively different from the margin requirements for swaps entered into with financial end users. Specifically, swaps entered into with nonfinancial commercial end users would not be subject to specific, numerical margin requirements. Rather, these swaps would only be subject to initial and variation margin requirements at such times, in such forms, and in such amounts, if any, that the CSE determines necessary to address the credit risk posed by the counterparty and the transaction.

There are currently cases where a swap entity does not collect initial or variation margin from nonfinancial end users because it has determined that margin is not needed to address the credit risk posed by the counterparty or the transaction. In such cases, the revised proposal would not require a change in current practice. The agencies believe that these requirements are consistent with the Dodd-Frank Act and appropriately reflect the low level of risk presented by most nonfinancial end users.

Concerns Regarding the Re-Proposed Rules

The revised proposal, like the original proposal, would require banks to post initial margin collateral to one another in connection with uncleared swaps between them, which has not traditionally been market practice. Opponents of the original uncleared bank swap margin proposal estimated that such a rule could tie up several hundred billion dollars of bank capital in margin collateral accounts. In a July 2011 joint comment letter to regulators on the joint margin proposal, ISDA and SIFMA cited a study by the OCC which estimated that $2 trillion in new margin collateral would have to be set aside under the joint margin proposal.

It is also noteworthy that the rules do not require CSEs to post variation margin to nonfinancial commercial end-user uncleared swap counterparties. Because of this, CSEs will continue to be able to negotiate one-way collateral posting with these end-user counterparties under these swaps. In this regard, the revised proposal, like the original proposal, does not provide protection for nonfinancial commercial end users against the threat of a dealer failure.

Revised Corollary CFTC Proposal for Uncleared Swaps of Nonbanks

On September 17, 2014, the CFTC re-proposed rules on margin requirements for uncleared swaps for SDs and MSPs that are not subject to regulation by the five US prudential bank regulators. The CFTC consulted with these regulators as well as with the SEC in developing its re-proposed rules, which were originally proposed in 2011. The CFTC's re-proposed rules are very similar to the rules re-proposed by the prudential regulators and are designed to align with international standards issued in 2013 by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) (see Legal Update, Final Global Margin Rules for Uncleared Derivatives Released by International Regulators).

SEC Proposal for Uncleared SBS Margin

Note that, in 2012, the SEC also released a proposal under Title VII covering margin collateral collection requirements for uncleared SBS. For more information, see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC: Uncleared Security-based Swap Margin Requirements.

Compliance Dates

All uncleared swaps to which a CSE becomes a party on or after the applicable compliance date for the revised proposal would be subject to the re-proposed rules.

Variation margin requirements would become effective on December 1, 2015.

Initial margin requirements would be subject to a phase-in schedule that ranges from December 1, 2015 to December 1, 2019 depending on the average daily aggregate notional amount of uncleared swaps, uncleared SBS, foreign exchange forwards and foreign exchange swaps of the CSE and its counterparty for June, July and August of each year.

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