Regulators Propose Conflicting Rules on Uncleared Swap Margin Requirements
An update on rules proposed under the Dodd-Frank Act by the Federal Reserve Board, the FDIC and other agencies, and separate rules proposed by the CFTC, imposing margin requirements on many uncleared swap trades. The rules contain divergent margin collateral requirements for nonfinancial end users of uncleared derivatives.
On April 12, 2011, several regulators, including the Federal Reserve Board and the FDIC, issued proposed rules under the Dodd-Frank Act (the Joint Proposed Rules) requiring most banks and financial institutions that are registered swap dealers, security-based swap dealers, major swap participants or major security-based swap participants to collect margin collateral from their uncleared-swap counterparties. The Joint Proposed Rules set out initial and variation margin requirements that are based on the type of swap counterparty to the uncleared swap.
The CFTC also proposed rules (the CFTC Proposed Rules) requiring non-security-based swap dealers (SDs) and non-security-based major swap participants (MSPs) to collect margin collateral from their swap counterparties. While these rules are similar to the Joint Proposed Rules, the CFTC's rules would not require SDs and MSPs to collect margin collateral from non-financial end users. The Joint Proposed Rules would include this requirement.Close speedread
On April 12, 2011, several regulators, including the Federal Reserve Board and the FDIC, issued proposed rules under the Dodd-Frank Act (the Joint Proposed Rules) requiring most banks and financial institutions that are registered swap dealers, security-based swap dealers, major swap participants or major security-based swap participants to collect margin collateral from their uncleared-swap counterparties. The Joint Proposed Rules set out initial and variation margin requirements that are based on the type of counterparty to the uncleared swap.
The CFTC also proposed rules (the CFTC Proposed Rules) requiring non-security-based swap dealers (SDs) and non-security-based major swap participants (MSPs) to collect margin collateral from their swap counterparties. While these rules are similar to the Joint Proposed Rules, the CFTC Proposed Rules would not require SDs and MSPs to collect margin collateral from non-financial end users. The Joint Proposed Rules would include this requirement.
The Joint Proposed Rules
The Joint Proposed Rules would impose initial and variation (or ongoing) margin requirements on the uncleared swaps of covered swap entities (CSEs). CSEs include SDs, MSPs, security-based swap dealers and security-based major swap participants that are regulated by one or more of the agencies that issued the Joint Proposed Rules. These regulators are the Federal Reserve Board, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency and the Office of the Comptroller of the Currency. The Joint Proposed Rules also impose certain uncleared-swap-related capital requirements on these entities.
The Joint Proposed Rules impose different margin-collateral requirements on counterparties to swaps with CSEs depending on the risk profile of the counterparty. Broadly, the rule distinguishes among uncleared swaps between a CSE and:
Another SD, MSP, security-based swap dealer or major security-based swap participant (each, a swap entity).
A high-risk financial end user of derivatives. This category includes commodity pools, private funds, employee benefit plans, any entity predominantly engaged in the business of banking, any vehicle that would be a commodity pool or private fund if organized under US law, and any other party that one of the applicable regulators may designate. This category also includes any financial end user that does not satisfy the low-risk financial end user criteria.
A low-risk financial end user of derivatives. This category includes any financial end user that meets the following three criteria:
its aggregate swap position under all of its outstanding swaps falls below a specified "significant swaps exposure" threshold of $2.5 billion in daily average aggregate uncollateralized "outward" uncleared non-security-based swap exposure or $4 billion in daily average aggregate uncollateralized "outward" uncleared non-security-based swap exposure plus daily average aggregate potential "outward" uncleared non-security-based swap exposure ($1 billion and $2 billion, respectively, for uncleared security-based swap exposure);
it predominantly uses swaps to hedge or mitigate the commercial risks of its business activities; and
it is subject to capital requirements established by a prudential regulator or state insurance regulator.
A non-financial end user of derivatives.
The Joint Proposed Rules would require a CSE to collect initial margin collateral from its uncleared-swap counterparties, which may be calculated by using either:
An internal margin model that meets certain criteria and has been approved by the relevant prudential regulator.
A standardized table, a working draft of which is contained within the proposal (shown below), which lists minimum initial margin amounts that must be collected. These amounts are to be calculated on a per-swap basis as a percentage of the notional amount of the swap or security-based swap being entered into. The table, including bracketed proposed initial margin amounts, appears at Appendix A of the proposal and reads as follows:
Standardized Minimum Initial Margin Requirements for Non-cleared Swaps and Non-cleared Security-Based Swaps
Initial Margin Requirement
(% of Notional Exposure)
Credit: 0-2 year duration
Credit: 2-5 year duration
Credit: 5+ year duration
Interest Rate: 0-2 year duration
Interest Rate: 2-5 year duration
Interest rate: 5+ year duration
Note that the rules are margin-collection-based, that is, they focus on the margin-collection responsibilities of CSEs rather than margin-posting obligations of counterparties. However, the rule still covers uncleared-swap margin requirements for all entities. The amount of initial margin that a creditworthy counterparty must post under the proposed rules will be on the low end of the bracketed per-exposure amounts listed in the above table. Riskier counterparties will obviously need to post margin on the high end of the bracketed range. As a result, it is expected that most major banks and swap dealers that enter into inter-dealer swaps (as well as other creditworthy parties that enter into swaps with CSEs) will be required to post initial margin amounts on the low end of these specified ranges.
A CSE may establish credit exposure limits for its uncleared-swap counterparties that are low-risk financial end users or non-financial end users. Below this limit, the CSE would not be required to collect initial margin from that swap counterparty.
For low-risk financial end users, the maximum threshold amount under which initial margin collateral would not need to be posted would be the lower of:
A hard number that is proposed to be between $15 to $45 million. The regulators are seeking comment on this point and have stated that the final number is likely to be somewhere in the middle of this range.
A percentage of the CSE's tier 1 capital that is proposed to be between 0.1% to 0.3%. The regulators are seeking comment on this point and have stated that the final number is likely to be somewhere in the middle of this range.
Initial margin collateral posting would be subject to a proposed minimum transfer amount of $100,000, meaning no margin must be posted until a counterparty's exposure reaches this amount.
The maximum threshold amount for initial margin collateral posting for uncleared swaps entered into with swap entities and high-risk financial end users is zero, subject to the minimum transfer amount.
The Joint Proposed Rules do not set a limit on the maximum initial margin threshold amount for uncleared swaps entered into with non-financial end users. This does not mean that non-financial end users are exempt from posting initial margin under these rules, but rather that they do not need to post initial margin if their aggregate credit exposure is below the threshold for that end user set by the CSE.
The Joint Proposed Rules also require that CSEs ensure that their uncleared-swap counterparties segregate the initial margin that the CSE posts when entering into a swap transaction with another CSE.
The Joint Proposed Rules also require CSEs to collect variation margin from their uncleared-swap counterparties. Variation margin is the ongoing posting of collateral to cover any new exposure arising from changes in the market value of the parties' positions under the uncleared swap since the trade was executed or last marked to market.
Subject to the minimum transfer amount, a counterparty to an uncleared swap with a CSE must post variation margin in the amount of any positive mark-to-market change to the CSE party's in-the-money position under all of the swaps and security-based swaps between the parties, less the value of all variation margin previously collected but not returned by the CSE. If the CSE is out of the money on an aggregate, net basis, its counterparty need not post variation margin. If the CSE party's net aggregate in-the-money position is reduced, the counterparty does not need to post additional variation margin (and may be entitled to the return of some collateral). Variation margin collateral posting would be subject to a proposed minimum transfer amount of $100,000, meaning no margin must be posted until a counterparty's uncollateralized mark-to-market exposure reaches this amount.
The variation margin requirements under the Joint Proposed Rules are subject to the same maximum thresholds specified under the initial margin credit exposure limits (see Initial Margin). The variation margin threshold is zero for any swap entity, meaning variation margin collateral must be posted by these entities whenever they are out of the money under a swap with a CSE, subject to the minimum transfer amount.
Positions across all uncleared swaps between two parties may be netted for the purposes of determining variation margin to the extent a "qualifying" master netting agreement is in place between the CSE and its counterparty.
A CSE must recalculate and collect variation margin:
Daily for transactions with swap entities and financial end users (both high and low risk).
Weekly for transactions with non-financial end users.
The Joint Proposed Rules list the following types of eligible collateral that may be used to satisfy these initial margin and variation margin requirements:
Immediately available cash.
Certain types of highly liquid, high-quality US government or agency obligations, such as US government bonds. This type of collateral is subject to discounts or minimum haircuts.
Swap-related Capital Requirements
The Joint Proposed Rules also require CSEs to comply with capital requirements (against their outstanding aggregate swap exposure) that are part of their current prudential regulation. The agencies chose not to impose any new capital requirements on CSEs, but noted that they expect to propose changes to capital requirements in accordance with the Basel III framework in the near future (see Article, Basel III: Overview and Implementation in the US (www.practicallaw.com/6-503-9909)).
The regulators request comment on the proposed rule by June 24, 2011.
The CFTC Proposed Rules
The CFTC also proposed rules on margin requirements for uncleared non-security-based swaps entered into by SDs or MSPs that are not regulated by any of the agencies that issued the Joint Proposed Rules.
In a departure from the Joint Proposed Rules, the CFTC Proposed Rules would not require SDs or MSPs to post or collect initial or variation margin from non-financial end users. The CFTC Proposed Rules only require that the SD or MSP enter into a credit support arrangement with their non-financial end user counterparties.
As under the Joint Proposed Rules, the CFTC's margin requirements for uncleared swaps would vary by counterparty and distinguish between financial and non-financial counterparties. Unlike under the Joint Proposed Rules, the CFTC Proposed Rules would require posting and collection of initial and variation margin for each trade between SDs and MSPs. For trades between a SD or MSP and a financial entity, the CFTC Proposed Rules would require the SD/MSP to collect, but not post, initial and variation margin for each trade, subject to thresholds.
Note that while the CFTC Proposed Rules would not apply to security-based swap dealers or major security-based swap participants, the Joint Proposed Rules would apply to all swap entities.
CFTC Initial Margin
Initial margin under the CFTC Proposed Rules would be calculated using any margin model that is approved by the CFTC and is either:
Used by a derivatives clearing organization (DCO) for clearing swaps.
Used by an entity subject to oversight by a prudential regulator.
Made available for licensing to any market participant by a vendor.
If no model is available, initial margin would be calculated by selecting a comparable cleared swap or futures contract and applying a multiplier specified in the rule. Initial margin must cover at least 99% of any 10-day price moves.
CFTC Variation Margin
Variation margin would be required to cover any new exposure arising from changes in the market value of the parties' positions under the uncleared swap since the trade was executed or last marked to market. Variation margin calculations must include an agreement on the methods, procedures, rules and inputs for determining the value of each swap position at any time from execution through termination, maturity or expiration of the swap.
No minimum transfer amount has yet been specified in the CFTC Proposed Rules.
SDs and MSPs may only accept certain assets as initial or variation margin from other SDs and MSPs and from financial entities. It is contemplated that cash and US government bonds will be the primary forms of collateral eligible for posting by these entities under the CFTC Proposed Rules. Non-cash collateral will be subject to haircuts. Non-financial entities may post non-traditional forms of collateral as specified by their credit support agreements.
Under the CFTC Proposed Rules, all posted collateral must be held by a third-party custodian and may not be rehypothecated. SDs and MSPs would be required to offer non-SD/non-MSP counterparties to uncleared swaps the opportunity to have their initial margin collateral segregated.
The CFTC issued a notice in the Federal Register announcing that it is accepting public comments on the CFTC Proposed Rules until July 11, 2011. Update: On July 6, 2012, the CFTC re-opened the comment period for the Proposed Rules in light of a consultative paper on uncleared swap margin collateral matters that was jointly published on July 6 by the Basel Committee on Banking Supervision (BCBS) and IOSCO (www.practicallaw.com/4-386-5634) (see Legal Update, CFTC Extends Comment Period on Uncleared Swap Margin Rules for Swap Dealers and MSPs (www.practicallaw.com/7-520-4376)). It is accepting comments on the proposed rules until September 14, 2012.
For more information on provisions of the Dodd-Frank Act applicable to swaps and derivatives, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives (www.practicallaw.com/3-502-8950). For information on rulemaking activities implementing those provisions, see Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (www.practicallaw.com/3-502-8479).