Final Uncleared Swaps Margin Rules for Banks Adopted by US Bank Regulators

Practical Law Legal Update w-000-7088 (Approx. 11 pages)

Final Uncleared Swaps Margin Rules for Banks Adopted by US Bank Regulators

by Practical Law Finance

Variation Margin (VM)

The final rule generally requires a CSE to collect and post VM for swaps with a swap entity or a financial end user, regardless of whether the financial end user has a material swaps exposure. The VM posted must be in an amount that is at least equal to the increase or decrease in the value of the swap since the counterparties' previous exchange of VM.

The final rule does not permit a CSE to adopt a threshold amount below which it need not collect or post VM on swaps with swap entity and financial end user counterparties. CSEs must collect or post VM with swap entities (which, as noted above, are other CSEs in their capacity as counterparty to a CSE) and financial end user counterparties on at least a daily basis.

Initial Margin

Similar to the re-proposed rules, the final rule requires CSEs to calculate their minimum IM requirements by using either:

A standardized margin schedule where IM would be calculated according to a standardized look-up table, which requires IM posting based on type and duration of swap (see table in Appendix A of the final rule, reproduced below). The standardized margin schedule allows for certain types of netting and offsetting of exposures.

Standardized Minimum Initial Margin Requirements for Uncleared Swaps and Uncleared SBS
Asset Class	Gross Initial Margin (% 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

An internally created risk-based approach, approved by prudential regulators, that would establish initial and VM requirements for CSEs (for details on an important proposal in this area, see Practice Note, The New ISDA® Credit Support Annexes and Global Margin Compliance for Uncleared Swaps: The ISDA Standard Initial Margin Model (SIMM™)).

IM is calculated daily and posted based on the previous day's exposure.

Initial Margin Threshold

The final rule does not require a CSE to collect or post IM to the extent that the aggregate un-margined exposure either to or from its counterparty remains below $50 million. This has been decreased from $65 million in the re-proposal.

This IM threshold applies on a consolidated entity level. It will be calculated across all non-exempted, non-cleared swaps between a CSE and its affiliates on the one hand, and the counterparty and the counterparty's affiliates on the other.

Dealer-to-Dealer Posting

The final rule requires CSEs to post and collect IM on uncleared swaps entered into with:

Swap entities (other CSEs). CSEs must collect and post IM with one another at least the amount required under the final rule.
Financial end users (including funds) that have material swaps exposure, which is at least $8 billion in aggregate notional amount of uncleared swaps. A CSE transacting with a financial end user with a material swaps exposure must collect at least the amount of IM required by the final rule and must post at least the amount of IM that the CSE would be required by the final rule to collect if the covered swap entity were in the place of the counterparty.

The final rule permits a CSE to adopt a maximum IM threshold amount of $50 million, below which it need not collect or post IM from or to swap entities and financial end users with material swaps exposures.

The final rule also requires CSEs to post VM with another swap entity or a financial end user (regardless of whether the financial end user has a material swaps exposure) based on mark-to-market exposure of the parties under the transaction.

Inter-Affiliate Margin

Significantly, in contrast to the re-proposed rules, the final rule requires that CSEs collect IM from their affiliate counterparties but does not require that CSEs post IM to their affiliate counterparties, other than to affiliate counterparties that are also CSEs required to collect.

In other words, the final rule does not require full bilateral margin from all affiliate counterparties. The CFTC notes that this is expected to cut collateral demands by billions of dollars across the banking industry in comparison to the re-proposed rules, which would have required both sides to post collateral when two affiliates of the same firm transact with one another. However, this part of the rule has already been the subject of market criticism, as the industry had hoped not to tie up IM in affiliate transactions.

The final rule includes an inter-affiliate IM threshold amount which is an aggregate credit exposure of $20 million resulting from all uncleared swaps and uncleared SBS between the CSE and the affiliate.

Collateral Segregation

Under the final rule, a CSE must require that any collateral other than VM that it posts to its counterparty (even collateral in excess of that required by the final rule) be segregated at one or more third-party custodians, which include entities that are not:

The CSE.
The counterparty.
Affiliates of the CSE or the counterparty.

This requirement applies to IM posted by a CSE (as well as any other collateral that is not VM) that is not required by the final rule but is posted by a CSE for other reasons, including:

Under a negotiated arrangement with its counterparty.
IM posted to a financial end user that does not have material swaps exposure.
IM posted to another CSE even though the amount was less than the $50 million IM threshold amount.

The final rule also requires a CSE to place the IM it collects (up to the amount required by the final rule) from a swap entity or a financial end user with material swaps exposure at a third-party custodian. The final rule sets out detailed specifications for the tri-party custodial agreement that must be in place to govern this arrangement, which also must prohibit rehypothecation of the collateral held by the custodian or any other party.

Eligible Collateral

The final rule limits the types of collateral that are eligible to be used to satisfy both the initial margin and VM requirements.

Eligible Collateral for Initial Margin

Eligible collateral for IM includes:

Cash.
Debt securities that are issued or guaranteed by:
- the US Department of Treasury or by another US government agency;
- the Bank for International Settlements;
- the International Monetary Fund;
- the European Central Bank;
- multilateral development banks;
- certain US government-sponsored enterprises ("GSEs"); and
- certain foreign governments.
Certain corporate debt securities.
Certain listed equities.
Shares in certain pooled investment vehicles.
Gold.

Appendix B of the final rule provides the following table of haircuts for eligible IM non-cash collateral. The collateral listed in the lefthand column is discounted by the percentage haircut in the righthand column. Cash is valued at 100% – a 0% haircut.

Margin Values for Eligible Non-Cash Margin Collateral
Asset Class	Discount (%)
Eligible government and related (e.g., central bank, multilateral development bank, GSE) debt securities identified in §_.6(a)(2)(iv) or §_.6(b)(5): residual maturity less than one year	0.5
Eligible government and related (e.g., central bank, multilateral development bank, GSE) debt securities identified in §_.6(a)(2)(iv) or §_.6(5): residual maturity between one and five years	2.0
Eligible government and related (e.g., central bank, multilateral development bank, GSE) debt securities identified in §_.6(a)(2)(iv) or §_.6(b)(5): residual maturity greater than five years	4.0
Eligible GSE debt securities not identified in §_.6(a)(2)(iv) or §_.6(b)(5): residual maturity less than one year	1.0
Eligible GSE debt securities not identified in §_.6(a)(2)(iv) or §_.6(b)(5): residual maturity between one and five years	4.0
Eligible GSE debt securities not identified in §_.6(a)(2)(iv) or §_.6(b)(6)(i): residual maturity greater than five years	8.0
Other eligible publicly traded debt: residual maturity less than one-year	1.0
Other eligible publicly traded debt: residual maturity between one and five years	4.0
Other eligible publicly traded debt: residual maturity greater than five years	8.0
Equities included in S&P 500 or related index	15.0
Equities included in S&P 1500 Composite or related index but not S&P 500 or related index	25.0
Gold	15.0

So, for example, $1 worth of gold would have a value of $0.85 if posted as IM collateral.

Eligible Collateral for Variation Margin

Eligible collateral for VM depends on the type of counterparty the CSE is facing in its swap transaction.

On the one hand, for swaps between a CSE and another swap entity, eligible collateral for VM is limited to only immediately available cash funds denominated in:

US dollars.
Another major currency.
The currency of settlement for the swap.

When a CSE faces financial end user counterparties, on the other hand, the CSE may exchange VM in any of the same forms of collateral as the final rule permits for IM collateral (see the list and table above for eligible IM non-cash collateral).

When determining collateral values for purposes of satisfying the final rule's VM requirements, non-cash collateral is subject to the same haircut listed in the table above for eligible IM collateral.

The limits on eligible collateral and the haircuts under the table above do not apply to margin collected or posted in excess of what is required by the rule.

Swaps Excluded from the Final Rule

The regulators have also adopted, and are seeking comment on, an interim final rule (IFR), released simultaneously with the final rule. Under the IFR, the final rule does not apply, and CSEs therefore do not have to post margin for:

Uncleared swaps of financial institutions with $10 billion or less in total assets that enter into swaps for hedging purposes. This includes small banks.
Uncleared swaps that qualify for an exception from mandatory Title VII clearing under Section 2(h)(7)(A) of the Commodity Exchange Act (CEA) or Section 3C(g)(1) of the Securities Exchange Act (Exchange Act) – that is, swaps entered into by commercial end users for purposes of hedging commercial risk (see Practice Note, The Dodd-Frank Act: The Commercial End-user Exception to the Mandatory Swap Clearing Requirement).

The IFR is effective April 1, 2016. Comments on the IFR should be received on or before January 31, 2016.

Further, under the final rule, certain transactions between CSEs and "other counterparties" (defined as including foreign sovereigns and nonfinancial end users that do not have a material swaps exposure) are exempt from the margin requirements. Specifically, the margin requirements do not apply, and CSEs therefore do not have to post margin, to uncleared swaps with a counterparty that:

Qualifies for an exception from clearing under Section 2(h)(7)(A) of the CEA or Section 3C(g)(1) of the Exchange Act (e.g., a nonfinancial entity using the uncleared swap to hedge or mitigate commercial risk, certain small financial institutions, and captive finance companies (CFCs)).
Qualifies for an exemption from clearing under Section 4(c)(1) of the CEA for cooperative entities that would otherwise be subject to the requirement to clear.
Satisfies the criteria for the affiliate exception from clearing pursuant to Section 2(h)(7)(D) of the CEA or Section 3C(g)(4) of the Exchange Act for treasury affiliates that act as agent for other affiliates.

The rules encourage CSEs to continue with the current practice of collecting IM or VM at such times and in such forms and amounts (if any) as the CSE determines appropriate in its overall credit risk management of the swap entity's exposure to the customer.

The agencies note in the rule that the rule establishes only minimum requirements with respect to initial and VM. Nothing in the final rule is intended to prevent or discourage a CSE from collecting or posting margin in amounts greater than is required under the final rule.

Corollary Rules for Nonbanks

The CFTC is currently drafting a parallel rule, based on its re-proposed rule, which covers SDs and MSPs not covered by the joint final rule (see Legal Update, CFTC Re-proposes Corollary Dodd-Frank Margin Rules for Uncleared Swaps). The final CFTC rules are expected by year end. The SEC has also released proposed rules on uncleared SBS margin requirements for CSEs not covered by the joint final rule (see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC).

Compliance Dates

The final rule and the IFR are technically effective on April 1, 2016. However, phase-in of the final rule will not begin until September 2016. The implementation schedule is in line with cross-border harmonization efforts in this area and is consistent with the September 2013 BCBS/IOSCO international framework (see Legal Update, Joint IOSCO and BCBS Final Framework for Margin Requirements for Non-Centrally Cleared Derivatives).

Compliance Dates for Initial Margin Requirements

As reflected in the table below, the compliance dates for IM exchange range from September 1, 2016, to September 1, 2020, depending on the average daily aggregate notional amount of uncleared swaps, uncleared SBS, foreign exchange (FX) forwards, and FX swaps of the CSE and its counterparty (collectively, covered swaps) for each business day in March, April, and May of that year.

Compliance Date	Initial Margin Requirement
September 1, 2016	Initial margin exchange is required for a covered swap entered into by a CSE where both (i) the CSE combined with all its affiliates and (ii) its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps outstanding for March, April, and May of 2016 that exceeds $3 trillion.
September 1, 2017	Initial margin exchange is required for a covered swap entered into by a CSE where both (i) the CSE combined with all its affiliates and (ii) its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps outstanding for March, April, and May of 2017 that exceeds $2.25 trillion.
September 1, 2018	Initial margin exchange is required for a covered swap entered into by a CSE where both (i) the CSE combined with all its affiliates and (ii) its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps outstanding for March, April, and May of 2018 that exceeds $1.5 trillion.
September 1, 2019	Initial margin exchange is required for a covered swap entered into by a CSE where both (i) the covered swap entity combined with all its affiliates and (ii) its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps outstanding for March, April, and May of 2019 that that exceeds $0.75 trillion.
September 1, 2020	Initial margin exchange is required for a CSE with respect to covered swaps entered into with any other counterparty.

Compliance Dates for Variation Margin (VM) Requirements

As reflected in the table below, the compliance dates for VM exchange are September 1, 2016 and March 1, 2017. The compliance dates also depend on the average daily aggregate notional amount of covered swaps of the CSE and its counterparty for each business day in March, April, and May of that year.

Compliance Date

VM Requirements

September 1, 2016

VM exchange is required for a CSE where both (i) the CSE combined with all its affiliates and (ii) its counterparty combined with all its affiliates have an average daily aggregate notional amount of covered swaps for March, April, and May of 2016 that exceeds $3 trillion.

March 1, 2017

VM exchange is required for a CSE with respect to covered swaps entered into with any other counterparty.

"ISDA" and "ISDA SIMM" are registered trademarks of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this resource.

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