CFTC Proposes Dodd-Frank Capital Requirements for Swap Dealers and MSPs

Practical Law Legal Update w-004-8410 (Approx. 10 pages)

CFTC Proposes Dodd-Frank Capital Requirements for Swap Dealers and MSPs

by Practical Law Finance

Proposed Capital Requirements for Swap Dealers and MSPs

The NPR includes proposed CFTC Regulation 23.10 which would set out capital requirements for SDs and MSPs (proposed capital rules or proposed rules). The proposed rules are consistent with the SEC's 2012 proposed capital requirements for security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) (see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC).

The proposed rules are also consistent with the prudential regulators' 2013 amendments to the capital requirements for banks and bank holding companies as set out in Section 171 of the Dodd-Frank Act (see Article, The Final US Basel III Capital Framework).

Proposed Capital Requirements for Swap Dealers

The proposed capital rules for SDs require that SDs compute the minimum amount of capital that the SD is required to maintain as well as the actual amount of capital that the SD maintains. The actual amount must be equal to or greater than the SD's minimum capital requirement.

The proposed rules provide details for three alternative capital approaches. SDs elect one of these approaches based upon its corporate structure and operations. The rules also define the capital computations for each approach, including various market-risk and credit-risk charges to determine whether an SD satisfies the minimum applicable capital requirement based on its selected approach.

The three capital approaches for SDs are:

The bank-based approach, which is based on existing bank holding company (BHC) capital rules adopted by the FRB (see Bank-Based Capital Approach). For details on the FRB capital rules, see Article, The Final US Basel III Capital Framework.
The net liquid assets approach, which is based on the existing FCM capital rule in CFTC Regulation 1.17, the existing SEC broker-dealer (BD) capital rule in SEC Rule 15c3-1, and the SEC's proposed capital requirements for SBSDs in proposed SEC Rule 18-1 (see Net Liquid Assets Capital Approach).
The tangible net worth approach, which permits SDs that are "predominantly engaged in non-financial activities" to compute their minimum regulatory capital based on the firm's tangible net worth (see Tangible Net Worth Capital Approach).

SDs are permitted to elect one of these methods depending on the characteristics of the SD, such as whether it is dually registered as an FCM, SBSD, BD, or over-the-counter (OTC) derivatives dealer, or is a subsidiary of a BHC, or is primarily engaged in non-financial activities. All registered SDs must compute their minimum capital requirement (as noted in the first paragraph of this section) and must have some capital approach to adhere to. SDs that are subject to existing capital requirements may remain under those existing requirements if they receive approval from the CFTC, such as through substituted compliance for non-US organized and domiciled SDs.

An SD that is dually registered as swap dealer and an FCM is required to follow the CFTC's proposed capital requirements for FCMs and not these capital requirements for SDs (see Proposed Capital Amendments for FCMs).

The CFTC has also proposed a substituted compliance provision for capital and financial reporting requirements for SDs that are not organized under the laws of the US and are not domiciled in the US. Such non-US SDs may petition the CFTC to satisfy their capital and financial reporting requirements through substituted compliance with the capital and financial reporting requirements of the SD's home jurisdiction.

Bank-Based Capital Approach

The bank-based capital approach is based upon the capital requirements adopted by the FRB for BHCs, which are consistent with the bank capital framework adopted by the Basel Committee on Banking Supervision (BCBS) (see Practice Note, Summary of the Dodd-Frank Act: Securitization: Final Basel and US Risk Capital Rules for Bank Securitization Exposures). This approach requires an SD to maintain a minimum level of regulatory capital that is equal to or in excess of the greater of:

Common equity tier 1 capital, as defined under the BHC regulations in 12 CFR 217.20, equal to $20 million.
Common equity tier 1 capital, as defined under the BHC regulations 12 CFR 217.20, equal to or greater than 8% of the SD's risk-weighted assets.
Common equity tier 1 capital, as defined under 12 CFR 217.20, equal to or greater than 8% of the sum of:
- the amount of uncleared swaps margin, defined as the amount of initial margin (IM) that the SD would be required to collect from a swap counterparty under the CFTC's margin rules for uncleared swaps, aggregated for each of the SD's uncleared swaps;
- the amount of IM that would be required for each of the SD's uncleared SBS, without regard to any IM exemptions or exclusions that the rules of the SEC may provide to such SBS; and
- the amount of IM required by a clearing organization for the SD's cleared proprietary futures, foreign futures, swaps, and SBS; or
The amount of capital required for the SD by the National Futures Association (NFA).

The proposed rules require SDs to include uncleared swaps that have been excluded or exempted from the CFTC's margin requirements when determining the capital requirement. Thus, swaps with commercial end users or affiliates of the SD must be included in capital requirement calculations.

The proposed rules specify that only common equity tier 1 capital would satisfy the SD's minimum capital requirement. This is different from the FRB requirements, which permit a BHC to meet its minimum capital requirements with a combination of common equity tier 1 capital, additional tier 1 capital, and tier 2 capital.

Net Liquid Assets Capital Approach

The net liquid assets capital approach is consistent with the current capital approach for FCMs in CFTC Regulation 1.17 as well as with the SEC's proposed capital rules for SBSDs and current capital requirements for BDs and OTC derivatives dealers.

SDs that elect to comply with the proposed net liquid assets capital approach would be required to compute their tentative net capital (net capital before deductions for market and credit risk), and net capital in accordance with proposed SEC Rule 18a-1 as if the SD were a SBSD registered with the SEC, subject to the modifications below, and maintain a minimum level of net capital equal to or greater than the highest of:

$20 million;
The SD's net capital, defined as the SD's liquid assets less all of the SD's liabilities, equal to or greater than 8% of the sum of:
- the amount of the SD's uncleared swaps margin for each uncleared swap, computed on a counterparty-by-counterparty basis pursuant to CFTC Regulation 23.154;
- the amount of IM that would be required for each of the SD's uncleared SBS, computed on a counterparty-by-counterparty basis pursuant to proposed SEC Rule 18a-3(c)(1)(i)(B), without regard for any amounts that may be excluded or exempted under SEC rules;
- the amount of risk margin requirement for the SD's cleared futures, foreign futures, and swaps; and
- the amount of IM required by a clearing organization for the SD's proprietary cleared SBS; or
The amount of capital required for that SD by the NFA.

Similar to the bank-based capital approach, under this approach, swaps with commercial end users and affiliates of the SD must be included in capital requirement calculations, as the proposed rules require the SD to include swaps that have been exempted or excluded from the CFTC's margin requirements.

In addition, an SD that has received approval to use internal models to compute market risk and credit risk capital charges must maintain a minimum level of tentative net capital equal to $100 million and net capital of $20 million.

SDs electing the net liquid assets capital approach that have not obtained approval to use internal models to compute market risk and credit risk charges must use the standardized capital charges set forth in proposed SEC Rule 18a-1.

For details on the SEC's proposed capital requirements for SBSDs, see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC.

For details on the SEC's broker-dealer capital rules, see Practice Note, Broker-Dealer Registration: Overview.

For details on market risk and credit risk in bank capital requirements, see Practice Note, BCBS Standards and Guidelines: Minimum Capital Requirements for Market Risk.

Tangible Net Worth Capital Approach

Under the proposed rules, SDs that are "predominantly engaged in non-financial activities" would be permitted to elect a capital requirement based upon the SD's tangible net worth. An entity is considered "predominantly engaged in non-financial activities" if both:

Its consolidated annual gross financial revenues in either of its two most recently completed fiscal years represents less than 15% of the consolidated gross revenue in that fiscal year (15% revenue test); and
Its consolidated total financial assets at the end of its two most recently completed fiscal years represents less than 15% of the consolidated total assets as of the end of the fiscal year (15% asset test).

"Financial revenues" and "financial assets" are those revenues or assets that are related to activities that are financial in nature. The CFTC further defines financial activities to include:

Lending, exchanging, transferring, investing for others, or safeguarding money or securities.
Insuring, guaranteeing, or indemnifying against loss or harm, damage or death in any state.
Providing financial, investment, or economic advisory services.
Issuing or selling interests in a pool.
Underwriting, dealing in, or making a market in securities.
Engaging as principal in the investment and trading of certain financial instruments.

An SD electing the tangible net worth approach would have to maintain a tangible net worth, which is generally based upon net equity as determined by US generally accepted accounting principles (GAAP), adjusted to exclude certain intangible assets such as goodwill, in an amount equal to or greater than the highest of:

$20 million plus the amount of the SD's market risk exposure requirement and credit risk exposure requirement, as computed either using internal capital models if the SD has obtained approval from the CFTC or the NFA or by using the standardized deductions under CFTC Regulation 1.17 associated with the SD's swap and related hedge positions that are part of the SD's swap dealing activities;
8% of the sum of:
- the amount of the SD's uncleared swap margin for each uncleared swap computed on a counterparty-by-counterparty basis pursuant to CFTC Regulation 23.154, without regard to any IM exemptions or thresholds that the CFTC regulations may provide;
- the amount of IM that would be required for each of the SD's uncleared SBS, without regard to any IM exemptions or exclusions that SEC rules may provide to such SBS; and
- the amount of IM required by clearing organizations for the SD's cleared proprietary futures, foreign futures, swaps and SBS; or
The amount of net capital required for that SD by the NFA.

In computing its tangible net worth, an SD would be required under the proposed rules to include all liabilities and obligations of any subsidiary or affiliate that the SD guarantees, endorses, or assumes either directly or indirectly.

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Proposed Capital Requirements for MSPs

The proposed rules include capital requirements for MSPs that are not subject to the capital rules of a US prudential bank regulator. Under the proposed rules, an MSP would be required to:

Maintain a positive tangible net worth, as determined in accordance with US GAAP; or
Maintain the amount of capital required by the NFA.

In computing its tangible net worth, an MSP would be required to include all liabilities or obligations of any subsidiary or affiliate that the MSP guarantees, endorses, or assumes either directly or indirectly. This tangible net worth approach is consistent with the SEC's proposed capital rule for MSBSPs (see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC).

Proposed Capital Amendments for FCM Swap Dealers

The CFTC is proposing to amend the minimum adjusted net capital requirements for FCMs that are also registered as SDs. These requirements are currently set out in CFTC Regulation 1.17. Under the proposed amendments, an FCM that is also an SD would be required to maintain adjusted net capital (current assets less all current liabilities) equal to or greater than the highest of:

$20 million;
8% of the sum of the following:
- the total risk margin for positions carried by the FCM in customer and non-customer accounts;
- the total IM that the FCM is required to post with a clearing agency or broker for SBS carried in customer and non-customer accounts;
- its total uncleared swaps margin, or the amount of IM that an SD would be required to collect under the CFTC's uncleared swaps margin rules;
- the total IM that the FCM is required to post with a broker or clearing organization for all proprietary cleared swap positions carried by the FCM;
- the total IM computed pursuant to SEC Rule 18a-3(c)(1)(i)(B) for all proprietary uncleared security-based swap positions carried by the FCM, without regard to any exemptions or exclusions that may be available to the FCM under the SEC's proposal; and
- the total IM that the FCM is required to post with a broker or clearing agency for its proprietary cleared security-based swaps.
The amount of net capital required by the SEC if the FCM were a BD; or
The amount of capital required for the FCM by the NFA.

The increase to $20 million from the current minimum capital requirement of $1 million is consistent with the CFTC's proposed requirements for SDs and MSPs.

The proposed amendments specify that in computing the uncleared swaps margin for purposes of these capital requirements, FCMs would be required to include IM collected from commercial end users, affiliated counterparties, exempt foreign exchange swaps, and foreign exchange forwards as if these swaps and transactions were not exempt from the CFTC's margin requirements.

For FCMs that are dually registered as BDs, referred to as alternative net capital firms (ANC firms), the proposed rule provides:

A schedule of standardized market risk capital deductions. The proposed standardized market-risk capital deductions used for computing market-risk capital charges are the same as the standardized market-risk capital deductions proposed by the SEC as part of its 2012 proposed rules on capital requirements for SBSDs and MSBSPs (see 17 CFR 240.15c3-1). The proposed standardized deductions apply to interest rate swaps, foreign exchange swaps, commodity swaps, and all other uncleared swaps. For credit default swaps (CDS), the CFTC is proposing standardized deductions based on a "maturity grid" that considers the length of time to maturity and the amount of the current offered basis point spread on the CDS.
A model-based approach for market-risk and credit-risk capital charges. The model-based approach permits the use of approved internal models to calculate market and credit risk capital charges instead of the standardized capital charges. FCMs that use internal models would be required to maintain capital of $100 million prior to the imposition of market risk and credit risk capital charges.

The capital charges require an FCM to set aside a minimum level of capital to cover potential future losses in the swap's value. In the event of a loss, this capital may have to be paid to the swap counterparty in variation margin (VM) or otherwise.

The CFTC is also proposing to extend the use of capital models to FCMs that are dually registered as SDs but that are not ANC firms. These FCMs would seek approval to use market risk and credit risk models and must maintain a minimum level of net capital of $100 million and a minimum level of adjusted net capital of $20 million.

Application for Approval of Internal Models

Under the proposed rules, SDs subject to the bank-based capital approach, the net liquid assets capital approach, or the tangible net worth capital approach are subject to market-risk and credit-risk capital charges on their swaps when computing regulatory capital.

The CFTC is proposing to allow CSEs to apply to the CFTC or the NFA for approval to use internal models for purposes of computing regulatory capital instead of using standardized deductions. The proposed rules incorporate requirements adopted by the FRB for BHCs and are comparable to the SEC's existing capital model requirements for OTC derivatives dealers and ANC BDs.

The proposed rule details the requirements for the following models, if used as internal models to satisfy capital requirements:

Value at risk (VaR) models.
Stressed VaR models.
Specific risk models.
Incremental risk models.
Comprehensive risk models.
Credit risk models.

Liquidity Requirements

Under the proposed rules, SDs that elect the bank-based and net liquid asset capital approaches would be subject to liquidity requirements and certain equity withdrawal restrictions. SDs that are registered FCMs would be subject to liquidity requirements as well.

For the bank-based approach, the liquidity requirement is based on requirements established by the prudential regulators.

For the net liquid asset approach, the liquidity requirement is based on proposed SEC liquidity requirements.

SDs that are subject the bank-based capital approach would be required to:

meet the liquidity coverage ratio requirements in 12 CFR 249;
maintain each day an amount of high quality liquid assets (HQLAs), which are assets that are unencumbered by liens and other transfer restrictions (as defined in 12 CFR 249) that is no less than 100% of the SD's total net cash outflows over a prospective 30 calendar-day period;
establish a contingency funding plan; and
obtain CFTC approval prior to transferring HQLAs to affiliates or parents if the result would result in the SD not being able to comply with the liquidity coverage ratio requirement.

SDs that are subject to the net liquid assets capital approach would be required to:

perform a liquidity stress test at least monthly that takes into account certain assumed conditions lasting for 30 consecutive days;
maintain at all times liquidity reserves based on the results of the liquidity stress tests; and
establish a contingency funding plan.

Financial Reporting, Recordkeeping and Notification Requirements

The proposed rules would require SDs and MSPs to report monthly financial statements and keep current books and records in accordance with US GAAP, or, if permitted, in accordance with the International Financial Reporting Standards (IFRS). Specifically, the proposed rules provide that:

SDs and MSPs must file a monthly unaudited financial report and annual audited financial report with the CFTC and NFA.
SDs and MSPs that are dually registered as FCMs or registered with the SEC as a BD may satisfy the reporting requirements by submitting a CFTC Form 1-FR-FCM or its application SEC Financial and Operational Combined Uniform Single (FOCUS) report.
SDs and MSPs that are subject to US prudential bank regulations and have existing financial reporting requirements under the prudential regulations will have quarterly financial reporting requirements under the proposed rule.
SDs and MSPs must provide quarterly public disclosure of some of the proposed required financial reporting.

In addition, all SDs and MSPs will be subject to certain notification requirements pertaining to the changes in the respective capital positions and will be required to provide weekly position and margin information.

For more information on capital requirements, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Dodd-Frank and Related Risk Capital Requirements for Derivatives Exposures.

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