The Prudential Regulators and the CFTC release final initial and variation margin rules for uncleared swaps and security-based swaps.

On October 22, 2015, the Federal Deposit Insurance Corporation, the Department of the Treasury (the Office of the Comptroller of the Currency), the Board of Governors of the Federal Reserve System, the Farm Credit Administration and the Federal Housing Finance Agency (collectively, the "Prudential Regulators") released final rules and accompanying interpretive guidance setting out the Prudential Regulators' initial and variation margin requirements applicable to uncleared swaps and security-based swaps (the "PR Final Margin Rules").24 Subsequently, on December 16, 2015, the Commodity Futures Trading Commission (the "CFTC") released final rules and accompanying interpretive guidance setting out the CFTC's initial and variation margin requirements applicable to uncleared swaps ("CFTC Final Margin Rules").25

The finalisation of these rules substantially implements one of the key regulatory reforms contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act by requiring each registered swap dealer ("SD"), major swap participant ("MPS"), security-based swap dealer ("SBSD") and major security-based swap participant ("MSBSP") that enters into uncleared swaps and security-based swaps to exchange both initial margin ("IM") and variation margin ("VM") with certain of their counterparties with the aim of protecting such entities from the risks arising from these transactions and to also generally cushion the US financial system at times of systemic stress.

We set out below a brief summary of these rules. For a more detailed explanation, please see our client alert on these rules (Prudential Regulators and CFTC: Final Margin Rules for Uncleared Swaps).

Covered Swap Entities

The PR Final Margin Rules apply to a registered SD, MSP, SBSD and MSBSP that is regulated by a Prudential Regulator. SDs and MSPs that are not regulated by a Prudential Regulator aresubject to the CFTC Final Margin Rules, whilst SBSDs and MSBSPs that are not regulated by a Prudential Regulator are subject to the initial and variation margin requirements of the Securities and Exchange Commission ("SEC"). Both the PR Final Margin Rules and the CFTC Final Margin Rules refer to such entities as a "covered swap entity" or "CSE". We have used the term "CSE" herein.

Covered Swaps

The PR Final Margin Rules apply to swaps and security-based swaps that are not cleared with a derivatives clearing organisation registered with the CFTC (or exempted from such registration) or a clearing agency registered with the SEC (or exempted from such registration), subject to certain exceptions. The CFTC Final Margin Rules apply to swaps (not security-based swaps) that are not cleared with a derivatives clearing organisation registered with the CFTC (or exempted from such registration).

We have referred to swaps and security-based swaps that are subject to the PR Final Margin Rules or the CFTC Final Margin Rules as "Covered Swaps".

Covered Counterparties

The nature of a CSE's obligations under the PR Final Margin Rules and the CFTC Final Margin Rules, as applicable, will depend on which of the following categories its counterparties fall into:

  • (a) Swap Entities;
  • (b) Financial End Users with a Material Swaps Exposure;
  • (c) Financial End Users without a Material Swaps Exposure;
  • (d) Affiliates of a CSE; or
  • (e) Other Counterparties.

Swap Entities

A Swap Entity is, with respect to the PR Final Margin Rules, a registered SD, MSP, SBSD and MSBSP (irrespective of whether it is regulated by a Prudential Regulator, the CFTC or the SEC) and, with respect to the CFTC Final Margin Rules, a registered SD and MSP.

Financial End Users

The definition of Financial End User broadly captures entities that engage in financial activities that are subject to US Federal or State regulation, including deposit-taking and lending, securities and swaps dealing, investment advisory activities and asset management as well as certain non-bank lending and retail payment firms. It also includes commodity pools and other entities or arrangements that raise or accept money from investors or clients for investing or trading in loans, swaps, securities or other assets as well as any entity that would be a Swap Entity or Financial End User if it were organised in the US. Sovereign governments (including its agencies, departments and ministries), central banks, multilateral development banks, the Bank for International Settlements, certain captive finance companies and certain eligible treasury affiliates are excluded from the definition.

A Financial End User has a "Material Swaps Exposure" when it and its affiliates, together, have an average daily aggregate notional amount of uncleared swaps, security-security based swaps, foreign exchange forwards, and foreign exchange swaps that are not excluded under TRIPRA (see below) with all counterparties (including its affiliates but without double counting) for June, July and August of the previous calendar year that is more than US$8 billion.

Other Counterparties

The Final Margin Rules only apply to Covered Swaps entered into by a CSE with a Swap Entity or a Financial End User. Covered Swaps entered into by a CSE with any other counterparty (including those excluded under TRIPRA, see below) are not subject to the PR Final Margin Rules or the CFTC Final Margin Rules.

The Terrorism Risk Insurance Program Reauthorisation Act of 2015 ("TRIPRA") provides for additional exclusions similar to those provided to cleared transactions for certain commercial end users that enter into swaps and security-based swaps that are not subject to mandatory clearing but would otherwise have been subject to compliance with the PR Final Margin Rules or the CFTC Final Margin Rules. The effect of TRIPRA is to completely exclude certain swaps and security-based swaps entered into by a CSE with the applicable counterparties from the PR Final Margin Rules and the CFTC Final Margin Rules.

Affiliates of a CSE

Both the PR Final Margin Rules and the CFTC Final Margin Rules each include special rules that provide full or partial relief for certain affiliate transactions from the requirement to post and collect IM. However, as the special rules do not apply to VM, VM will need to be posted and collected with all affiliate counterparties in accordance with both the PR Final Margin Rules and the CFTC Final Margin Rules.

Margin Requirements

Initial Margin Requirements

The Prudential Regulators and the CFTC have both adopted a collect and post approach which will require each CSE to:

  • (a) collect IM from each counterparty that is a Swap Entity and Financial End User with a Material Swaps Exposure; and
  • (b) post IM to each counterparty that is a Financial End User with a Material Swaps Exposure;

in each case, commencing on or before the end of the business day following the day of execution of the particular Covered Swap (which is adjusted to accommodate circumstances where the counterparties to a particular Covered Swap do not observe the same business day) and thereafter collect and post on a daily basis until the Covered Swap is terminated or expires.

A CSE is required to calculate IM for a Covered Swap using either an approved risk-based model or a table of standardised minimum gross initial margin requirements. The required amount of IM would be the amount calculated pursuant to the applicable approach minus a threshold amount of up to US$50 million (which is applied with respect to all Covered Swaps across the CSE's consolidated group, not individually to each entity). This IM amount would be a minimum requirement and the parties may negotiate a higher amount.

Variation Margin Requirements

Each CSE must collect VM from, and post VM to, each counterparty that is a Swap Entity or a Financial End User (irrespective of whether the counterparty has a Material Swaps Exposure), commencing on or before the end of the business day following the day of execution for each Covered Swap with that counterparty and thereafter collect and post not less than daily until the termination or expiry of the Covered Swap. The amount of VM to be posted or collected with respect to a Covered Swap is the amount equal to:

  • (a) the cumulative mark-to-market change in value to a Covered Swap as determined pursuant to the applicable documentation (i.e., mid-market prices, if consistent with the agreement of the parties); less
  • (b) the value of all VM previously collected; plus
  • (c) the value of all VM previously posted.

The CSE must collect this amount if it is positive, and post this amount if it is negative.

Minimum Transfer Amount

A CSE is only required to collect or post IM or VM when the combined amount of both IM and VM required to be collected or posted exceeds US$500,000. This requirement only affects the timing of margin transfers, not the amount—that is, once the threshold is crossed, the full amount of IM and VM is required to be transferred.

Netting Arrangements

Where more than one Covered Swap is executed pursuant to an eligible master netting agreement (for example, a 1992 or 2002 ISDA Master Agreement), the CSE is permitted to calculate IM and VM on an aggregate basis with respect to all Covered Swaps governed by such agreement.

A CSE is entitled to maintain multiple netting portfolios under a single eligible master netting agreement (for example, through the use of multiple credit support annexes). This facilitates the ability of parties to document two separate netting sets, one for Covered Swaps and another for swaps and security-based swaps that are not subject to the PR Final Margin Rules and the CFTC Final Margin Rules.

Collateral

Eligibility

The types of collateral eligible for VM will depend on the type of counterparty, whilst eligible collateral for IM applies across all counterparty types. The list below sets out a summary of the eligibility requirements.

  • Asset Class: US dollars

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: yes

Variation Margin—Financial End Users: yes

  • Asset Class: A currency in which the payment obligations under the Covered Swap are required to be settled

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: yes

Variation Margin—Financial End Users: yes

  • Asset Class: Other major currencies, including Canadian dollars, euros, United Kingdom pounds, Japanese yen, Swiss francs, New Zealand dollars, Australian dollar, Swedish kroner, Danish kroner, Norwegian krone and any other currency designated by the Prudential Regulators or the CFTC

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: yes

Variation Margin—Financial End Users: yes

  • Asset Class: US Treasury securities

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Certain securities guaranteed by the US government

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Certain redeemable securities in a pooled investment fund

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Certain securities issued or guaranteed by the European Central Bank, a sovereign entity, the Bank for International Settlements, the International Monetary Fund or a multilateral development bank

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Certain corporate debt securities

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Certain equity securities maintained in major indices

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

  • Asset Class: Gold

Initial Margin—All Counterparties: yes

Variation Margin—Swap Entities: no

Variation Margin—Financial End Users: yes

The following assets are excluded as eligible collateral for both IM and VM:

  • (a) securities issued by a party (or any affiliate of that party) posting that security;
  • (b) securities issued by bank holding companies, depository institutions and market intermediaries; and
  • (c) securities issued by certain systemically important non-bank financial institutions.

Haircuts

All non-cash eligible collateral is subject to a haircut (or discount) that varies by the type of asset and, in some instances, the length of its maturity. There is also a cross-currency haircut of 8% that is applied (in addition to any other asset-specific haircut that might apply) whenever eligible collateral (including cash) posted as either IM or VM is denominated in a currency other than the currency in which regularly occurring payment obligations related to a Covered Swap are to be discharged under the applicable agreement.

Segregation of Collateral

IM that is posted or collected by a CSE must be held by one or more custodians that are not the CSE, the counterparty, or any of their affiliates (subject to certain limited exceptions). The custodian must enter into a legal, valid, binding an enforceable agreement that (i) prohibits the custodian from re-hypothecating, re-pledging, reusing or otherwise transferring the custodied assets and (ii) limits the rights of substitution and reinvestment to assets that are eligible collateral (see above).These segregation requirements do not apply to any collateral collected or posted as VM.

Documentation Requirements

A CSE and a counterparty that is a Swap Entity or Financial End User must enter into documentation that provides the CSE with a contractual right and obligation to exchange IM and VM in such amounts, in such form, and under such circumstances as are required by the PR Final Margin Rules and the CFTC Final Margin Rules. The documentation must include the methodology and data sources to be used to value positions and to calculate IM and VM, and the valuation dispute resolution procedures.

Cross-Border Application

PR Final Margin Rules

Exclusion

The PR Final Margin Rules exclude any "foreign non-cleared swap or foreign non-cleared security-based swap" of a "foreign covered swap entity" from the PR Final Margin Rule's requirements. A "foreign covered swap entity" means a CSE that is not:

  • (a) an entity organised under US or State law, including a US branch, agency, or subsidiary of a foreign bank;
  • (b) a branch or office of an entity organised under US or State law; or
  • (c) an entity controlled by an entity organised under US or State law

"Foreign non-cleared swap" means any non-cleared swap of a foreign covered swap entity to which neither the counterparty nor any guarantor (on either side) is:

  • (a) an entity organised under US or State law, including a US branch, agency, or subsidiary of a foreign bank;
  • (b) a branch or office of an entity organised under US or State law; or
  • (c) a CSE controlled by an entity organised under US or State law

This would not include a swap with a non-US branch of a US bank or a US branch or subsidiary of a non-US bank.

Substituted Compliance

A CSE may also be entitled to satisfy the requirements of the PR Final Margin Rules through substituted compliance with a non-US regulatory framework where the Prudential Regulators have made a substituted compliance determination.

CFTC Final Margin Rules

On May 24, 2016 the CFTC adopted finalised rules and accompanying interpretative guidance setting forth the application of the CFTC Final Margin Rules to cross-border swap transactions.26 A White & Case Client Alert detailing these final rules will be released in due course on whitecase.com.

Implementation

The compliance date for the IM and VM requirements depends on the average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps in March, April and May of a given year for both:

  • (a) the applicable CSE combined with all of its affiliates; and
  • (b) its counterparty combined with all of its affiliates.

A CSE may well have multiple compliance dates as the triggers are dependent on both the CSE itself and its counterparties. Once a CSE and its counterparty are subject to the Final Margin Rules, they will both remain subject from that period forward.

  • Compliance Date: September 1, 2016

Initial Margin: If average daily aggregate notional amount of uncleared instruments greater than US$3 Trillion in March, April and May of 2016

Variation Margin: If average daily aggregate notional amount of uncleared instruments greater than US$3 Trillion in March, April and May 2016

  • Compliance Date: March 1, 2017

Initial Margin: ---

Variation Margin: For any other CSE with respect to uncleared instruments entered into with any other counterparty

  • Compliance Date: September 1, 2017

Initial Margin: If average daily aggregate notional amount of uncleared instruments greater than US$2.25 Trillion in March, April and May 2017

Variation Margin: ---

  • Compliance Date: September 1, 2018

Initial Margin: If average daily aggregate notional amount of uncleared instruments greater than US$1.5 Trillion in March, April and May 2018

Variation Margin: ---

  • Compliance Date: September 1, 2019

Initial Margin: If average daily aggregate notional amount of uncleared instruments greater than US$0.75 Trillion in March, April and May 2019

Variation Margin: ---

  • Compliance Date: September 1, 2020

Initial Margin: For any other CSE with respect to uncleared instruments entered into with any other counterparty

Variation Margin: ---