Introduction

Alas, for better or worse, the U.S. Commodity Futures Trading Commission’s (“CFTC”) final rules (the “Rules”) on margins for uncleared swaps are here.  On December 16, 2015, the CFTC—by a 2 to 1 vote—approved its Rules addressing margin requirements for uncleared swaps.[1] For some swaps market participants, the Rules will fundamentally alter their business.  For others, opportunities may exist.  In this Client Alert, we discuss the Rules and look ahead to the potential implications.  We also highlight a few surprises.  According to the CFTC, the purpose of the Rules is to protect the safety and soundness of swap dealers [2] and the financial integrity of the markets.  As a general matter, the Rules apply to swaps that are not cleared through a derivatives clearing organization (“DCO”), and the Rules address a host of issues, including which products are covered, which market participants are subject to the Rules, initial margin requirements, variation margin requirements and custodial arrangements.  The Rules do not apply to transactions that are exempt from mandatory clearing pursuant to the end-user exemption or are otherwise exempt pursuant to a CFTC determination.[3] Further, after some controversy, the Rules also include an exemption for transactions between certain affiliated entities of swap dealers.  Finally, and of practical importance from a market structure perspective, the Rules do not apply to de minimisswap dealers. When will the Rules take effect?  Implementation is staggered based on the size of a market participant’s swaps business and the Rules will become effective during 2016 through 2020. 

Which Products Are Covered?

The products covered by the Rules include uncleared swaps[4] entered into after the effective date of the Rules, which depends on the size of the market participant’s swaps business.  The Rules will not apply retroactively to swaps entered into prior to the applicable effective date. For purposes of the Rules, an uncleared swap is one that is not cleared on a registered or exempt DCO.  The Rules do not apply to uncleared security-based swaps which will be governed by separate rules to be issued by the U.S. Securities and Exchange Commission (“SEC”).[5] Foreign exchange swaps, foreign exchange forwards and fixed, physically settled foreign exchange transactions associated with the exchange of principal in cross-currency swaps are also not subject to the CFTC’s margin requirements.

Which Market Participants Are Covered?

The Rules apply to any entity that is a “covered swap entity” other swap entities and financial end users, all of which can include non-U.S. entities.[6]  A covered swap entity (“CSE”) is any CFTC-registered swap dealer or major swap participant that is not subject to regulation by a prudential regulator.[7] A swap entity is any registered swap dealer and major swap participant, including those subject to regulation by a prudential regulator.[8] CSEs and swap entities do not include de minimis swap dealers that deal in less than $8 billion in notional swaps per year and are exempt from registration. Generally, initial margin will be required for any “financial end user” with “material swaps exposure” or a swap entity that enters into a swap with a CSE.  Variation margin will be required for all financial end users, regardless of their material swaps exposure, and swap entities for swaps entered into with CSEs.  The definition of a financial end user includes a variety of entities and businesses such as bank holding companies, depository institutions, foreign banks, state-licensed credit or lending entities, broker-dealers, investment advisers, private funds, commodity pools, employee benefit plans and insurance companies.[9] Sovereign entities and multilateral development banks are explicitly excluded from the definition of a financial end user.[10] Commercial end users that are not financial end users are not subject to the Rules. For purposes of determining whether a financial end user will be subject to initial margin, material swaps exposure is defined as the entity having, with its “margin affiliates” an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps that exceed $8 billion during the months of June, July and August of the previous year.[11]  Notably, the calculation of material swaps exposure includes foreign exchange forwards and foreign exchange swaps even though such swaps and forwards are excluded from the definition of a swap under the Commodity Exchange Act.[12]

What are the Margin Requirements?

The Rules cover initial margin and variation margin.  Initial margin refers to collateral collected or posted in connection with entering into one or more uncleared swap,[13] Variation margin is the amount of collateral collected or posted under one or more uncleared swaps as a result of a change in the value since the trade was executed or the last time such collateral was provided. [14] Within one business day of a swap being executed, a CSE will be required to post and collect initial margin.[15] Initial margin must be held throughout the duration of the swap.  However, the collection and posting of margin is subject to a minimum transfer amount of $500,000.[16] Additionally, a CSE and the counterparty will be permitted to calculate initial margin based on an aggregate net basis with respect to all uncleared swap entered into pursuant to an agreement between the parties.[17] Variation margin will also be required during the life of the swap through termination.  As of the first business day after the swap transaction has been initiated, the CSE will be required to collect variation margin from the counterparty when the amount is positive, or post margin when the amount is negative as calculated in accordance with the Rules.[18] Similar to the initial margin requirements, variation margin will be required throughout the life of the swap.[19]  Variation margin is also subject to a minimum transfer amount of $500,000 as well as netting in accordance with any eligible master agreement.[20]

How is Initial Margin Calculated?  

The Rules provide that initial margin may be calculated in one of two ways.  CSEs may either rely upon their own risk-based initial margin model provided it meets the Rules’ requirements, or alternatively, CSEs may follow the Rules’ standardized table which calculates initial margin based on varying percentages of notional exposure depending on the respective asset class.[21] CSEs must have written approval from the CFTC or the National Futures Association (“NFA”) to using their own risk-based model.  Additionally, written approval is required to: (i) apply the initial margin model to a new asset class; (ii) make any change to the initial margin model that would result in a material change to the CSE’s assessment of initial margin; or (iii) make any change to modeling assumptions by the initial margin model.[22]  Any initial margin model must also include different technical elements mandated by the Rules.[23] These technical elements include, among others, the following:

  • Under any initial margin model, initial margin must equal the potential future exposure of the uncleared swap taking into account any netting as well as any “instantaneous price shock” resulting from the movement in all material risk factors such as prices, rates and spreads over a period of time equal to the shorter of ten business days or the maturity of the swap or netting portfolio.
  • The initial margin model must rely upon data from a period of time ranging from 1 to 5 years, which includes at least one period of significant financial stress to the respective asset class.
  • The initial margin model must use risk factors sufficient to calculate all material price risks inherent in the uncleared swap with the understanding that risk factors may vary depending on the asset class.

In addition, the CSE must have a robust process in place for re-estimating, re-evaluating and updating its internal margin models on an ongoing basis as well as ensuring, at least on an annual basis, that data used for calibrating the internal margin model is appropriate in light of market conditions.[24] The sophistication of an internal margin model must be on par with the relative complexity of the transactions to which it is applied.[25]  Finally, notwithstanding any of the foregoing, the CFTC or NFA may require a CSE to collect a higher amount of initial margin than that required by its initial margin model.[26] At least annually, the CSE must assess its initial margin model in light of conditions in the financial markets and modify it accordingly.[27] Presumably, CFTC or NFA approval is required for any modifications to the initial margin model in accordance with Rule 23.154(b)(1). On an ongoing basis, a CSE’s risk management unit must subject the initial margin model to a validation process which includes general evaluations, comparing generated internal margin requirements against other benchmarks or data sources, and performing outcomes analysis by back testing the model.  The Rules also provide that validation shall ensure that the initial margin required is not less than what would be required of a DCO for a similarly cleared transaction.[28] As part of their recordkeeping requirements, CSEs are required to maintain documentation regarding any modifications, testing and validation of their initial margin models.[29]

For those CSEs that do not implement their own initial margin models, they may rely upon the table-based method, following the standardized initial margin schedule according to the asset class set forth in the Rules.[30] The table-based method also provides ways to calculate initial margin in the case of multiple uncleared swaps subject to the same master netting agreement.

 How is Variation Margin Calculated?

The Rules’ requirements for determining variation margin are more flexible than those Rules governing initial margin calculations.  In determining variation margins, CSEs may rely upon recently-executed transactions, valuations provided by independent third parties or other objective criteria.[31]  Regardless of the methods relied upon to determine variation margin, CSEs are required to have a back-up method in place in the event they cannot rely upon their primary methods for whatever reason.[32] CSEs are also required to have control mechanisms in place to ensure the reliability of their methodologies.[33]  In certain instances, the CFTC or NFA may request a CSE provide an explanation of its methodology including a general description, the basis of the methodology and empirical data to support the effectiveness and reliability of the methodology and its inputs.[34]

What Types of Collateral may be used for Margin?

For initial margin, acceptable forms of collateral include, among others, the following:

  • Immediately available cash funds including U.S. Dollars, a major currency, and the currency of settlement for the uncleared swap;
  • U.S. treasuries;
  • Certain European treasuries;
  • Publicly-traded debt that has been accepted as a form of margin by a prudential regulator;
  • Publicly-traded equity securities included in the S&P 1500 Index or other similar indices (including certain non-U.S. indices);
  • Redeemable securities in a pooled investment fund that holds only securities issued by the U.S. government and cash, or certain European treasuries and cash (i.e., money market mutual funds and bank certificates of deposits); and
  • Gold.[35]

While securities are a permissible form of collateral, securities of the CSE or any of its margin affiliates as well as securities of any domestic and non-U.S. banking institutions or their margin affiliates and any nonbank financial institution subject to the supervision of the Federal Reserve are not permitted as collateral.[36] The Rules also set forth standardized haircuts or discounts applicable to collateral for initial margin based on the collateral type.[37] Variation margin for uncleared swaps between a CSE and a financial end user may be posted and collected in the same types of collateral described above for initial margin.  However for uncleared swaps between a CSE and a counterparty that is also a swap entity, only immediately available cash may be used as collateral.[38] Collateral posted or collected for variation margin is also subject to similar standardized haircuts.

What Custodial Arrangements and Documentation are Required?

Initial margin collected or posted by a CSE may be held by a custodian that is not: (i) the CSE; (ii) the counterparty, or (iii) margin affiliates of either party.[39] Custody agreements must be legal, valid, binding and enforceable under the laws of all relevant jurisdictions including any applicable bankruptcy or insolvency laws.  In addition, the custody agreement must provide that the custodian may not rehypothecate, repledge, reuse or otherwise transfer the collateral except that cash collateral may be held in a general account.[40] Notwithstanding the foregoing restrictions, the custody agreement may permit the posting party to direct the custodian to reinvest collateral provided the reinvestment amount is sufficient to meet margin requirements taking into account applicable discounts, which may vary according to the type of collateral.[41] The custody agreement may also permit a posting party to substitute posted collateral with another form of eligible collateral.  Counterparties will also have the ability to require that any initial margin be segregated.[42] CSEs will be required to enter into documentation with counterparties governing margin requirements for uncleared swaps.[43] For swaps entered into between a CSE and a financial end user or swap entity, the documentation shall provide the CSE with the contractual right and obligation to exchange initial margin and variation margin in such amounts and such forms as permitted under the Rules.  The margin documentation must also set forth in detail, the methods used by the CSE in determining the value of the uncleared swap, calculating initial margin and variation margin, and resolving any disputes that may arise.[44]

Are Inter-Affiliates of CSEs Treated any Differently under the Rules?

In a controversial decision, the CFTC adopted an exemption from the initial margin requirements for uncleared swaps entered into between CSEs and their margin affiliates.[45] The CFTC’s exemption is unique insofar as the prudential regulators’ rules governing banking entities do not include the same exemption.  However, the CFTC reasoned that because inter-affiliated transactions are not outward facing, they do not pose the same level of risk exposure of consolidated entities to third parties.  Nonetheless, in order to rely upon the exemption, the CSE must meet the following conditions: (1) the swap must be subject to a centralized risk management program designed to monitor and to manage risks arising from inter-affiliated transactions; and (2) the CSE must still exchange variation margin with the margin affiliate in accordance with the Rules if such affiliate is a swap entity or financial end user.[46] Additionally, if the margin affiliate is a swap entity subject to supervision by the prudential regulators, the CSE must post initial margin in an amount that would be required under the rules of the prudential regulator.[47] Initial margin will also be required for uncleared swaps entered into by CSEs with “foreign margin affiliates,” which are financial end users that enter into swaps with third parties for which the Rules would apply if: (i) such an affiliate was a swap entity, and (ii) the affiliate is located in a jurisdiction where the CFTC has not yet found to be eligible for substituted compliance.[48]

When will the Rules become Effective?

Compliance with the Rules is staggered based on the combined notional amount of the CSE’s and the counterparty’ swaps exposure including each of their margin affiliates.  In addition, for purposes of determining the threshold amount, each party must include the notional amount of certain uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps including those of its margin affiliates.[49] Each swaps transaction shall only be counted once even if it could be included in the calculations for more than one party.  Swaps exempt from clearing based on the end user exemption or by CFTC order, and security-based swaps exempt from margin requirements pursuant to section 15F(e) of the Securities Exchange Act of 1934, may be excluded from the calculation. The first compliance date is September 1, 2016 for those entities with a combined average daily notional amount of $3 trillion during the months of March, April and May 2016.[50] As of September 1, 2016, CSEs and counterparties meeting this threshold will need to exchange initial margin and variation margin.  The second compliance date is March 1, 2017 at which time all CSEs and counterparties will need to begin collecting and posting variation margin.  The remaining effective dates for initial margin are as follows:

  Effective Date                                       Combined Notional Amount September 1, 2017                                $2.25 trillion September 1, 2018                                $1.5 trillion September 1, 2019                                $0.75 trillion September 1, 2020                                No threshold amount [51]

For the above combined notional amount, the calculation period will be March, April and May of that particular year.  Additionally, once a CSE and a counterparty must comply with the initial margin and variation margin requirements, they will be required to continue to do so regardless of whether their combined notional amount falls below any required threshold at a later date.[52] In addition if a counterparty changes its status at any time (i.e., a financial end user with material swaps exposure becomes a financial end user without material swaps exposure or vice versa), stricter or less strict margin requirements may apply to swaps entered into after the change in status.[53]