This is the fourth article in a series on the U.S. Commodity Futures Trading Commission’s (CFTC’s) proposed margin rules for uncleared swaps, with a particular focus on the rules as they relate to swap market participants that are neither swap dealers nor commercial end users.
Our first installment on the CFTC’s proposed margin rules (Margin Rules) for uncleared swaps addressed the importance of the “financial end user” definition and making certain notional calculations. Our second and third installments addressed certain collateral requirements and the custody of initial margin. In this fourth and penultimate installment, we turn to the calculation of margin and related issues. Managing resources and capital meaningfully requires financial end users, as entities that will be exchanging margin with covered swap entities (CSEs), to understand how CSEs may be required to calculate margin.
“I don’t get out of bed for less than $10,000 a day.” – Linda Evangelista
As discussed in our prior update, notional thresholds matter. Under the Margin Rules, CSEs would be required to exchange initial margin with financial end users that have “material swaps exposure.” CSEs must calculate the required amount of initial margin daily, using either a risk-based model or a standardized table. Initial margin would not be required under a $65 million threshold. This initial margin threshold is calculated by taking into account the aggregate credit exposure of all uncleared swaps and security-based swaps between a CSE and its affiliates, and a financial end user and its affiliates. (For a refresher on key defined terms, please see our prior update.) The Margin Rules also apply a minimum transfer amount of $650,000 for any posting or collection of margin.
CSEs would be required to exchange mark-to-market variation margin daily with all financial end users, irrespective of whether the financial end users have material swaps exposure. Variation margin is to be calculated by reference to recently executed transactions, independent third-party valuations or other objective criteria. CSEs must have alternative methods in place to value swaps in the event of the unavailability or failure of any input required to value a swap.
“A smart model is a good model.” – Tyra Banks
If a CSE utilizes a risk-based model to calculate initial margin, the model must determine the amount of initial margin equal to the potential future exposure of the uncleared swap or netting set of uncleared swaps covered by an “eligible master netting agreement” (to be discussed further below).
The “potential future exposure” is an estimate of the one-tailed 99 percent confidence interval for an increase in the value of the uncleared swap, or netting set of uncleared swaps, over a holding period equal to the shorter of 10 business days or the maturity of the swap. The data used to calibrate the model is to be based on an equally weighted historical observation period of at least one year and not more than five years, and must incorporate a period of significant financial stress for each broad asset class that is appropriate to the uncleared swap(s) to which the model is applied.
Importantly, the assumed 10 day close-out period in determining potential future exposure is significantly longer than the five-day period for most cleared swaps, and the one day period for certain commodity swaps, that is required under CFTC Rule 39.13(g)(2)(ii). In addition, the typical close-out period for uncleared swaps under an ISDA Master Agreement would reasonably be expected to take less than 10 business days, assuming standard cure periods are used. All else equal, the longer the assumed close-out period, the more margin that is required to collateralize the position. According to the CFTC, this is intended to “make cleared swaps relatively more attractive” than uncleared swaps.
The model must meet numerous qualitative requirements. For instance, the CSE must obtain written approval from the CFTC, demonstrate that the model satisfies applicable requirements on an ongoing basis, and notify the CFTC prior to making certain changes to the model. The CSE also must establish and document certain control, oversight and validation mechanisms with respect to the model and its data sources.
“I don't know what a supermodel is. If they call me that, I might have to punch them.” – Waris Dirie
If a CSE does not use a risk-based model, it must use a standardized table set out in the Margin Rules. The table prescribes the initial margin to be exchanged for different asset classes and durations, ranging from 1 percent of notional exposure for short dated cross-currency and interest rate swaps to 15 percent of notional exposure for commodity, equity and other swaps. When using the standardized table, the Margin Rules allow for recognition of offsetting exposures for multiple uncleared swaps that are subject to an eligible master netting agreement through the use of a formula that incorporates a net-to-gross ratio.
It is worth noting that the standardized table lacks the specificity to account for the different risk profiles of certain product types within the same asset class, particularly those with embedded optionality. For example, within the credit asset class, the proposed table does not distinguish the asymmetric risk profiles of parties buying protection under a credit default swap (CDS) and parties selling such protection. Rather, the table would appear to impose the same initial margin percentage on both sides to a CDS trade.
"Not everything that counts can be counted, and not everything that can be counted counts." – Albert Einstein
Eligible Master Netting Agreements
For both the risk-based model approach and the standardized table, the Margin Rules permit the offset of exposures for uncleared swaps that are subject to the same eligible master netting agreement and fall into the same broad risk category.
An “eligible master netting agreement” is defined as a written, legally enforceable agreement that:
- creates a single legal obligation for transactions covered by the agreement upon default of the counterparty;
- provides the CSE the right to close out on a net basis all transactions under the agreement and liquidate or set off collateral promptly upon an event of default, including insolvency, of its counterparty, provided that any exercise of rights under the agreement will not be stayed or avoided, subject to certain laws relating to close out against systemically important financial institutions and banks;
- does not contain a walkaway clause (a provision that permits a non-defaulting counterparty to make a lower payment than it otherwise would make under the agreement, or no payment at all, to the defaulting party); and
- the CSE conducts sufficient legal review to conclude with a well-founded basis that the agreement meets the foregoing requirements and is legal, valid, binding and enforceable under the law of the relevant jurisdiction, and establishes and maintains written procedures to ensure that the agreement continues to satisfy these requirements.
The condition that the eligible master netting agreement must be “legal, valid, binding and enforceable under the law of the relevant jurisdictions” gives rise to challenges similar to those raised by Margin Rules in relation to the custody agreements required for the segregation of initial margin. These include identifying the “relevant jurisdictions” and determining what level of legal review suffices for concluding that the agreement is enforceable under those jurisdictions. If opinions are required, it may not be possible to obtain an opinion without qualification for all counterparty types, such as certain pension plans or insurance companies, or in all jurisdictions.
Notably, the Margin Rules retroactively apply to swaps executed prior to the applicable compliance date if they are subject to the same eligible master netting agreement that governs swaps executed after the compliance date. As a result, if a financial end user does not want its pre-compliance date swaps to be subject to the Margin Rules, it will need to enter into a separate eligible master netting agreement for the purpose of post-compliance date swaps and therefore split its portfolio into separate netting sets.
Broad Risk Categories
The Margin Rules also restrict risk-based models to recognizing offsetting exposures only where swaps fall into the same “broad risk category.” The categories are: agriculture, credit, energy, equity, foreign exchange/interest rate, metals and other. The overall initial margin required would be the sum of the initial margin amounts for the swaps in each of these seven categories.
Offsetting exposures across these categories, or with other types of non-swap assets, would not be recognized. For example, a financial end user may have a master agreement in place that permits portfolio margining across futures, cleared swaps, repo and uncleared swaps. Although this agreement might cover multiple economically correlated and offsetting products, a CSE’s risk-based model would not be allowed to account for truly like exposures across these different products, potentially leading to the financial end user posting more margin than would otherwise be required if these exposures could be offset.
In its release, the CFTC recognized that it may be difficult to determine an appropriate risk category because some swaps have characteristics that relate to more than one asset class. Under the Margin Rules, the CFTC would expect that the CSE would make a determination as to which asset class best represents the swap based on a holistic view of the underlying swap. The CFTC sought comment on whether this approach is reasonable. Ideally some degree of market consensus on the right classification in these close scenarios would be present, in order to avoid disagreements among CSEs or financial end users as to appropriate risk category. In addition, the Margin Rules do not contemplate that the primary source of risk for a particular swap may change over time. The need to categorize swaps applies at trade date and does not appear to allow for changes thereafter; for instance, the primary source of risk for an equity total return swap that incorporates both FX and equity exposure (a “compo” swap) may, over time, change from FX to equity or vice versa, yet under the Margin Rules it appears a single categorization would apply at inception and for the life of the trade.
Chairman Massad’s recent remarks before the 3rd Annual OTC Derivatives Summit North America indicate that regulators remain focused on finalizing margin rules for uncleared swaps in the near future. Once finalized, the Margin Rules will launch a search for margin super models. As CSEs implement these models, it will create a project of economic and operational complexity for many financial end users, to say nothing of particular regulatory differences that market participants may need to navigate.