Yesterday the CFTC and a group of “prudential regulators” proposed rules regarding capital and margin requirements for uncleared swaps entered into by swap dealers (SDs) and major swap participants (MSPs) (see discussion of proposed rule on SD and MSP definitions here). The CFTC’s rules applies to non-bank SDs and MSPs, while the prudential regulators’ rules apply to bank SDs and MSPs. While the governing bodies purportedly attempted to make their respective proposals comparable to the maximum extent practicable, notable differences between the two sets of rules exist. In particular, under the prudential regulators’ rules, end users are only partially exempt from the requirement of posting margin, a fact that could drive trading activity in derivatives markets towards non-bank SDs and MSPs and away from the banks.
CFTC Rule–Margin Requirements for Non-Bank SDs and MSPs
End Users Exempt
Comments from the CFTC indicate that its proposed rules (the text of which has not been released) does not impose margin requirements on commercial end users. The margin requirements under the proposed rule distinguish between financial entities (which includes all SD/MSPs) and end users as follows:
- Trades between SD/MSPs and other SD/MSPs – Both SD/MSPs must pay and collect initial and variation margin for each trade;
- Trades between SD/MSPs and non-SD/MSP financial entities – The SD/MSP must collect, but not pay, initial and variation margin for each trade, subject in certain circumstances to permissible thresholds;
- Trades between SD/MSPs and end users – SD/MSPs are not required to pay or collect initial or variation margin, but must enter into credit support arrangements (e.g., ISDA credit support annex) with their end user counterparties.
Initial margin must cover 99% of 10-day price moves and can be calculated using a model that is approved by the Commission and is:
- used by a derivatives clearing organization for clearing swaps;
- used by an entity subject to oversight by a prudential regulator; or
- made available for licensing to any market participant by a vendor.
If no such model is available, initial margin would be calculated by selecting a comparable cleared swap or futures contract and applying a multiplier set forth in the proposed rule.
Variation margin must cover the current exposure arising from changes in the market value of the swap since the trade was executed or since the previous time the position was marked to market. Under previously proposed CFTC rules for SDs and MSPs, documentation would be required with respect to agreement on the methods, procedures, rules, and inputs for determining the value of each swap at any time from execution to the termination, maturity, or expiration of the swap.
Form and Location of Margin
Form of Margin – SD/MSPs would be required to accept only certain specified assets as initial or variation margin from other SD/MSPs or from financial entities. Appropriate haircuts are specified in the proposed rule.
Location of Margin – Collateral for trades between SD/MSPs and other SD/MSP would be required to be held at third-party custodians and could not be rehypothecated. SDs and MSPs would be required to offer non-SD/MSPs the opportunity to have any initial margin segregated.
Notable Differences In Prudential Regulators’ Rules—Margin & Capital Requirements for Bank SDs and MSPs
End Users Not Completely Exempt
Commercial end-users would be required to pay initial and variation margin in their swaps with a bank SD/MSP if their margin exposure exceeded an appropriate credit exposure limit established by the SD/MSP.
While the CFTC has not yet addressed the capital requirements for SD/MSPs with respect to uncleared swaps, the prudential regulators did address them in their proposed rules. The proposed rules would simply require the SD/MSPs to comply with the existing capital standards that already apply to those entities as part of their prudential regulation with respect to uncleared swaps.
Commissioner O’Malia’s Criticisms of the CFTC Proposed Rule
Commissioner Scott O’Malia voted against the CFTC’s proposed rule, leveling pointed criticism in his opening statement regarding the following aspects of the rule:
- Lack of harmonization with respect to the prudential regulator’s proposed rule;
- Failure to simultaneously propose a rule on capital requirements;
- Failure to prevent indirect price increases on swaps for end users due to the capital charges dealers will incur simply for providing liquidity to end users; and
- Failure to provide a robust cost benefit analysis;
In particular, Commissioner O’Malia encouraged the public to identify the cost-burden associated with the rulemaking in the comments they submit on the proposed rules.
Comments on the Proposed Rules
Comments on the prudential regulators’ rules should be received on or before June 24, 2011. Comments on the CFTC’s rule will likely be due within 60 days of the rule’s publication in the Federal Register, though Commissioner comments suggest it may run simultaneously with the comment period on the CFTC’s proposed rule on capital requirements (expected to be released within a couple of weeks).