U.S. bank regulators recently adopted final rules establishing initial and variation margin requirements for uncleared swaps (Final Margin Rules). These rules apply to regulated entities such as banks and subsidiaries of bank holding companies that are swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants. As a result, most of the major swap dealers in the United States are subject to the new requirements and most of their counterparties on such transactions, therefore, will be required to post margin. For purposes of this update, we will focus on the rules as they apply to swap dealers and the impact on their counterparties.
The Final Margin Rules were adopted in accordance with the requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). As adopted, the Final Margin Rules establish only minimum initial and variation margin requirements and do not prevent a swap dealer from collecting or posting margin beyond the amount required thereunder.
Compliance with the variation margin requirements begins September 1, 2016. There is a four-year staggered implementation period for initial margin requirements depending on whether both the swap dealer's and the counterparty’s notional amount of swap activity exceed a designated “volume threshold.” The last staggered compliance date is September 1, 2020.
Types of Swap Dealer Swap Counterparties
The Final Margin Rules distinguish among four types of swap counterparties with which a swap dealer may transact: (1) counterparties that are swap dealers; (2) counterparties that are financial end users1 who, together with their affiliates, have a material swaps exposure (an aggregate average notional amount calculated in accordance with the Final Rules that exceeds $8 billion); (3) counterparties that are financial end users who, together with their affiliates, do not have a material swaps exposure; and (4) other counterparties such as corporate end users that generally trade swaps in order to hedge commercial risk, sovereigns, and multilateral development banks.
Swap Entities and Financial End Users
Initial Margin Requirements
Under the Final Margin Rules, a swap dealer that transacts with another swap dealer or a financial end user that has a material swaps exposure will be required to collect from that entity, on a daily basis, the minimum required amount of initial margin calculated using a prescribed method of calculation.
A swap dealer also will be permitted to establish a threshold amount on a counterparty-by-counterparty basis for initial margin below which the swap dealer (together with its affiliates) will, at all times, be unsecured in relation to a counterparty and its affiliates. The maximum threshold allowed under the rules is $50 million. The Final Margin Rules are silent on how a swap dealer and its counterparty should allocate the designated threshold amount.
The Final Margin Rules address variation margin in connection with swaps entered into with a counterparty that is a swap dealer or a financial end user with or without a material swaps exposure. A swap dealer will be required, on a daily basis, to collect variation margin from, or post variation margin to, such counterparty in an amount equal to the increase or decrease, as applicable, in the value of the swap since the counterparties’ last exchange of variation margin. A swap dealer will be required to collect the full amount of required variation margin subject to a minimum transfer amount, if applicable.
Minimum Transfer Amount
The Final Margin Rules provide for a permitted minimum margin transfer amount that cannot exceed $500,000. A swap dealer, therefore, will not be obligated to post initial or variation margin to, or collect initial or variation margin from, any type of counterparty unless and until the requisite aggregate amount of initial and variation margin exceeds $500,000 (or such lower amount as the parties to the swap may agree). Subject to any applicable initial margin threshold, the entire amount of the required margin will be required to be collected or posted once the minimum transfer amount is surpassed.
The regulators adopted interim final rules regarding application of the Final Margin Rules to counterparties that qualify for an exception or exemption from clearing their trades, such as corporate end users, and small banks, savings institutions, and credit unions with assets less than $10 billion that were exempted from clearing by the Commodity Futures Trading Commission(CFTC). In general, the interim rule, if adopted in its form, will not require a swap dealer to post margin to, or collect margin from, such counterparties. Comments to this interim final rule were due by January 31, 2016.
Types of Eligible Collateral
Under the Final Margin Rules, variation margin, if required, must be posted in cash. Initial margin, on the other hand, may be posted in cash or certain other prescribed types of debt securities.
Segregation of Collateral
The Final Margin Rules require that any collateral posted by a swap dealer to its counterparty (other than variation margin) be held at a third-party custodian. Only initial margin that a counterparty is required to post to a swap dealer, however, is required to be held at a mutually agreed upon third-party custodian. Such custodian cannot be an affiliate of the swap dealer or counterparty. The Final Margin Rules provide that the parties need to execute a custodial agreement and that such agreement needs to be enforceable even in bankruptcy, and include provisions that prohibit the custodian from rehypothecating, repledging, reusing, or otherwise transferring the funds held by it.
The Final Margin Rules require swap dealers to execute documentation with each entity that is a swap dealer or financial end user that contractually provides for the collection and posting of initial and variation margin between the parties. The documentation is required to provide for, among other things, the method of valuing each swap and resolving disputes regarding swap valuations or valuations of assets posted as margin. Compliance with CFTC or SEC rules regarding the documentation of swaps and security-based swaps, as applicable, will satisfy the rules regarding documentation under the Final Margin Rules. It is expected that swap dealers may require amendments to existing documentation to ensure compliance with the applicable rules.
In light of the global nature of derivative transactions, the Final Margin Rules provide that application of the margin rules will not apply to foreign non-cleared swaps of a foreign swap dealer.2 In addition, a foreign swap dealer trading with a U.S. entity will be permitted to comply with a foreign regulatory framework for non-cleared swaps to the extent that the regulators have jointly approved such framework. The Final Margin Rules also will not require compliance with rules regarding segregation of initial margin by certain foreign branches of swap dealers and foreign subsidiaries if it is impracticable due to the foreign regulations to which such entity is subject.
Special Rules for Affiliates
The Final Margin Rules addressed the posting of initial and variation margin between affiliates. In general, affiliates are not required to collect initial margin among themselves for non-cleared swaps. However, such affiliates will be required to collect and post variation margin.