On December 16, 2015, the Commodity Futures Trading Commission (“CFTC”) adopted a final rule to establish minimum margin requirements for registered swap dealers and major swap participants (collectively, “swap entities”) that are not subject to margin requirements promulgated by one of the prudential regulators1 (“covered swap entities” or “CSEs”), including provisions (adopted as an interim final rule, on which the CFTC requests comment) to implement margin exemptions added by the Terrorism Risk Insurance Program Reauthorization Act of 2015 (“TRIPRA”) for swaps that qualify for the clearing exemptions and exceptions available to non-financial entities (including commercial end-users, captive finance subsidiaries and small financial institutions), treasury affiliates acting as agent and certain cooperatives.
With some exceptions, the CFTC’s margin requirements are substantively parallel to those adopted in October 2015 by the prudential regulators (“PRs”) for prudentially regulated swap entities and security-based swap entities (together, “PRSEs”) (for more information, please see our legal update, “Prudential Regulators in the United States Adopt Margin Rules for Swaps and Security-Based Swaps”2). The following is a brief summary of certain differences between the CFTC’s and the PRs’ margin requirements. Readers should consult the full text of each rule for further detail.
Eligible Treasury Affiliates
The CFTC rule defines “financial end-user” in substantially identical fashion to the PR rule (and includes a similar preamble statement noting the inclusion of securitization vehicles). However, the CFTC definition excludes eligible treasury affiliates that the CFTC exempts by rule from the margin requirements, whereas the PRs merely state in their rule preamble3 that, to the extent the CFTC acts to exempt such entities from clearing by rule, the entities would also be excluded from the definition of financial end-user for purposes of the PR rule. The CFTC states that it will separately implement a margin exclusion for eligible treasury affiliates by rule or staff no-action letter. The term “eligible treasury affiliate” is not defined in the CFTC or the PR rule. Currently, the term is used in CFTC staff no-action relief from the clearing requirement that is available to treasury center entities that engage in swaps as principal on behalf of affiliates and satisfy certain conditions (for more information, please see our legal update, “CFTC Staff Liberalizes Conditions of Clearing No-Action Relief for Eligible Treasury Affiliates”).
The PR rule requires PRSEs to collect margin from non-financial end-users in such forms and amounts (if any) that the PRSE determines appropriately address counterparty credit and other risk, except in transactions that qualify for the TRIPRA exemptions. The CFTC rule contains no such requirement, and the CFTC did not adopt a proposal that would have required CSEs to calculate hypothetical margin amounts for non-financial end users in certain circumstances.
Variation Margin Standards
The CFTC sets more detailed standards than the PR rule for the calculation of variation margin, requiring methods and inputs that, to the maximum extent practicable, rely on recently executed transactions, independent third-party valuations and other objective criteria, as well as alternative methods if a required input becomes unavailable. In addition, the CFTC requires control mechanisms for the variation margin calculation, including maintenance of documentation setting forth the variation methodology with sufficient specificity to allow the CSE’s counterparty and regulators to calculate a reasonable approximation of the variation margin requirement independently. If the master agreement between a PRSE and its counterparty does not qualify as an “eligible master netting agreement,” the PRSE must collect variation margin on a gross basis but may post on a net basis. The CFTC rule makes no similar allowance to permit net posting of variation margin under an ineligible master netting agreement.
The CFTC and the PR rules each provide an exemption from initial margin for inter-affiliate transactions, but differ somewhat in their approach. A PRSE is relieved from posting initial margin to its affiliates;4 however, the requirement to collect initial margin still applies (albeit under modified standards with regard to the threshold and computation of the amount, and without required segregation of non-cash collateral at an independent custodian).
Under the CFTC rule, a CSE is relieved from posting initial marginexcept to affiliates that are PRSEs. In addition, a CSE is relieved from collection of initial margin except in certain circumstances. Specifically, a collection requirement applies (with no modification of thresholds or amounts) with respect to any affiliate that (i) is a financial end-user, (ii) enters into swaps with third parties, (iii) does not collect initial margin for such outward-facing swaps in a manner that would comply with the CFTC margin requirements and (iv) is located in a jurisdiction that the CFTC has not found eligible for substituted compliance with regard to its margin requirements. The collection requirement also applies with respect to any financial end-user affiliates that enter into such outward-facing swaps indirectly (including through a series of transactions) with other affiliates. The CFTC’s inter-affiliate exemption generally is conditioned on the swaps being subject to a centralized risk management program that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps.
Cross-border application of the CFTC margin requirements will be the subject of a future rulemaking. The CFTC has previously proposed and solicited comment on four alternative approaches to cross-border application of swap margin requirements, including, most recently, a “hybrid” approach that is a combination of previous transaction- and entity-level approaches and is closely aligned with the PRs’ approach.5