On July 9, 2019, the CFTC issued new guidance relieving swap dealers that are subject to the CFTC’s initial margin requirements for uncleared OTC swaps from complying with documentation requirements governing the posting, collection, and custody of initial margin until the amount exceeds the $50 million threshold. Subsequently, on July 21, 2019, the Securities and Exchange Commission (SEC) published its final rules on margin requirements for non-bank security-based swap dealers, and on July 23, 2019, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a statement that proposes a one-year delay for the implementation of Phase Five of the margin rules. This Client Alert discusses the status of initial margin requirements in the United States and the effects of the recently proposed relief.
The Division of Swap Dealer and Intermediary Oversight (DSIO) of the Commodity Futures Trading Commission (CFTC) issued new and long-anticipated guidance on July 9, 2019. The guidance relieves swap dealers (SD) that are subject to the CFTC’s initial margin (IM) requirements for uncleared over the counter (OTC) swaps (collectively, the Margin Rules)1 from complying with documentation requirements governing the posting, collection, and custody of IM until the IM amount exceeds $50 million.2
DSIO’s advisory came shortly after then-CFTC chairman J. Christopher Giancarlo urged U.S. and global financial regulators to “mak[e] the relatively modest adjustment of clarifying that an entity need not have in place systems and documentation to exchange initial margin on uncleared swaps with a given counterparty if the calculated bilateral initial margin amount with that counterparty is less than $50 million.”3
Subsequently, in response to market pressure, on July 23, 2019, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a statement that presents the final policy framework that establishes minimum standards for margin requirements for non-centrally cleared derivatives. This statement specifies a one-year delay for the implementation of phase five (as defined below) of the Margin Rules. The BCBS/IOSCO statement presents a framework but it is not binding law.
Separately, the Securities and Exchange Commission (SEC) on July 21, 2019, adopted their final rule (SEC Margin Rules)4 on capital and margin for non-bank security-based swap dealers (SBSD) which rule was substantially revised from its previous proposed version and now closely tracks the provisions of the Margin Rules. Compliance with the SEC Margin Rules, however, will only be due 18 months after the effectiveness of SEC’s record keeping and reporting requirements for SBSD or the SEC’s cross-border rules.
Below we discuss the status of the Margin Rules’ IM requirements in the United States and the effects of the proposed relief.
- For SDs regulated by CFTC margin rules, no documentation is required to be put in place governing the posting, collection and custody of IM for affected entities until margin threshold exceeds $50 million.
- SDs regulated by margin rules must implement risk management systems to calculate and monitor margin amounts approaching the $50 million threshold (either under a grid or an approved model) for commodity swaps.5
- Prudential Regulators6 will need to issue their own documentation relief with respect to prudentially-regulated SDs7.
- Until relevant regulators like the CFTC and the Prudential Regulators adopt the one-year extension, the BSBC/IOSCO’s statement has no legally binding effect.
- The effective compliance date of the SEC Margin Rules is contingent on the adoption of other SEC rules in the future which is likely to occur after 2020.
- Security-based swaps (SBS) traded by Prudential Regulators’ registered SDs are subject to the variation margin and IM requirements under the margin rules implemented by Prudential Regulators.
Status of uncleared margin requirements
In accordance with section 4s(e) of the Commodity Exchange Act (CEA), the CFTC adopted the Margin Rules for OTC swaps entered into by non-bank SDs or major swap participants (MSP) with financial institutions that are not cleared through a clearinghouse, i.e., “uncleared swaps.”8 Specifically, the Margin Rules require a covered swap entity (CSE)9 to collect the IM10 from a covered counterparty.11 The Margin Rules also mandate that a CSE must collect variation margin (VM)12 from a swap entity or a financial end-user when the amount is positive. Conversely, if the VM amount is negative, a CSE must post VM with the swap entity or financial end user.13
The Margin Rules have gradually required CSEs to begin posting and collecting IM in phases depending on the CSE’s material swaps exposure, a threshold that is based on the aggregate average notional amount (AANA) of uncleared swaps, uncleared security-based swaps, foreign exchange forwards, and foreign exchange swaps.14 If the AANA for the CSE and all its margin affiliates combined with its counterparty and all its counterparty’s margin affiliates in March, April, and May 2016 exceeded $3 trillion, the CSE was required to begin collecting and posting IM by the phase one deadline: September 1, 2016. The phase two compliance date was September 1, 2017, and $2.25 trillion, and phase three ($1.5 trillion) was September 1, 2018. Phase four ($750 billion) and phase five ($8 billion) are looming on September 1, 2019, and September 1, 2020, respectively.
CSEs subject to the Margin Rules are not required to post or collect IM from or post IM to SDs or financial end users15 if their IM material swap exposure (MSE)16 is less than $50 million. The $50 million IM threshold applies on a consolidated or group basis. It therefore applies across all swaps subject to the IM requirement between a CSE and its affiliates that qualify as margin affiliates17 and the counterparty and its margin affiliates.
Finally, the CFTC’s Margin Rules require that a CSE subject to the IM requirements execute trading documentation with each counterparty that is either a CSE or a financial end-user, which provides the parties with the contractual right to collect and post IM and VM in such amounts, in such form, and under such circumstances as required by the Margin Rules.18 The final Margin Rules also specify that the documentation requirement must be completed prior to or contemporaneously with entering into a swap transaction after the applicable compliance date.19 The documentation requirements apply to all in-scope CSEs regardless of whether the CSE exceeds the $50 million IM threshold.
The IM Threshold Advisory
On March 5, 2019, the BCBS and the IOSCO issued a statement on the final implementation phases of the margin requirements for non-centrally cleared derivatives that noted the internationally agreed framework for margin requirements for non-centrally-cleared derivatives “does not specify documentation, custodial or operational requirements if the bilateral initial margin amount does not exceed the framework’s €50 million initial margin threshold.”20 In response to the BCBS’ and the IOSCO’s March 5 statement, on July 9, 2019, DISO issued an advisory clarifying that in-scope CSEs are not required to comply with the documentation provisions of the Margin Rules unless and until the IM amount exceeds $50 million.
The IM Threshold Advisory also explained that while no specific IM documentation is required prior to reaching the $50 million threshold, DSIO expects CFTC-regulated SDs to have appropriate risk management systems in place to calculate and monitor IM amounts and to act diligently as the amounts approach the $50 million threshold to ensure compliance with the documentation requirements. Furthermore, prior to reaching the threshold, the CSE must enter into a custodian agreement to ensure the IM collateral is held by an independent custodian, as required under the Margin Rules.
Notably, the IM Threshold Advisory applies only to SDs that are subject to the CFTC’s Margin Rules and not to SDs that are subject to the final margin rules issued by the Prudential Regulators. Therefore, market participants who are financial end-users will still need to comply with the documentation requirements for their SD counterparties that are regulated by the Prudential Regulators and not subject to the CFTC’s Margin Rules, even if they have not met the $50 million threshold for posting IM.
While U.S. financial regulators continue to adapt the Margin Rules for effective implementation, the BCBS and the IOSCO on July 23, 2019, extended the schedule for the implementation of international IM and VM requirements. Under the BCBS/IOSCO’s proposed revised timetable, from September, 1 2019, to August 31, 2020, any covered entity belonging to a group whose AANA for March, April, and May of 2019 exceeds €0.75 trillion will be subject to the IM requirements when transacting with another covered entity.
From September 1, 2020, to August 31, 2021, any covered entity belonging to a group whose AANA for March, April, and May of 2020 exceeds €50 billion (for parties subject to the EMIR margin rules) will be subject to the IM requirements when transacting with another covered entity. This is a new threshold that had not existed in either the EU regulators’ or U.S. regulators’ margin rules and is intended to smooth out the drop from €750 billion to €8 billion.
Beginning September 1, 2021, any covered entity belonging to a group whose AANA for March, April, and May of the year exceeds €8 billion will be subject to the IM requirements. In announcing the extension of the IM implementation dates, the BCBS and the IOSCO also noted that the international margin framework, like the U.S. Margin Rules, does not specify documentation, custodial or operational requirements if a covered entity’s bilateral initial margin amount does not exceed the framework’s €50 million initial margin threshold.
The BCBS/IOSCO’s proposal is not binding and only serves as a concept release to be considered and adopted by local regulators in the EU, the United States and other jurisdictions.
The CFTC is aware of significant issues arising with the implementation of phase five and is considering a number of other advisories, no action letters and orders that are intended to make the transition to phase five less burdensome.
SEC’s Margin Rules
On July 21, 2019, the SEC published the long-awaited SEC Margin Rules as part of a package of rules on capital and margin for non-bank SBSD and major security-based swap participants, segregation requirements for SBSD, and notification requirements with respect to segregation for SBSD and major security-based swap participants. Compared to the SEC’s proposed margin rules,21 the SEC’s Margin Rules are more closely aligned to the CFTC’s Margin Rules and the rules promulgated by the Prudential Regulators, although there are still significant differences between the SEC Margin Rules and the other U.S. margin rules.
The SEC Margin Rules require that non-bank SBSDs post VM to many of their counterparties (calculated by marking the position to market), but do not require the posting of IM, although it is not prohibited; conversely, non-bank SBSDs are required to collect IM and VM from certain counterparties if according to SBSD’s calculation margin is due, although there are more exclusions for the types of counterparties from whom IM only has to be collected. As under CFTC’s Margin Rules, no margin is required to be posted if the swap and security-based swap exposure does not exceed the $50 million margin threshold. There are differences, however. For example, the SEC’s Margin Rules do not require (but permit) SBSDs to collect IM from counterparties that are financial intermediaries (other SBSDs, swap dealers, FCMs, broker dealers and banks). Also, the SEC Margin Rules do not contain the exception from the requirement to collect IM from counterparties such as financial end-users that do not have material swaps exposures.
Even though the SEC Margin Rules become effective 60 days after the publication of the rule in the federal register,22 the SEC set the compliance date for its Margin Rules as the date which is 18 months after the later to occur of the effective date of the final rules establishing record-keeping and reporting rules for SBSDs, or the effective date of its final cross-border rules. The SEC Margin Rules also set this date as the compliance date for SBSDs and major security-based swap participants to meet registration requirements. Accordingly, the SEC’s compliance date for its registration requirements and its margin rules (as well as the capital and segregation rules set forth in the same release as the SEC Margin Rules) will occur on the same date.
As required by the Dodd-Frank Act, the implementation of IM and VM requirements for swaps and security-based swaps is proceeding with a certain amount of coordination among the CFTC, the Prudential Regulators and the SEC. In addition. U.S. regulators are coordinating some of their efforts with the EU regulators and it is expected that the margin rules of many global regulators and regimes will be consistent with BCBS/IOSCO guidelines and statements. Given the numerous practical market implications, U.S. regulators may continue adjusting or providing relief with respect to substantive requirements of their margin rules and the related implementation schedule.