Dodd-Frank mandates the margining of uncleared swaps and requires U.S. federal regulators to adopt implementing rules covering initial and variation margin. On September 2, 2014, five U.S. prudential regulators (the Prudential Regulators) re-proposed their implementing rules for the mandate (the Prudential Regulator Proposal).1 On September 17, 2014, the Commodity Futures Trading Commission (CFTC) re-proposed its own implementing rules (theCFTC Proposal).2 The Proposals mirror to a significant degree the final international standards on margin requirements for non-centrally cleared derivatives issued in September 2013 by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions (the BCBS/IOSCO Standards).3
Each registered swap dealer that is supervised by one of the Prudential Regulators will be required to meet the minimum initial and variation margin requirements set by the Prudential Regulators;4 other registered swap dealers will be required to meet requirements set by the CFTC. The Proposals apply to material swap participants as well as to swap dealers (which are collectively referred to as covered swap entities).
The Dodd-Frank mandate also covered security-based swaps. Although the Securities and Exchange Commission (SEC) originally proposed margin rules for uncleared security-based swaps, it has not yet followed the Prudential Regulators and the CFTC in re-proposing those rules in response to the BCBS/IOSCO Standards. Although it is expected that the SEC will similarly re-propose its own implementing rules, it is not clear when it will do so.
The Prudential Regulator Proposal will be open for public comment through November 24, 2014; the CFTC Proposal will be open for public comment through December 2, 2014.
A description of important elements of the two Proposals follows. We provide brief descriptions of key implications of the Proposals for certain specific industry groups. A table at the end of this Sidley Update provides a more detailed side-by-side comparison of the two Proposals.
Key Elements of the Proposals
The Prudential Regulators and the CFTC view the Proposals’ variation margin requirements as being generally consistent with current market practice, and those requirements will be effective as of December 1, 2015. Initial margin obligations, which are viewed as representing a departure from market practice, will be phased in over a four-year schedule, from December 1, 2015 to December 1, 2019. The phase-in schedule, which is consistent with the schedule set forth in the BCBS/IOSCO Standards, is set out in more detail in the table at the end of this Sidley Update.
Swap Participants Subject to the Proposals
Each of the Proposals defines four relevant categories of swap market participants:
“financial end users” with “material swaps exposure”5
“financial end users” without “material swaps exposure”
counterparties that do not fall into the first three categories6
Each of the Proposals requires covered swap entities to post and collect both initial margin7and variation margin8 with respect to its uncleared swaps with other covered swap entities or financial end users with material swaps exposure. Additionally, each of the Proposals mandates that covered swap entities post or collect, as applicable, variation margin (but not initial margin) from financial end users without material swaps exposure. Neither Proposal imposes any specific margin requirements with respect to non-financial end users.
“Financial End Users”: Departure from Section 4(k) of the Bank Holding Company Act
Although both the Prudential Regulators’ and CFTC’s prior proposals in 2011 (the 2011 Proposals) used the term “financial entity,” the Proposals do not; instead they use the term “financial end user.” The former term is based on the statutory definition for entities that are not eligible for the CFTC’s end user exemption from mandatory clearing, which references (in part) Section 4(k) of the Bank Holding Company Act.9 The new term is defined more narrowly and does not rely on Section 4(k), which covers a broader, and less specific, range of entities engaged in “activities that are financial in nature.”10 Financial end users effectively represent a subset of the “financial entity” universe, limited to private funds, commodity pools and a range of financial firms that are subject to specified federal or state regulation, licensing and/or registration.11 The term also includes entities that would meet the definition of financial end user if organized under the laws of the United States (or any State thereof) and expressly excludes certain sovereign entities, multilateral development banks and the Bank for International Settlements.
The CFTC’s use of the term “financial entity” in connection with its end user exemption for the swap mandate has led to significant concern in that area, as it captures entities that have not traditionally considered themselves to be “financials.” The approach of the Proposals is more favorable in this regard because of its focus on federal or state regulation, licensing and/or registration – i.e., because it captures fewer swap market participants that normally would not consider themselves to be financials. Thus certain end users that do not benefit from the CFTC’s exemption from mandated swap clearing would benefit from the Proposals’ approach.
As a consequence of the different terminology, the subject of where to draw the line for end users – between those engaged in financial activities and those engaged in commercial activities – is likely to be an area for industry comment on the Proposals, including possibly for discussion with the CFTC concerning whether the mandatory clearing rules should be aligned with the uncleared swaps margin rules.
“Material Swaps Exposure” Is Set at a Level Lower than in the BCBS/IOSCO Standards
Under the Proposals, material swaps exposure – the gross notional amount below which a financial end user is not subject to initial margin requirements – would be $3 billion.12 This is substantially lower than the EUR 8 billion level under the BCBS-IOSCO Standards. In proposing the $3 billion level, the Prudential Regulators and the CFTC reasoned that it was consistent with the maximum initial margin threshold amount of $65 million, which was reflected both in the Proposals and in the BCBS-IOSCO Standards (and is discussed below).
Two-Way Initial Margin
The Proposals would require covered swap entities both to post initial margin to, and to collect initial margin from, other swap entities and financial end users with material swaps exposure. The two-way exchange of initial margin represents a departure from the 2011 Proposals (which mandated that covered swap entities only collect initial margin), but is consistent with the BCBS/IOSCO Standards. Under the Proposals, initial margin may include cash, gold or certain securities, including U.S. Treasuries, securities of certain government-sponsored enterprises (GSEs), and certain corporate debt or equity securities.
Initial margin must be collected no later than the one business day after the date of the relevant swap transaction, but will only be required to the extent the amount of initial margin exceeds an “initial margin threshold amount” of $65 million, and will be subject to a minimum transfer amount of $650,000. The threshold amount is applied to all uncleared swaps and uncleared security-based swaps between a covered swap entity and its affiliates, on the one hand, and a covered counterparty and its affiliates, on the other.13
Two-Way Cash Variation Margin
The Proposals would require covered swap entities, on a daily basis, both to post variation margin to, and to collect variation from, other swap entities and all financial end users, regardless of material swaps exposure. Variation margin must be in the form of cash, either in U.S. dollars or the currency in which payment obligations under the swap in question is required to be settled.
Covered Swap Entities Will Be Permitted to Use Models to Calculate Initial Margin
The Proposals would each require that initial margin be calculated based on either a risk-based model or the following table set forth in the Proposals:
Given the initial margining levels produced by the percentage factors set out in the table above, it is expected that most covered swap entities will use risk models to calculate initial margin. In order for a covered swap entity to use such a model, the model must be approved, in writing, by the applicable Prudential Regulator or CFTC, as applicable, and meet specified modeling criteria.14 Covered swap entities using models would be required to calculate initial margin amounts on a daily basis in order to take into account changes over time of swap characteristics (for example, credit quality of the reference obligation for a single-name credit default swap) or of model parameters (for example, changes in the market risk environment that informs the model’s stress period). It is our understanding that in order to provide consistency across market participants and to minimize disputes over initial margin calculations, ISDA is working to develop a uniform initial margin model that will be available for use by all market participants.
Enforceable Master Netting Agreements
Both Proposals permit covered swap entities to take into account enforceable master netting agreements when calculating either initial margin (whether via the standardized tabular approach set out in the Proposals or via permitted models) or variation margin. However, to the extent that a master netting agreement covers swaps executed before the effective date of the rules and swaps executed thereafter, all swaps under the agreement would be subject to the margining requirements if a covered swap entity takes into account the netting agreement. To the extent a covered swap entity and a given counterparty wanted to take advantage of the master netting agreement provisions but did not want to subject pre-existing swaps to new margining, they would need to execute a new master netting agreement to cover only the new swaps.
Initial Margin Must Be Segregated and May Not Be Rehypothecated
For uncleared swaps, both the Prudential Regulators and the CFTC have proposed that all funds or other property that a covered swap entity provides or collects as initial margin (but not variation margin) must be segregated and held by one or more independent custodians that are not affiliates of the covered swap entity or the counterparty. In connection with any required third-party custodial arrangements, no rehypothecation of margin is permitted (which is at variance with the BCBS/IOSCO Standards, under which “one-time” rehypothecation of initial margin is permitted in certain circumstances).15
The Proposals can be contrasted with the CFTC’s rules margin for cleared swaps. Margin for cleared swaps, which is posted by customers to their futures commission merchants (FCMs) and by the FCMs to the derivatives clearing organizations, is subject to existing CFTC segregation requirements, which require margin to be segregated from the assets of the FCM, but allow margin of multiple customers to be comingled in a single “omnibus” account. Although the CFTC Proposal does not address the use of an omnibus segregated account structure versus an individual segregated account, Commissioner Wetjen stated that he understood that the CFTC staff believes that the CFTC Proposal may permit an omnibus account structure. He further noted that this may present U.S. bankruptcy law issues for financial end users posting initial margin with third-party custodians. Commissioner Wetjen asked that the staff provide a legal analysis of the bankruptcy law implications of the use of an omnibus segregated account structure.
Impact on Foreign Exchange Swaps and Forwards
The Proposals do not require either initial margin or variation margin for uncleared foreign exchange swaps or foreign exchange forwards. This is consistent with the U.S. Treasury having exempted physically settled foreign exchange swaps and forwards from Dodd-Frank’s definition of a “swap” in November 2012.16 Although not subject to mandatory margining, physically settled foreign exchange swaps and forwards are included in determining whether a financial end user exceeds the threshold for material swap exposure, which is consistent with the BCBS/IOSCO Standards. Neither Proposal addresses whether foreign exchange swaps and forwards may be taken into account for purposes of margining requirements determined on a portfolio basis – including in a case where foreign exchange swaps and forwards are executed under an eligible master netting agreement that governs uncleared swap transactions; this raises an issue on which market participants may wish to comment.17
Questions Remain About Scope – Which Swaps are “Non-cleared” or “Uncleared”?
The Prudential Regulator Proposal would apply to “non-cleared swaps.” The CFTC Proposal would apply to “uncleared swaps.”18 Applicability of the Prudential Regulator Proposal turns on Section 1a(7) of the Commodity Exchange Act (CEA), which defines cleared swap as a swap that is directly or indirectly submitted to and cleared by a derivatives clearing organization registered with the CFTC.19 Interestingly, the CFTC’s definition of “uncleared swap” appears narrower, inasmuch as it would exclude swaps that are cleared by clearing organizations that have received CFTC no-action or exemptive relief (as well as those that may not qualify as “cleared swaps” under CEA Section 1a(7)). Thus, these definitions raise the question of whether and how margin requirements would apply to swaps that are cleared through non-U.S. clearing houses that have not registered with the CFTC.
Do the Proposals Undercut the CFTC Inter-Affiliate Clearing Exemption?
CFTC rules exempt certain inter-affiliate swaps from the CFTC’s mandatory clearing requirements, provided certain conditions are met.20 The CFTC rules do not require that affiliated entities exchange initial or variation margin as a condition of qualifying for the exemption.
Both of the Proposals would apply margin requirements to uncleared swaps between covered swaps entities and any affiliates that are financial end users (as many presumably would be).21At the CFTC open meeting on September 17, Commissioner Wetjen noted that the CFTC’s inter-affiliate clearing exemption was in the public interest, because inter-affiliate swaps offer risk-mitigating, hedging and netting benefits, and pointed out that the exemption does not, however, require that affiliated entities exchange margin. He questioned whether the proposal to impose a margin requirement on uncleared swaps between covered swap entities and their affiliates in circumstances where the CFTC’s clearing exemption would apply “would stifle their use and potentially balkanize risk management at systematically relevant registrants.” He invited the public to comment on this issue.22
Cross-Border Implications to Be Determined
Cross-border issues have been the subject of significant attention in the swaps market and among regulators, and the cross-border application of the uncleared swap margin rules will certainly have significant implications. The Prudential Regulator Proposal includes specific cross-border provisions. By contrast, the CFTC Proposal does not propose a specific approach to its cross-border application, but instead sets out three possible alternatives.
Interestingly, to address its cross-border jurisdiction under the CFTC Proposal, the CFTC did not simply fall back on its 2013 cross-border guidance (the Cross-Border Guidance),23 which enunciated the CFTC’s general approach to cross-border application of its swap rules. Instead, the CFTC Proposal includes an Advance Notice of Proposed Rulemaking in which three approaches to cross-border application of the margin requirements are offered for comment: a transaction-level approach consistent with the Cross-Border Guidance; an entity-level approach; and an approach that is largely consistent with the approach taken in the Prudential Regulator Proposal.
The Cross-Border Guidance approach would apply the CFTC’s margin rules to: (i) U.S. swap dealers for all of their uncleared swaps with all of their counterparties, and (ii) non-U.S. swap dealers when their counterparties are “U.S. persons” under the guidance. Branches, guaranteed affiliates and affiliate conduits would be treated as they are under the Cross-Border Guidance for other transaction-level requirements.
The entity-level approach would apply the CFTC’s margin rules based on the status of a swap dealer as a U.S. person or a non-U.S. person. A wrinkle in this approach is that the CFTC would allow substituted compliance for collateral posted by U.S. swap dealers and non-U.S. swap dealers with a U.S. guarantee. Substituted compliance could also be applicable to non-U.S. swap dealers trading with counterparties other than U.S. swap dealers. Substituted compliance would be permitted only if the CFTC were to make a determination that the foreign jurisdiction’s rules were comparable to the CFTC’s rules.
The Prudential Regulator Proposal for cross-border application of the margin rules has two basic components. First, the Prudential Regulators exclude from the application of the proposed rule “foreign non-cleared swaps” of “foreign covered swap entities.” A “foreign covered swap entity” includes a banking entity that (i) is registered with the CFTC as a swap dealer, (ii) is organized outside the United States, and (iii) is not controlled, directly or indirectly, by a U.S. entity. A U.S. branch of a foreign covered swap entity is not itself a foreign covered swap entity, nor is a foreign branch or subsidiary of a U.S. bank (whether guaranteed by the U.S. parent or not).
Under the Prudential Regulator Proposal, a foreign covered swap entity’s “foreign non-cleared swaps” include all swaps for which the counterparty (and its guarantor, if any) is not (i) organized in the United States, or (ii) a branch of an entity organized in the United States. The Prudential Regulator Proposal would not apply to a swap between a foreign covered swap entity and, for example, a fund that is organized in the Cayman Islands, even if that fund constituted a “U.S. person” for purposes of the CFTC’s Cross-Border Guidance. By contrast, the Prudential Regulator Proposal would be applicable to uncleared swaps of a foreign swap dealer that is controlled, directly or indirectly, by a U.S. parent.
The second component of the Prudential Regulator Proposal is the possibility of substituted compliance for foreign covered swap entities, a category that includes swap dealers that are foreign banks and their U.S. branches, and foreign subsidiaries of U.S. companies so long as they are not guaranteed by a U.S. company. Use of substituted compliance requires a determination by the Prudential Regulators that the requirements of the foreign jurisdiction are comparable to the rules established by the Prudential Regulators.
Cooperation among the international regulators on matters such as margin and clearing will be necessary to avoid over- or under-regulation. If the U.S. regulators choose to construe broadly the jurisdictional reach of Dodd-Frank, the possibility exists for there to be overlapping and inconsistent requirements imposed on market participants (this has been the case with certain reporting requirements, but the repercussions for margin would arguably be more significant). A non-coordinated approach could also lead to gaps in regulation and create opportunities for regulatory arbitrage.
Key Consequences for Certain Market Participants
Entities organized as insurance companies or licensed as insurers (or reinsurers) would constitute financial end users under both Proposals24 and thus would be subject to variation margin requirements and also, if the insurance company has a material swaps exposure, to initial margin requirements. Insurance companies that have a material swaps exposure will be required to post and will receive initial margin for each transaction with a covered swap entity; however, initial margin will be required only to the extent the amount of initial margin (for it and its affiliates) exceeds the $65 million initial margin threshold amount (subject to a $650,000 minimum transfer amount). Separate and apart from the initial margin requirements that will apply to insurance companies with a material swaps exposure, all insurance companies that are financial end users will be required to post or collect, as applicable, cash variation margin on a daily basis, commencing no later than one business day after the execution of each transaction.
Banks constitute a significant portion of registered swap dealers. Furthermore, banks would qualify as financial end users, and thus banks that are not covered swap entities will be relatively more affected by the margin regulations than other end users. For both contingents, the proposed margin regulations pose a set of challenges and questions.
Assuming that the rules are adopted as proposed, bank swap entities will likely undertake two key parallel workstreams. The first will be with the relevant Prudential Regulator, and the second will be with their swap counterparties. The first will be aimed at obtaining approval for internal initial margin models. Most if not all banks registered as swap dealers will seek to use their own internal models or industry standard models to calculate minimum initial margin, in lieu of using the table-based approach in the Proposals (reflecting standardized haircuts) due to the potential for significant efficiencies in collateral management.
In parallel, covered swap entities will likely undertake a review of ongoing trading relationships to conform them to the new requirements (including requirements on documentation and restrictions on eligible collateral). This second work-stream will involve engagement with counterparties and, in some cases, significant revisions to master agreements and collateral support arrangements. Both work-streams are likely to require dedication of significant resources, although efficiencies will be gained from well-run implementation programs that coordinate legal, compliance, risk, trading and other teams involved in derivatives operations, as well as assistance from outside counsel.
Banks that are not covered swap entities will nevertheless face challenges and questions in complying with the regulations when entering into swaps with covered swap entities. Because the applicability of initial margin requirements turns on whether a financial end user has material swaps exposure, banks (like other financial end users) will need to develop means for assessing whether they meet this threshold on a group-wide basis. Relatedly, due to the inclusion of “a bank holding company or an affiliate thereof” in the definition of financial end user, the presence of a bank within a corporate family will raise this question across all related entities, each of which will need to take its affiliates into account in its assessment.
Hedge Funds and Other Alternative Investment Vehicles
The Proposals would define financial end user in a manner that would include virtually all hedge funds and other alternative investment vehicles. Funds would therefore be subject to variation margin requirements; they would also be subject to initial margin requirements to the extent that they have material swaps exposure. For fund managers that have been accustomed to negotiating their own favorable collateral terms with their swaps counterparties (e.g., negotiated unsecured thresholds), the Proposals would impose significant constraints. However, required initial margin (where the fund has material swaps exposure) would be posted in both directions. Although initial margin amounts would not be netted against one another for posting purposes (and would be subject to third-party custodial arrangements), the presence of two-way initial margin postings would limit credit exposure, provided the arrangements were subject to enforceable netting agreements. Funds that do not have material swaps exposure would retain their ability to negotiate initial margin terms that may be more favorable than those required by the Proposals.
Securitization vehicles would generally be covered by the definition of financial end user.25Thus, like hedge funds and other alternative investment vehicles, they would be subject to variation margin requirements. In addition, to the extent they have material swaps exposure, securitization vehicles would be subject to initial margin requirements. The Proposals do not, however, expressly address the application of the definition of material swaps exposure to newly formed issuing vehicles. The definition employs a look-back mechanism – referencing “June, July and August of the previous calendar year.” No newly-formed securitization vehicle would have material swaps exposure if it is determined on a look-back basis. This may have been intentional, but it was not the subject to commentary under either Proposal.
The Prudential Regulators (but not the CFTC) sought specific comment on the definition of “control” (which is the same under both Proposals) as applied to securitization vehicles. The definition is relevant because it determines whether a securitization vehicle would be deemed to be an affiliate of its sponsor or investment adviser and thus subject to aggregation mechanisms for determination of its material swaps exposure. The Prudential Regulators stated that they “believe that advised and sponsored funds and sponsored securitization vehicles would not be affiliates of the investment adviser or sponsor unless the adviser or sponsor meets the definition of control (e.g., owning 25 percent or more of the voting securities or total equity or controlling the election of the majority of the directors or trustees).”26 The Prudential Regulators requested specific comment on this view.
Energy and Other Operating Companies
Energy companies and other traditional operating companies should, in most cases, avoid qualification as financial end users, and thus should not be required to post or collect either initial margin or variation margin under the Proposals. However, it should be noted that even though the Proposals do not require covered swap entities to post margin to or collect margin from non-financial end users in specific amounts, covered swap entities are expressly required to engage in prudent risk management. Thus from a credit-risk perspective, they may require energy other operating companies to post collateral (or provide other suitable credit enhancement). The amount and extent of such collateral (or credit enhancement) generally would not be subject to regulatory requirements, and thus should be negotiable between the parties.
Because many of these entities are also exempt from the clearing mandate (to the extent transactions are entered into for hedging purposes and the entities make the necessary elections and filings), these entities may be able to engage in hedging swap transactions without having to clear or otherwise post margin.
Selective Comparison of the Proposals27