Introduction

The Dodd-Frank Wall Street Reform and Consumer Protection Act and related Commodity Futures Trading Commission (“CFTC”) regulations require that swap dealers notify their swap counterparties (“end-users”) of their right to require segregation of initial margin posted in connection with uncleared swap transactions.

Final CFTC rules on initial margin segregation 1 became effective earlier this year and in order to comply with their obligations, swap dealers have started sending their counterparties an initial margin segregation right notice (the “Segregation Rights Notice”) requesting that end-users make elections whether or not to require segregation of collateral in accordance with CFTC regulations.

This alert describes the main features of the CFTC initial margin segregation requirements for uncleared swaps (the “CFTC IA Segregation Regime”) and applicable compliance deadlines, as well as alternatives and practical next steps for end-users.

CFTC IA Segregation Regime

The main features of the CFTC IA Segregation Regime are as follows:

  • Initial margin must be held at an independent custodian in a segregated account that is designated for and on behalf of the end-user;
  • An initial margin segregation agreement (typically in the form of a tri-party account control agreement) must be in writing and provide that:
    1. a party can obtain the transfer of segregated initial margin without the other party’s consent if such party provides the custodian with a written statement (made under penalty of perjury) that it is entitled to control pursuant to the tri-party agreement;
    2. any other withdrawal of margin must be in accordance with the agreement of both the end-user and swap dealer; and
    3. in each instance, the non-withdrawing party must receive immediate notification of a withdrawal.
  • Segregated initial margin posted in cash can only be invested by the custodian pursuant to CFTC Rule 1.25, which only permits certain highly liquid investments that are intended to preserve principal (e.g., certain government securities, certificates of deposit, and money market mutual funds).

Segregation Rights Notice and Applicable Deadlines

In their Segregation Rights Notice, swap dealers are required to (i) identify one or more independent custodians (one of which must be a creditworthy non-affiliate) which an end-user can select to hold initial margin and (ii) provide initial margin segregation pricing information.

End-users should receive the Segregation Rights Notice via e-mail or ISDA Amend if they have provided certain collateral contact information on that platform. In order to avoid disruptions to their swap trading activities, endusers will need to (i) confirm that the applicable collateral contact has received the Segregation Rights Notice and (ii) make an election with respect to the CFTC IA Segregation Regime prior to May 5, 2014 (for swap agreements entered into after January 6, 2014) or November 3, 2014 (for swap agreements entered into before January 6, 2014) (each, the “Compliance Date”). If an end-user elects the CFTC IA Segregation Regime, only initial margin relating to swaps entered into after the applicable Compliance Date is required to be segregated. End-users will receive Segregation Rights Notices on annual basis and have the right to change any previous CFTC IA Segregation Regime election at their discretion by delivering a written notice to their swap dealer counterparty.

End-users Alternatives and Next Steps

Before returning the Segregation Rights Notice, end-users should consider the costs and benefits of initial margin segregation, including the additional protection that segregation provides in the event of the insolvency of their swap dealer counterparties.

End-users may elect not to request segregation of initial margin pursuant to the CFTC regime and, instead adopt (or maintain existing) initial margin segregation pursuant to an agreement with their swap dealer counterparties and a custodian that would not strictly follow the CFTC IA Segregation Regime. In weighing this alternative, market participants should consider the differences between the CFTC IA Segregation Regime and other approaches that have been adopted by the industry in the aftermath of the credit crisis. In either case, market participants should carefully negotiate segregation agreements specifying which counterparty will have access to the segregated initial margin and under which circumstances (see Effective Collateral Protection for Swaps for more information on contractual provisions customarily negotiated in those agreements).

End-users may also elect not to segregate initial margin at all for their uncleared swap transactions.

In the meantime, market participants should take one of the following steps by the applicable Compliance Date in order to avoid trading disruptions:

  • If an end-user does not currently, but wishes to, segregate initial margin pursuant to the CFTC IA Segregation Regime, it should (i) make an election to that effect in the Segregation Rights Notice and (ii) enter into corresponding tri-party agreements. In such a case, the end-user should consider whether mutually acceptable tri-party custodial agreements will be in place by the applicable Compliance Date.
  • If an end-user already segregates initial margin but wishes to elect the CFTC IA Segregation Regime, it should (i) make such election in the Segregation Rights Notice and (ii) amend existing tri-party custodial agreements to be consistent with the CFTC IA Segregation Regime.
  • If an end-user already segregates initial margin and does not wish to elect the CFTC IA Segregation Regime, existing agreements do not need to be amended. However, such end-user will still need to complete the Segregation Rights Notice and elect not to apply the CFTC IA Segregation Regime.
  • If an end-user does not wish to segregate initial margin, it should merely elect not to apply the CFTC IA Segregation Regime in the Segregation Rights Notice.