Types of transactionClearing transactions
What categories of equity derivatives transactions must be centrally cleared and what rules govern clearing?
All listed equity options must be centrally cleared, and the Options Clearing Corporation (OCC) is the only clearinghouse for listed equity options traded on all US exchanges.
Equity derivatives that are Commodity Futures Trading Commission (CFTC)-regulated swaps (such as swaps referencing broad-based securities indices or US government securities) must be centrally cleared if the CFTC has issued an order requiring clearing of that category of swap. Certain index credit default swaps (CDS) are currently required to be cleared.
Equity derivatives that are security-based swaps are subject to analogous rules under the Exchange Act. The Securities and Exchange Commission (SEC) has recently finalised rules triggering the implementation of the security-based swap regulatory regime under the Dodd-Frank Act. As a result, while no equity derivatives that are security-based swaps are currently required to be cleared, the SEC could begin issuing mandatory clearing orders as soon as October 2021.Exchange-trading
What categories of equity derivatives must be exchange-traded and what rules govern trading?
Listed equity options must be traded on an options exchange.
Any equity derivative that is a CFTC-regulated swap that is subject to mandatory clearing and has been determined to be ‘made available to trade’ must generally be executed on a designated contract market, which is a futures exchange registered with the CFTC, or a CFTC-regulated swap execution facility. Currently, equity derivatives subject to mandatory clearing and trade execution requirements include certain index CDS.
Equity derivatives that are security-based swaps are subject to analogous rules under the Exchange Act. However, the SEC has yet to finalise rules implementing these requirements. As a result, no equity derivatives that are security-based swaps must be executed on an execution facility or exchange.
If one or both of the parties to an equity derivatives transaction that is a swap or security-based swap is not an ‘eligible contract participant’ (as defined in the Commodity Exchange Act), then the transaction must be exchange-traded.Collateral arrangements
Describe common collateral arrangements for listed, cleared and uncleared equity derivatives transactions.Swaps and security-based swaps
Counterparties to uncleared equity derivatives that are swaps or security-based swaps typically document their collateral arrangements using a Credit Support Annex published by ISDA that supplements the ISDA Master Agreement. Under rules issued by US banking regulators and the CFTC, swap dealers (and security-based swap dealers, in the case of the US banking regulators’ rules) are (in some cases) and will be (in others) required to collect and post initial and variation margin with certain counterparties in specified amounts, and subject to requirements concerning collateral types, segregation and documentation. The SEC recently issued similar rules for security-based swap dealers that are not subject to the US banking regulators’ rules, compliance with which rules will be required beginning in October 2021.
For listed equity options, an investor must deposit cash or securities or both as collateral in its brokerage account when writing an option. Options buyers generally do not post margin, but they are required to pay a premium. Initial and maintenance margin requirements for options writers are established by the options exchanges and Financial Industry Regulatory Authority, Inc (FINRA) rules and vary by option and position type. Broker-dealers carrying customer options accounts may impose higher margin standards than those required by FINRA and the exchanges. The OCC imposes margin requirements on its clearing members with respect to each account maintained at the OCC.
There are no margin requirements imposed by US regulators, exchanges or clearinghouses for OTC equity options, and therefore any collateral arrangements are established bilaterally between the counterparties.Exchanging collateral
Must counterparties exchange collateral for some categories of equity derivatives transactions?Swaps and security-based swapsUncleared swaps and security-based swaps
Swap dealers and security-based swap dealers are, in certain cases, required to collect and post margin pursuant to rules that have been issued by the US banking regulators (which apply to swaps and security-based swaps entered into by bank dealers and certain other ‘prudentially regulated’ dealers) and the CFTC (which apply to swaps entered into by non-bank swap dealers). The SEC has recently finalised its uncleared security-based swap margin rules that will apply to security-based swap dealers that are not prudentially regulated by a US banking regulator.
The uncleared swap and uncleared security-based swap margin rules of the CFTC and US banking regulators are in effect for variation margin, and are subject to a phased-in compliance schedule for initial margin, lasting until 1 September 2022, with the precise date for a given counterparty pair depending on the size of their respective derivative portfolios.
Under the CFTC’s and US banking regulators’ rules, certain counterparties of swap dealers and security-based swap dealers to uncleared swap and uncleared security-based swap transactions may be required to collect or post initial and variation margin. Specifically, all transactions where one counterparty is a swap dealer (or a security-based swap dealer, in the case of the US banking regulators’ rules) and the other counterparty is either a swap dealer (or security-based swap dealer, as applicable) or financial end user require variation margin to be exchanged bilaterally. Additionally, if the counterparty facing a swap dealer (or a security-based swap dealer, in the case of the US banking regulators’ rules) is a swap dealer (or security-based swap dealer, as applicable) or a financial end user with ‘material swaps exposure’, the parties will be required to exchange initial margin bilaterally (subject to regulatory minimums). If the counterparty facing a swap dealer (or a security-based swap dealer, as applicable) is not a financial end user, the US banking regulators’ rules require that the swap dealer or security-based swap dealer collect initial and variation margin, as appropriate; the CFTC’s rules, on the other hand, do not affirmatively require the collection of initial and variation margin from non-financial end users. Certain swap transactions that are subject to an exemption from the CFTC’s mandatory clearing requirement are exempt from the initial and variation margin requirements. Finally, if neither counterparty is a swap dealer (or security-based swap dealer, in the case of the US banking regulators’ rules), the margin rules do not apply.
Special rules also apply to certain cross-border transactions, in which certain exemptions are provided for foreign banks (but not their US branches), though these exemptions are subject to many conditions and limitations.
For uncleared security-based swaps with a security-based swap dealer that is regulated by the SEC and not by a US banking regulator, compliance with the SEC’s uncleared security-based swap margin rules will begin in October 2021. Counterparties to these transactions, however, may determine to exchange non-regulatory collateral bilaterally in the interim.
Cleared swaps and security-based swaps
For cleared swaps and security-based swaps, the counterparty must comply with the collateral exchange requirements of the particular clearing organisation and the clearing member through which the counterparty obtains access to that clearing organisation, which has requirements that are themselves subject to CFTC and SEC requirements.
For listed equity options, there is no requirement for the counterparties to exchange collateral, although a listed equity options writer is required to post collateral to its broker-dealer.
Any collateral arrangements for OTC equity options are established bilaterally between the counterparties.