On April 13, both the Commodity Futures Trading Commission ("CFTC") and Federal Banking Regulators including the Federal Reserve1 proposed rules pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") to establish collateral and margin requirements for Swap Dealers and Major Swap Participants ("SD/MSPs") and swap counterparties. While end-user counterparties who are using a swap to hedge or mitigate commercial risk would be generally exempt from mandatory margin requirements under the CFTC's proposal applicable to non-bank SD/MSPs, they would have to post cash margin to bank SD/MSPs if they exceed certain thresholds under the Federal Banking Regulators' proposal.
Section 731 of Dodd-Frank directs both the CFTC and the Federal Banking Regulators to adopt rules for non-bank and bank SD/MSPs, respectively, imposing initial and variation margin requirements on all uncleared swaps to which such SD/MSPs are parties. In proposing these rules, the CFTC and the Federal Banking Regulators have produced differing proposals, with the CFTC proposing to largely exempt end-users who are using a swap to hedge commercial risk from mandatory margin requirements when transacting with non-banks, while the Federal Banking Regulators would require such end-users to post cash margin in certain circumstances when transacting with banks. Under both proposals, it is clear that financial institutions who are not using a swap to hedge commercial risk would have to post margin to SD/MSP counterparties, subject in some cases to exposure thresholds beneath which margin would need not be posted.
The CFTC's Proposal
Under the CFTC's proposal, for swaps entered into between non-bank SD/MSPs, each entity would be required to collect initial and variation margin in cash or certain equivalents,2 and no threshold would apply below which margin would not have to be collected. For financial entities, which include banking entities, certain funds and commodity pools, the proposal effectively distinguishes between high-risk and low-risk entities, and applies different margin collection obligations on SD/MSP-counterparties accordingly. For financial counterparties that qualify as being low-risk, i.e. those that are subject to capital requirements of a prudential regulator, lack significant uncleared swaps exposure and predominantly use swaps to hedge or mitigate interest rate or other business risk, non-bank SD/MSPs must collect margin only to the extent exposure to the counterparty exceeds a threshold established based on ranges put forth for comment in the CFTC's proposal. For financial counterparties that do not qualify under the low-risk criteria, both initial and variation margin would have to be collected by a non-bank SD/MSP without regard to any threshold.
However, for a non-financial entity, including end-users hedging or mitigating commercial risk and thus eligible to opt out of clearing of a swap, the CFTC proposal would not require non-bank SD/MSPs to collect initial or variation margin. Rather, the proposal effectively permits current credit practices to continue while requiring that SD/MSPs and non-financial counterparties must have negotiated "credit support arrangements" in place to cover exposure under the relevant swap. Non-cash collateral would be permitted in accordance with such negotiated credit support arrangements, as long as the value of the assets is reasonably ascertainable on a periodic basis.
The Federal Banking Regulators' Proposal
The Federal Banking Regulators' proposal sets forth initial and variation margin collection obligations for bank SD/MSPs that are in most respects aligned with the CFTC's proposal in the treatment of financial counterparties. That is, financial counterparties that qualify as "low risk" (with criteria similar to that set forth in the CFTC's proposal) will only have to post margin to bank SD/MSPs to the extent the SD/MSP's exposure under the relevant swap exceeds certain thresholds to be established based on proposed ranges set forth in the proposal. Financial counterparties that do not meet those "low risk" criteria will have to post initial and variation margin in cash or cash equivalents regardless of any thresholds.
However, unlike under the CFTC proposal, non-financial end-user entities who are using a swap to hedge commercial risk would have to post both initial and variation margin to a bank SD/MSP to the extent the SD/MSP's exposure under a swap exceeds a given threshold. Such margin must be posted in cash or in a limited set of U S government-backed cash equivalent securities (which will be subject to a “haircut”). Letters of credit do not appear to qualify as margin under the Federal Banking Regulators' proposal. The thresholds would be set for such end-user entities by the bank SD/MSP according to prudent credit practices. While no specific procedure is set forth for determining such thresholds, a major question remains the extent to which end-users and bank SD/MSPs will be free under the proposal to set their own appropriate thresholds to avoid the collection of margin from end-users.
Under these competing proposals, financial entities engaging in swap transactions with SD/MSPs would be treated largely the same with respect to the collection of margin regardless of whether they are transacting with a bank or a non-bank. If such an entity qualifies under similar standards under both proposals, it would have to post margin only where its SD/MSP counterparty's exposure exceeds a certain threshold to be further specified in the final rules.
However, a non-financial entity using swaps to hedge commercial risk, even one eligible to opt of the Dodd-Frank swap clearing requirement, would face seriously disparate treatment under the proposals depending on whether it is entering into a swap with a bank or a non-bank. If its SD/MSP counterparty is a non-bank subject to the CFTC's jurisdiction, such an entity would not have to post margin to cover exposure as long as it and its counterparty have a negotiated credit support arrangement in place. While the exact contours of acceptable credit support arrangements remain to be spelled out in detail, it is clear that such arrangements could continue to include non-cash collateral. On the other hand, if a non-financial end-user enters into a swap with a bank subject to the jurisdiction of one or more of the Federal Banking Regulators, it would be subject to exposure thresholds above which it would have to post cash margin.
Since most swap counterparties of end-users today are banks, the Federal Banking Regulators' proposal would have the likely effect of requiring the posting of cash margins by end-users in order to continue using swaps to hedge commercial risk. Standard practices in today’s energy commodity market such as the use of letters of credit as collateral, or a pari passu first lien as collateral in conjunction with a credit agreement or other loan, will not be permitted. Given the common use of these forms of collateral and the cash positions of many energy commodity firms, the Federal Banking Regulators' proposal will have a material impact on the continued ability to hedge risk.
As banks and their affiliates are currently the vast majority of hedging counterparties for energy commodity end-users (at least until the “Push Out Rule”3 takes effect), the Federal Banking Regulators' proposal, if adopted as proposed, will disrupt lending and hedging practices in a significant portion of the energy commodity space. The Federal Banking Regulators' proposal will remain open for comment until June 24. We expect that end-user entities will turn their attention to educating the Federal Banking Regulators concerning risk mitigation in the industry and the detrimental effects of their proposal on swap-based hedging.