On September 3, 2014, the Board of Governors of the Federal Reserve System (the Board) jointly adopted, with certain federal banking regulators,1 re-proposed rules that will require registered swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, that are regulated by one of the Prudential Regulators (covered swap entities), to collect margin from, and post margin to, certain of their counterparties in connection with over-the-counter swaps. The re-proposed rules (the 2014 PR Proposal) are one of the last key aspects of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act that remain to be implemented.
Following the Prudential Regulators’ re-proposal, the Commodity Futures Trading Commission (CFTC) voted on September 17, 2014, to re-propose rules that would impose margin collection and posting requirements on registered swap dealers and major swap participants that are not subject to the oversight of a Prudential Regulator.2 Because the CFTC’s re-proposed margin rules will only apply to those swap dealers and major swap participants that are not subject to regulation by one of the Prudential Regulators or the Securities and Exchange Commission, such re-proposed rules will primarily apply to non-bank swap dealers and major swap participants. Although the CFTC rules are substantially similar to the 2014 PR Proposal, this Legal Alert focuses only on the 2014 PR Proposal.
The 2014 PR Proposal
The Prudential Regulators issued a proposed rule on this same topic in 2011 (the 2011 Proposal); however, in light of comments received in response to the 2011 Proposal, and a recommended global framework for margin requirements that was released two years later by the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision, the Prudential Regulators issued the 2014 PR Proposal. The 2014 PR Proposal was published in the Federal Register on September 24, 2014 and is open for public comment through November 24, 2014. In that regard, the 2014 PR Proposal is not finalized, and the terms described below may change in the final rules adopted by the Prudential Regulators.
The 2014 PR Proposal outlines the requirements for both initial margin and variation margin in connection with over-the-counter swap transactions. Whether a market participant must post collateral depends upon its categorization and overall exposure with any given counterparty on a consolidated basis, as discussed further below.
The 2014 PR Proposal categorizes market participants as follows:
- Covered Swap Entities
- “Covered swap entities” are swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants.
- Financial End-Users
- “Financial end-users” are a specific set of entities listed in the re-proposed rules. Such entities include, among others, non-swap dealer banks, money services businesses, any institution chartered and regulated by the Farm Credit Administration, entities regulated by the Federal Housing Finance Agency, private funds, broker-dealers, insurance companies, commodity pools, commodity trading advisors, employee benefit plans, and business development companies. The definition purposefully doesnot include the “catch all” bucket contained in the definition of “financial entity” in Section 2(h)(7)(C) of the Commodity Exchange Act, i.e., an entity predominantly engaged in activities that are financial in nature (as defined in the Bank Holding Company Act). However, the 2014 PR Proposal affords the Prudential Regulators discretion to designate an entity a “financial end-user.”
- Other Counterparties
- Entities not falling within the “covered swap entity” or “financial end-user” categories are considered “other counterparties” for purposes of the 2014 PR Proposal. Certain entities that are expressly carved out of the financial end-user category, including sovereign entities, multilateral development banks and financing affiliates, are considered “other counterparties.”
Covered swap entities are required to both collect and post initial margin for swap transactions with other covered swap entities or with financial end-users that have material swaps exposure.3 The collection and posting of initial margin is required if the counterparties (and their affiliates) have an aggregate credit exposure, for over-the-counter swaps and security-based swaps, of $65 million or more.4 The 2014 PR Proposal defines “material swaps exposure” as an average daily aggregate notional amount of $3 billion or more for all non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps.5 or purposes of calculating whether it has “material swaps exposure,” a financial end-user must take into consideration all of its and its affiliates’ transactions with all counterparties.
Initial margin, which must be re-calculated and paid daily, may include cash, gold and certain government bonds, corporate bonds, and equities. The 2014 PR Proposal requires that initial margin be calculated pursuant to a model approved by a covered swap entity’s Prudential Regulator or a standardized approach detailed in Appendix A to the 2014 PR Proposal. Initial margin that is required to be collected by a covered swap entity must be segregated with a third-party custodian. All initial margin (i.e., that which is required and any excess) that is posted by a covered swap entity to its counterparty must be segregated with a third-party custodian.6
Swap transactions entered into by a covered swap entity and “other counterparties” have no set initial margin requirements, unless the covered swap entity determines that it must collect initial margin to address the credit risk posed by such counterparty and/or the risk of the swap transaction itself.
Covered swap entities must collect variation margin from, and post variation margin to, all covered swap entity and all financial end-user counterparties (i.e., regardless of whether a financial end-user has material swaps exposure). Like initial margin, variation margin must be re-calculated and paid daily, and both types of margin are subject to an aggregate $650,000 minimum transfer amount. Notably, the 2014 PR Proposal only allows for cash as “eligible collateral” for variation margin, even though many market participants include in their trading documentation the ability to post as variation margin other types of collateral, e.g., U.S. Treasuries. Variation margin is not subject to any segregation requirements under the 2014 PR Proposal and may be re-hypothecated if permitted under the parties’ trading documentation.
If a covered swap entity enters into a swap transaction with an “other counterparty,” then it only must collect variation margin from such counterparty if it determines that the credit risk of that counterparty and the nature of the transaction require the margin payments. If the other counterparty would like for its swap entity counterparty to post variation margin, it will be required to negotiate that obligation in the relevant trading documentation.
For variation margin, all covered swap entities must comply with the rule on December 1, 2015. Thus, this compliance date applies to financial end-users as well.
The 2014 PR Proposal provides for a phased-in compliance schedule for the initial margin requirement that is based on the average daily aggregate notional amount of covered swaps between the covered swap entity and its counterparty. Most financial end-users that have material swaps exposure (and are thus subject to the initial margin requirements) would likely not be subject to the initial margin requirements until December 1, 2019; however, compliance dates would arrive earlier for covered swap entities, beginning on December 1, 2015, in accordance with the following:
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Changes to Documentation
Market participants that are impacted by the new margin rules would have to make a number of changes to their existing trading documentation to comply with the new margin requirements. At a minimum, these changes would include provisions for separate calculations and payments for initial and variation margin, modification to collateral thresholds, eligible collateral, minimum transfer amounts, dispute resolution, and mandatory valuation days. Parties to swap transactions requiring initial margin would also be required to enter into tri-party custodial agreements to satisfy the segregation requirements contained in the 2014 PR Proposal.
The 2014 PR Proposal would have a retroactive effect on existing swaps to the extent that both initial and variation margin are calculated on an aggregate net basis for all swaps entered into under a single master agreement. Aggregate netting must include historic swaps entered into prior to the effective date of the new margin rules to the extent that they are entered into under the same master agreement with swaps entered into after the compliance date for the new margin requirements. If a party chooses not to net historic swaps on an aggregate basis, it would have to enter into new master agreements that would cover only those swaps entered into with a covered swap entity after the compliance dates for the final margin rules. Potentially, three master agreements could be required to avoid retroactive treatment with respect to both variation and initial margin requirements.7
Of Special Note to “Other Counterparties”
Although the 2014 PR Proposal generally seems to exclude “other counterparties” from the margin requirements, such entities should be aware that the 2014 PR Proposal requires a covered swap entity to consider requiring margin due to credit or risk concerns (determined at the sole discretion of the covered swap entity). In addition, covered swap entities that are subject to new capital requirements under Basel III may require margin for uncollateralized transactions to cover the capital requirements, because under Basel III covered swap entities may be penalized for failing to do so. Also, nothing would preclude entities that are not subject to the margin rules from bilaterally negotiating margin requirements.
Potential Comments to Prudential Regulators
As noted above, comments in response to the 2014 PR Proposal will be due to the Prudential Regulators by November 24, 2014. Among other things, it is anticipated that market participants will comment on the following aspects of the 2014 PR Proposal:
- Limitation on Eligible Collateral for Variation Margin
- The 2014 PR Proposal would require all variation margin payments to be made in cash. According to the 2014 PR Proposal, this is meant to reflect existing market practice. In addition, requiring cash is consistent with variation margin requirements for cleared swaps. However, many end-users, to the extent that they exchange variation margin with their over-the-counter swaps counterparties, routinely post other assets. Requiring cash will affect liquidity and would be costly for those entities that have traditionally posted collateral other than cash.
- December 1, 2015, Compliance Date for Variation Margin Requirement
- Under the 2014 PR Proposal, covered swap entities would be required to exchange variation margin, in cash, on a daily basis, with their covered swap entity and financial end-user counterparties, beginning on December 1, 2015. This compliance deadline may be too short. In order to comply with this requirement, it would be necessary to develop and execute thousands of amendments to existing over-the-counter swaps documentation. Such amendments would likely require a great deal of time and resources.
- Retroactive Effect of Margin Requirements
- The 2014 PR Proposal indicates that the initial and variation margin requirements would only apply prospectively, but only to the extent that swaps executed after the relevant compliance date are not netted with swaps that were executed prior to the relevant compliance date. The practical effect of this requirement, as pointed out above, is that market participants wishing to grandfather their existing trades would be required to put new sets of documentation in place. Effectively, this would cause market participants to weigh the difference in the costs of putting new documentation in place and applying the new margin requirements to their entire portfolios, either of which may be unduly burdensome.
- Implications of Including Affiliates in Key Calculations
- The 2014 PR Proposal requires covered swap entities and financial end-users to determine the $65 million initial margin threshold, and financial end-users to calculate whether they have material swaps exposure on a consolidated entity basis. This may prove difficult for certain market participants, including asset managers, in light of the relatively low (25%) threshold for ownership and control contained in the 2014 PR Proposal, which the Prudential Regulators assert is similar to the definition of control in the Bank Holding Company Act. It may not be possible or practical for market participants to obtain information from, and allocate initial margin thresholds between, entities that are only 25% owned.
- Calculating Material Swaps Exposure
- The 2014 PR Proposal does not address the scenario where a financial end-user ceases to have material swaps exposure. The 2014 PR Proposal indicates that material swaps exposure is to be calculated by reference to the months of June, July and August of the prior calendar year. Because posting initial margin will be burdensome, it is anticipated that financial end-users that fall below the material swaps exposure threshold prior to the stipulated calculation time frames would want to cease having to post initial margin as soon as possible after they fall below the material swaps exposure threshold.
- Interplay of the 2014 PR Proposal and CFTC Trade Documentation Requirements
- As discussed above, the 2014 PR Proposal will require market participants to make significant amendments to their existing trade documentation. It will be necessary for market participants to compare the necessary changes resulting from the 2014 PR Proposal with the trade documentation requirements imposed on swap dealers and major swap participants under CFTC rules.
- Characterization of Treasury Affiliates and Centralized Hedging Centers
- Certain market participants consolidate their swaps trading activities in treasury affiliates or centralized hedging centers. Under the Commodity Exchange Act, such affiliates and centralized hedging centers are considered financial entities, because they are predominantly engaged in activities that are financial in nature. The 2014 PR Proposal does not include treasury affiliates and centralized hedging centers in the “financial end-user” definition, but it does not expressly exclude them either. It is anticipated that market participants with treasury affiliates or centralized hedging centers will request that the Prudential Regulators confirm that such affiliates and hedging centers are not financial end-users.