SEC Order Grants Exemptions to Permit Portfolio Margining of CDS

SUMMARY

The SEC has adopted an exemptive order that provides relief from certain Exchange Act requirements otherwise applicable to customer accounts carrying credit default swap positions consisting of swaps and security-based swaps. The relief is available to (i) clearing organizations dually registered as clearing agencies with the SEC and derivatives clearing organizations with the CFTC, and (ii) entities dually registered as broker-dealers with the SEC and futures commission merchants with the CFTC. The relief is available only with respect to accounts of customers that qualify as eligible contract participants. The relief available to a dually registered clearing organization is conditioned on, among other things, adoption of rules by the CFTC permitting portfolio margining of CDS and the clearing organization permitting its clearing members to elect between offering customers accounts that conform to requirements related to segregation and portfolio margining under either the Exchange Act or the CEA. The relief available to a dually registered broker-dealer / futures commission merchant is conditioned on, among other things:

  • the customer entering into a non-conforming subordination agreement;
  • maintenance of margin levels no lower than those determined using a margin methodology that has been approved by the SEC (or its staff); and
  • provision of certain disclosures to customers with accounts participating in a CDS margining program undertaken pursuant to the Exemptive Order.  

The SEC seeks comment on all aspects of the Exemptive Order. The Exemptive Order became effective on December 19, 2012 and comments on it are due by February 19, 2013.  

BACKGROUND

Pursuant to the regulatory framework established by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Title VII”), the SEC has regulatory authority over security-based swaps under rather than a swap if it settles on the basis of:

  • a single security,
  • a narrow-based security index or
  • an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index if such event directly affects the financial statements, condition, or obligations of the issuer(s).  

Under this definition, a credit default swap may qualify as either a “security-based swap” or “swap” depending on whether or not it is based on a single security or narrow-based security index (or events directly affecting the financial statement, condition or obligations of issuer(s) of a single security or narrow-based security index). As a result, a portfolio of credit default swaps may be subject to two distinct sets of requirements, one administered by the SEC and the other administered by the CFTC.  

Distinct requirements under the Exchange Act and CEA include those related to safeguarding of money, securities, and property (“Collateral”) provided by customers to margin, guarantee or secure (“Margin”) their:

  • in the context of the Exchange Act, security-based swap positions with a broker-dealer (“BD”); and
  • in the context of the CEA, swap positions with a futures commission merchant (“FCM”).  

Distinct requirements also apply to clearing organizations regulated under the Exchange Act, referred to as clearing agencies, and those regulated under the Commodity Exchange Act, referred to as derivatives clearing organizations (DCOs). A clearing agency that provides clearing services with respect to security-based swaps is subject to registration requirements under Section 17A of the Exchange Act2; a DCO that provides clearing services with respect to swaps is subject to registration requirements under Section 5b of the CEA.  

Due to the distinct requirements with respect to maintenance of accounts for cleared security-based swap positions and cleared swap positions under the Exchange Act and CEA, respectively, in the absence of relief, a program could not be established to commingle and portfolio margin cleared customer portfolios of credit default swaps where the portfolio includes both security-based swaps and swaps (a “CDS Portfolio”). As discussed in more detail below, the Order Granting Conditional Exemptions under the Securities Exchange Act of 1934 in Connection with Portfolio Margining of Swaps and Security-Based Swaps (“Exemptive Order”)3 enables dually registered entities to comply with certain requirements applicable to maintenance of customer accounts under the CEA without complying with parallel requirements under the Exchange Act in order to permit clearing organizations and their clearing members to offer programs that provide for commingling and portfolio margining of cleared customer CDS Portfolios (“CDS Margining Programs”).

EXEMPTIVE ORDER

To permit CDS Margining Programs, the Exemptive Order provides conditional relief from otherwise applicable restrictions related to customer accounts under the Exchange Act to (i) persons dually registered as a clearing agency under the Exchange Act and a DCO under the CEA (a “clearing agency/DCO”), and (ii) persons dually registered as a broker-dealer under the Exchange Act and a futures commission merchant under the CEA (a “BD/FCM”). Subject to a number of conditions, the relief permits dual registrants to comply with certain requirements related to segregation and margining of customer accounts under the CEA in lieu of parallel requirements under the Exchange Act. The CFTC will have to issue relief from certain parallel requirements under the CEA for a clearing agency/DCOs and BD/FCMs to benefit from the Exemptive Order.  

A. CDS PORTFOLIO MARGINING BY ENTITIES DUALLY REGISTERED AS CLEARING AGENCIES AND DERIVATIVES CLEARING ORGANIZATIONS

The Exemptive Order permits a clearing agency/DCO to be exempted from restrictions (concerning segregation, investment and use of customer Collateral for security-based swap positions) under Sections 3E(b), (d), and (e) of the Exchange Act and rules thereunder to the extent that it is performing the functions of a clearing agency for a customer participating in a CDS Margining Program. This relief is only available to accounts of customers that are eligible contract participants.4 To qualify for relief under the Exemptive Order, the clearing agency/DCO must undertake certain actions aimed at providing its BD/FCM clearing members with a choice as between offering customers the protections afforded under the Exchange Act and the protections afforded under the CEA. Specifically, to qualify for relief under the Exemptive Order:

  • The clearing agency/DCO must take all necessary action within its control to both (i) obtain any relief needed and (ii) establish rules and operational practices, so as to permit a BD/FCM (at the BD/FCM’s election) to maintain Collateral received to Margin a customer’s cleared CDS Portfolio in a segregated account established and maintained in accordance with Section 3E of the Exchange Act and any rules thereunder for purposes of clearing such customer positions under a CDS Margining Program.5 These actions must be taken by the later of (i) six months after the adoption date of final rules setting forth margin and segregation requirements applicable to security-based swaps consistent with Section 3E of the Exchange Act or (ii) the compliance date of such rules.
  • The clearing agency/DCO must both (i) obtain any relief needed and (ii) establish rules and operational practices, to permit a BD/FCM that is a clearing member to provide (at the BD/FCM’s election) a CDS Margining Program with respect to customer Collateral received to Margin positions in a cleared CDS Portfolio in a segregated account established and maintained in accordance with Section 4d(f) of the CEA and rules thereunder for the purpose of clearing such customer positions under a CDS Margining Program.  

B. CDS PORTFOLIO MARGINING BY ENTITIES DUALLY REGISTERED AS BROKER-DEALERS AND FUTURES COMMISSION MERCHANTS

The Exemptive Order provides relief to a BD/FCM from the requirements of Exchange Act Sections 3E(b), (d), and (e), and Section 15(c)(3) and Rule 15c3–3 thereunder and any requirement to treat an affiliate6 as a customer for purposes of Exchange Act Rules 8c–1 and 15c2-1 to permit the BD/FCM to Margin customer positions in security-based-swaps included in a segregated account established and maintained in accordance with Section 4d(f) of the CEA under a CDS Margining Program. To qualify for this relief, the following conditions must be met:

  • The BD/FCM must require minimum margin levels with respect to any customer transaction participating in the CDS Margining Program at least equal to the amount determined using a margin methodology established and maintained by the BD/FCM that has been approved by the Commission or the Commission staff.7 This requirement will result in the SEC reviewing margin methodologies for non-securities. The SEC intends to review margin methodologies in consultation with CFTC staff and take into consideration the margin methodology used by the clearing agency/DCO in setting customer margin levels under CFTC risk management regulations. The SEC expects that considerations applied in reviewing margin methodologies submitted by a BD/FCM would include whether the type and amount of securities permitted to be held for margin purposes are restricted to those which would facilitate the CDS Margining Program and whether the BD/FCM’s VaR model meets the standards set forth in Appendix E to Exchange Act Rule 15c3-1; alternately, if a BD/FCM proposes to use a standardized methodology, considerations would include whether the methodology could be expected to be at least as conservative in setting margin amounts as a model meeting the requirements in Appendix E.8 This review is intended to, among other things, promote the establishment of consistent margin levels for securities across account types.
  • The BD/FCM must be in compliance with applicable laws and regulations relating to risk management, capital and liquidity, as well as applicable clearing agency/DCO rules and CFTC requirements (including segregation and related books and records provisions) for accounts established and maintained in accordance with Section 4d(f) of the CEA and rules thereunder.
  • Participation is limited to customers that qualify as eligible contract participants.
  • Before receiving any Collateral from a customer to Margin its positions in a cleared CDS Portfolio participating in a CDS Margining Program, the BD/FCM must furnish to the customer a disclosure document containing the following information: (i) a statement indicating that the customer’s Collateral will be held in an account maintained in accordance with the segregation requirements of Section 4d(f) of the CEA and that the customer has elected to seek protections under Subchapter IV of Chapter 7 of Title 11 of the U.S.C. (governing liquidation of commodity brokers) and the rules and regulations thereunder with respect to such Collateral; and (ii) a statement that the broker-dealer segregation requirements of Section 15(c)(3) and Section 3E of the Exchange Act and the rules thereunder, and any customer protections under the Securities Investor Protection Act of 1970 (“SIPA”) and the stockbroker liquidation provisions, will not apply to such Collateral.9 The SEC views this disclosure requirement as “essential to highlight to customers who elect to participate [in a CDS Margining Program] maintained in accordance with Section 4d(f) of the CEA that the account will be governed by the segregation requirements under the CFTC’s regulatory regime and that any protections under the SIPA will not be available to the account in the event of insolvency.”10  

Additional conditions for a BD/FCM to obtain relief under the Exemptive Order are separated between those applicable to the accounts of affiliates and those applicable to the accounts of third-party customers11:

  • With respect to a customer that is not an affiliate of the BD/FCM, (i) the BD/FCM must maintain Collateral received to Margin the customer’s CDS Portfolio positions in a segregated account established and maintained in accordance with Section 4d(f) of the CEA and rules thereunder for the purpose of clearing such customer positions under a CDS Margining Program; and (ii) the BD/FCM must enter into a non-conforming subordination agreement with each customer.12 The subordination agreement must contain a specific acknowledgment by the customer that its Collateral will not receive customer treatment under the Exchange Act or SIPA or be treated as customer property as defined in 11 U.S.C. 741 in a liquidation of the BD/FCM and that such Collateral will be subject to any applicable protections under Subchapter IV of Chapter 7 of Title 11 of the U.S.C. and rules and regulations thereunder; as well as an affirmation by the customer that all of its claims with respect to such Collateral against the BD/FCM will be subordinated to the claims of other securities customers and security-based swap customers not operating under a CDS Margining Program.
  • With respect to customers that are affiliates of the BD/FCM:
  • The BD/FCM must maintain Collateral of affiliates received to Margin cleared CDS Portfolio positions in a “cleared swaps proprietary account”13 for the purpose of clearing such positions under a CDS Margining Program.
  • The BD/FCM must enter into a nonconforming subordination agreement with each affiliate. The agreement must contain a specific acknowledgment by the affiliate that its Collateral will not receive customer treatment under the Exchange Act or SIPA or be treated as customer property as defined in 11 U.S.C. 741 in a liquidation of the BD/FCM, and that such Collateral will be held in a proprietary account in accordance with CFTC requirements and will be subject to any applicable protections under Subchapter IV of Chapter 7 of Title 11 of the U.S.C. and rules and regulations thereunder. The nonconforming subordination agreement must also include an affirmation by the affiliate that all of its claims with respect to such Collateral against the BD/FCM will be subordinated to the claims of other securities customers and security-based swap customers not operating under a CDS Margining Program; and
  • The BD/FCM must obtain from the affiliate an opinion of counsel that the affiliate is legally authorized to subordinate all of its claims against the BD/FCM to those of customers.  

IMPLICATIONS

The Exemptive Order recognizes that portfolio margining of cleared CDS Portfolios can promote greater efficiencies in more closely aligning costs with overall risks. The SEC indicates that benefits of portfolio margining of cleared CDS may include reduced collateral calls, improved liquidity and reduced volatility. However, a number of steps need to be taken before CDS Margining Programs can be implemented under the Exemptive Order, including:

  • The SEC needs to finalize rules establishing the margin and segregation requirements applicable to cleared security-based swap positions;
  • The CFTC needs to grant similar exemptive relief that would permit clearing agency/DCOs and BD/FCMs to conform to Exchange Act margin and segregation requirements with respect to customers’ cleared CDS Portfolios in lieu of meeting requirements under the CEA.
  • Clearing agency/DCOs seeking to qualify for relief under the Exemptive Order need to develop their rules and operational practices to support CDS Margining Programs.
  • BD/FCMs need to:
    • Develop models to calculate margin amounts (unless standardized methodologies will be applied) for customers’ cleared CDS Portfolios;
    • Draft forms of non-conforming subordination agreements and customer disclosures; and
    • Where an affiliate’s CDS Portfolio will be cleared, obtain from the affiliate an opinion of counsel that such affiliate is legally authorized to subordinate its claims against the BD/FCM to those of customers.

Clearing agency/DCOs, BD/FCMs, clearing customers and other market participants that have an interest in the availability of, and conditions to, CDS Margining Programs should consider submitting comments on the Exemptive Order. As noted above, the due date for comments is February 19, 2013.