Buy-side swap counterparties are beginning to receive notices from their swap dealers of the right to have their initial margin for uncleared swaps (swaps that are not cleared through a clearinghouse) segregated and held in a separate account with an independent third party custodian. Failure to respond to these segregation rights notices may result in swap dealers ceasing or delaying trading uncleared swaps with the buy-side entity.
Section 724(c) of the Dodd-Frank Wall Street Reform and Consumer Protection Act,1 codified as Section 4s(l) of the Commodity Exchange Act, contains provisions regarding treatment of margin for uncleared swaps and in response the Commodity Futures Trading Commission (the “CFTC”) adopted Regulations 23.700 through 23.7042 with respect to the protection of collateral of counterparties to uncleared swaps. Swap dealers are required to provide segregation rights notices to end-users of their right to segregate initial margin for uncleared swaps as of the following dates:
- May 5, 2014 for “new counterparties” (those with whom there was no agreement concerning uncleared swaps as of January 6, 2014); and
- November 3, 2014 for “existing counterparties” (those with whom there was such an existing agreement as of January 6, 2014).
The rules were implemented in response to the Lehman Brothers bankruptcy and the Lehman’s customers’ losses, and are designed to protect and segregate collateral from the assets of the swap dealers.
The right to segregation applies only to initial margin (collat- eral posted to cover future exposures arising from changes in the market value of the position, and which is referred to in the International Swaps and Derivatives Association (“ISDA”) Credit Support Annex as the “Independent Amount”), not variation margin (additional collateral posted to cover current exposures arising from changes in the market value of the position).
If buy-side counterparties elect to segregate initial margin, the swap dealer must identify one or more custodians, of which one must be a creditworthy non-affiliate, and provide the price of segregation, if known. There likely may be higher fees associated with trading as the swap dealer will lose the benefit of being able to use the segregated collateral. Buy- side counterparties will need to enter into a written custodial agreement with the custodian and the swap dealer that meets the requirements of CFTC Regulation 23.702. Specifically, if the buy-side counterparty elects to segregate initial margin,
- such segregated collateral must be held in a segregated account designated as being for and on behalf of the buy- side counterparty,
- withdrawals from the account can be made only by agree- ment of both the buy-side counterparty and the swap dealer, unless exclusive control is exercised, and
- any notice to the custodian for the purpose of obtaining ex- clusive control of the collateral must be in writing and given under oath and under penalty of perjury, stating that such party is entitled to exclusive control pursuant to an agree- ment between the parties, and the other party must be no- tified immediately.
The segregated collateral must be invested in “highly liquid” investments consistent with CFTC Regulation 1.25, which limits how futures commission merchants and deriva- tives clearing organizations may invest customer funds and imposes requirements to better mitigate credit, liquidity and market risk. For example, the collateral may not be invested in corporate debt securities that are not guaranteed by the United States or in foreign sovereign debt securities.
The segregation rights notice from the swap dealer must be provided:
- to the officer responsible for collateral management (or if no such officer is identified, to the chief risk officer, or if there is none, then to the chief executive officer, or if there is none, then to the next highest level decision-maker); and
- at least annually (unless there are no uncleared swaps between the parties during such year).
The segregation rights notice may be given on a swap-by- swap basis. Investment advisers or asset managers who provide the segregation election on behalf of the buy-side counterparty may be required to represent as to their author- ity to do so. The election would apply solely with respect to the counterparty’s swaps executed by the electing invest- ment advisor or manager and identified in the election letter.
The buy-side counterparty may change its election at any time, but such election will apply only to future swaps and not existing ones. Markit’s ISDA Amend platform will allow counterparties to identify the appropriate recipient for the segregation rights notices, to confirm receipt of such notices and to make the election. Alternatively, buy-side counterpar- ties may make such designations in a separate communica- tion to the swap dealer.
If a buy-side counterparty already has an existing collateral segregation agreement in place with its swap dealer, it has the option to continue that existing arrangement (and not elect segregation under the new CFTC regulations) or elect to apply the new CFTC regulations to the existing collateral segregation agreement (and such agreement will need to be revised accordingly).
If a buy-side counterparty elects not to segregate the initial margin, the swap dealer’s chief compliance officer must provide a quarterly notice of whether its back office proce- dures were in compliance with the agreement between the counterparty and the swap dealer.
On March 27, 2014, ISDA published a form of segregation rights notice, along with a form of segregation election letter and frequently asked questions, which are available on its website. It is important that buy-side counterparties respond promptly to the segregation rights notices from their swap dealers, acknowledging receipt of the notice and providing notice of their election to avoid any lapse in trading.