Last week the Board of Governors of the Federal Reserve System (the "Federal Reserve") and the Office of the Comptroller of the Currency (the "OCC" and, collectively with the Federal Reserve, the "Banking Agencies") released guidance (the "Examination Guidance")1 on the examinations of swap entities subject to their regulation (the "Fed/OCC Swap Entities") with respect to rules requiring such entities to exchange margin with their counterparties to non-cleared swaps and security-based swaps (the "Margin Rules").2

The Examination Guidance signals that, with respect to variation margin,3 the Banking Agencies will not immediately seek to enforce strict compliance with the Margin Rules, which are scheduled to go into effect on March 1, 2017, in relation to variation margin requirements for non-cleared transactions between swap dealers and counterparties including financial end users.4 Instead, the Examination Guidance states the Banking Agencies' expectation that the Fed/OCC Swap Entities will prioritize their compliance efforts, achieving full compliance by March 1 in relation to those counterparties whose transactions pose significant credit or market risks.

The Examination Guidance will likely have a significant effect on the manner in which the Fed/OCC Swap Entities implement their plans to comply with the Margin Rules and, in turn, on their counterparties, including financial end users.5 Together with a no-action letter6 issued earlier this month by the Commodity Futures Trading

Commission ("CFTC") regarding its margin rules for dealers that are not subject to regulation by the Federal Reserve or OCC, the Examination Guidance provides much needed relief not only to swap dealers but also to their smaller counterparties, many of which are not expected to be fully prepared to comply with variation margin requirements by March 1.

Indeed, the March 1 deadline for variation margin has been a source of considerable controversy, with numerous market participants and industry groups, including the International Swaps and Derivatives Association ("ISDA"), warning that lack of preparation was widespread and the deadline was not realistic without significant market disruptions.7 By their terms, the Margin Rules require Fed/OCC Swap Entities and their financial end user counterparties by March 1 to exchange variation margin on terms that in many cases differ from the parties' current arrangements for the exchange of collateral. In particular, by their terms the Margin Rules require the exchange of margin on a zero-threshold basis and with a prescribed minimum transfer amount, specified types of collateral and same-day transfer of collateral in many cases. Further, the market has seen confusion regarding the forms that amendments of existing contractual arrangements should take, with different parties taking different approaches to new ISDA documentation and to their arrangements for legacy transactions predating the effectiveness of the Margin Rules.

The Examination Guidance states that swap dealers should prioritize their efforts according to the size and risk inherent in the credit and market risk exposures presented by each counterparty. By March 1, swap dealers are expected to be in full compliance with respect to other swap dealers and financial end users that present significant exposures. For other counterparties, swap dealers must make good faith efforts to comply with variation margin requirements in a timely manner, and in no case later than September 1, 2017.8

In view of the substantial changes necessary for swap dealers to achieve full effective compliance, the Examination Guidance states that during initial examinations for compliance with the variation margin requirements, Federal Reserve and OCC examiners should evaluate a swap dealer's management systems and program to come into compliance. Swap dealers are expected to have governance processes that assess and manage current and potential future credit exposure to counterparties to non-cleared swaps, as well as any other market risk arising from such transactions. Examiners will consider swap dealers' implementation plans, including actions taken to update documentation, policies, procedures, and processes, as well as training of appropriate staff and handling of early technical problems or other implementation challenges.9