The U.S. Commodity Futures Trading Commission (CFTC) approved on December 16 final rules (Final Rules) on margin requirements for over-the-counter uncleared swaps entered into by CFTC-registered swap dealers (SDs) and major swap participants (MSPs) that are not subject to regulation by the so-called U.S. “Prudential Regulators.”1 The Final Rules are substantially consistent with the final margin rules adopted by the Prudential Regulators on October 22, 2015 (PR Rules). Investment funds and other buy-side participants will be required to comply with the Final Rules and PR Rules as a result of the obligations imposed on their SD counterparties.

Affected Parties

SDs and MSPs not subject to prudential regulation (Covered Swap Entities, or “CSEs) will be required to exchange minimum initial and variation margin amounts with many of their counterparties – a significant change from current market practice. The exact margin requirements will vary depending on the classification of the CSE’s counterparty.

CSEs must exchange both initial and variation margin when facing an SD, MSP or “Financial End User” that has over $8 billion in gross notional exposure in uncleared swaps.2 The Final Rules broadly define a Financial End User to include entity types ranging from large financial institutions to pooled investment vehicles (e.g., registered funds, private funds and commodity pools).3 When facing a Financial End User that falls below this threshold, the CSE will be required to exchange variation margin only. CSEs will not be required to exchange initial or variation margin with any counterparty that is not an SD, MSP or Financial End User.

Throughout the Final Rules, market participants are required to account for the trading activity of their affiliates (e.g., when calculating notional exposure). The Final Rules use an accounting-based definition of the term “affiliate” that considers whether: (1) the entities are consolidated in financial statements prepared in accordance with generally accepted accounting standards, or (2) the entities are each consolidated with another entity in financial statements prepared in accordance with generally accepted accounting standards.

Margin Requirements

A CSE may calculate the minimum amounts of initial margin to be posted and collected by using either: (1) a risk-based proprietary model, or (2) a standardized schedule provided in the Final Rules (where the initial margin amount will equal a percentage of the notional exposure of the transaction). Amounts for variation margin will be equal to the mark-to-market change in the value of the transaction. Such amounts are calculated based on: recently-executed transactions, valuations provided by third parties or other objective criteria. In addition, the minimum initial and variation margin requirements mandated by the Final Rules will be subject to the following terms:

  1. The minimum transfer amount is $500,000 (combined for both initial and variation margin), subject to a lower minimum as agreed by the parties.
  2. The maximum threshold is $50 million for initial margin, applied at the consolidated level across all affiliates of both the CSE and its counterparty.
  3. Both initial and variation margin must be posted and collected on a daily basis.  

Eligible Collateral

For both initial and variation margin, CSEs and their counterparties will be permitted to use: cash, sovereign debt, government-sponsored debt, instrument grade debt (including corporate and municipal bonds), equities, gold, and shares of certain funds. Certain haircuts (including an 8% cross currency haircut) will be applied both to initial and variation margin posted, depending on the form of collateral. Variation margin for transactions between a CSE and an SD or MSP, however, will be limited to cash collateral.

Segregation of Collateral

Initial margin posted pursuant to the Final Rules must be segregated with an independent, third-party custodian, subject to the following conditions:

  1. Rehypothecation: Rehypothecation is not permitted.
  2. Limitations on cash as initial margin: Cash may be used for initial margin and posted with a custodian in a general deposit account, provided that: such posted cash is used only to purchase eligible non-cash assets within a reasonable time period after the cash has been collected; and the purchased assets are subsequently segregated.  

Variation margin posted pursuant to the Final Rules is not required to be segregated.

Compliance Dates

Both the initial and variation margin requirements will be phased in, depending on the average daily aggregate notional amount of uncleared swaps, security-based swaps, foreign exchange forwards and foreign exchange swaps for both parties outstanding during the preceding March, April and May (calculating for business days only) (Notional Amount). For such calculations, each party must include its affiliates.

The phase-in schedule for initial margin is:

  • September 1, 2016 if the Notional Amount for each party (and its affiliates) exceeds USD 3 trillion.
  • September 1, 2017 if the Notional Amount for each party (and its affiliates) exceeds USD 2.25 trillion.
  • September 1, 2018 if the Notional Amount for each party (and its affiliates) exceeds USD 1.5 trillion.
  • September 1, 2019 if the Notional Amount for each party (and its affiliates) exceeds USD 75 trillion.
  • September 1, 2020 for all other parties.  

The phase-in schedule for variation margin is:

  • September 1, 2016 if the Notional Amount for each party (and its affiliates) exceeds USD 3 trillion.
  • March 1, 2017 for all other parties.  

Next Steps

While the release of the Final Rules helps clarify the manner in which the over-the-counter uncleared derivatives market will change going forward, the full impact of the new regulatory margin requirements will not be known by industry participants until the CFTC finalizes its cross border application of the Final Rules.4 In addition, the SEC and certain foreign regulators such as the European Securities and Markets Authority (ESMA) have not yet released their final rules on initial and variation margin. ESMA’s final rules are expected to be released in the near future, while it is currently unclear as to when the SEC will be releasing its related rules.