This is the third article in a series on the U.S. Commodity Futures Trading Commission’s (CFTC’s) proposed margin rules for uncleared swaps, with a particular focus on the rules as they relate to swap market participants that are neither swap dealers nor commercial end users.
In our first installment on the CFTC’s proposed margin rules (Margin Rules) for uncleared swaps, we discussed the importance of applying the “financial end user” definition and making related notional calculations. In our second installment we discussed collateral requirements, timing, eligibility and haircuts. In this issue we move on to custody and segregation of initial margin and related documentation requirements.
Custodial Arrangements for Initial Margin
Under the Margin Rules, covered swap entities (CSEs) would be required to exchange initial margin with financial end users that have “material swaps exposure.” (For a refresh on the definitions of CSE, financial end user and material swaps exposure, please see our prior update.) In general, the initial margin posted or collected by a CSE must be held by one or more custodians that are unaffiliated with either the CSE or its counterparty. In addition, the agreement among the CSE, its counterparty and the custodian must meet certain requirements. CFTC Rule 23.157 specifies that the custody agreement: (1) must prohibit the custodian from rehypothecating or otherwise transferring the initial margin it holds; (2) may, notwithstanding the prohibition on rehypothecation, permit the posting party to substitute or direct reinvestment of initial margin held by the custodian, provided all assets remain eligible as initial margin and of sufficient value; and (3) must be legal, valid, binding and enforceable under the laws of all relevant jurisdictions, including in the event of bankruptcy, insolvency or a similar proceeding.
While these requirements may appear straightforward, they pose the following important considerations for financial end users.
Mandatory Segregation for Certain Financial End Users
CFTC Rule 23.701 requires that swap dealers notify their counterparties of their right to elect segregation of initial margin at an unaffiliated custodian. The Margin Rules would turn the current election to segregate initial margin into a mandatory requirement for financial end users that have material swaps exposure. As a result, financial end users with material swaps exposure will no longer be able to opt out of initial margin segregation when they trade uncleared swaps with CSEs. CSEs and financial end users subject to this requirement will need to review their custodians and triparty custody agreements to confirm that (1) the custodian is unaffiliated with either party, (2) rehypothecation is prohibited and (3) the custody agreement is enforceable under the laws of all relevant jurisdictions.
Financial end users without material swaps exposure are not required to post initial margin under the Margin Rules. As such, they would still retain the option, but not the requirement, to segregate initial margin under CFTC Rule 23.701. To the extent these financial end users exercise this right, they would not be required to segregate initial margin posted to a CSE because the Margin Rules apply the segregation requirement only to initial margin that is required to be collected by a CSE.
Know Your Custodians
Financial end users that trade with many CSEs or use multiple custodians will need to determine whether any particular transaction is in compliance with the requirement to use an unaffiliated custodian. For instance, asset managers that use global custodial arrangements on behalf of multiple clients may need to take a fresh look at whether existing custodial arrangements can continue to be used or new arrangements for certain client-CSE pairs will need to be implemented. The requirement to use an unaffiliated custodian may also pose a problem for pension plans that use their trustees, or affiliates of their trustees, as custodians. It is also unclear how, or whether, this requirement would apply to sub-custodians. If it does, custodians will need to track and monitor the affiliations of their sub-custodians with respect to specific CSE-financial end user pairs.
More generally, given the limited number of large custodians, there are also concerns that the non-affiliation requirement will serve to further increase market concentration in the custody services industry and will put pressure on custodial capacity.
Standards for Custody Agreements
The condition that the custody agreement must be “legal, valid, binding and enforceable under the laws of all relevant jurisdictions including in the event of bankruptcy, insolvency, or a similar proceeding” gives rise to the following challenges.
First, it may be difficult to identify all the “relevant jurisdictions” for the purpose of the enforceability analysis. The organizational structures through which CSEs, financial end users and custodians (and their sub-custodians) exchange and hold margin may implicate several relevant jurisdictions.
Second, it is unclear what level of review suffices for determining that the agreement is enforceable. If legal opinions are required, what type of qualifications would be permitted? It may not be possible to obtain unqualified opinions in all circumstances or jurisdictions. Obtaining any required opinions – perhaps for multiple jurisdictions – will also add a significant cost and expense to implementing initial margin segregation.
Third, it is not clear what exactly the phrase "including in the event of bankruptcy" refers to. One possible interpretation is that the custodial agreement is generally enforceable notwithstanding the bankruptcy of any party, but that interpretation is dissonant with equitable principles of U.S. bankruptcy law, as contracts are generally subject to the insolvency of a party unless there is a specific exemption under the Bankruptcy Code, such as the safe harbor that protects the netting of qualified financial contracts. It is possible that the CFTC’s intention was that "in the event of bankruptcy" referred to the custodian’s bankruptcy, but this is not clear from the proposed rule.
Prime Brokerage Transactions
Under the Margin Rules, the custodian is not permitted to rehypothecate initial margin it holds, although the posting party is permitted to substitute or direct reinvestment of initial margin held by the custodian, provided all assets remain eligible as initial margin and of sufficient value. There is some confusion as to how the prohibition on rehypothecation will affect intermediated prime brokerage transactions. In these transactions, a client, typically an asset manager, will enter into a trade with an executing dealer, which then “gives up” the swap to client’s prime broker, which may be a CSE. The parties are left with a trade between the client and its prime broker and a substantially equal and offsetting trade between the prime broker and the executing dealer. The prime broker is principal to both legs of the transaction: one facing the client and the other facing the executing dealer. The prime broker effectively transfers initial margin it receives from one party to satisfy the demand for initial margin from the other party. Under the Margin Rules it is unclear whether this would constitute an unpermitted rehypothecation. Without allowing for these arrangements, intermediate prime brokerage transactions may no longer be economically viable for many prime brokers that are also CSEs.
The Margin Rules also require that CSEs enter into documentation with counterparties that satisfies the swap trading relationship documentation (STRD) requirements under CFTC Rule 23.504 and provides for the exchange of any margin required by the Margin Rules. While most CSEs and their counterparties have already adhered to the ISDA March 2013 Dodd-Frank Protocol designed to comply with the STRD rules, Rule 23.158 of the Margin Rules may require additional documentation between CSEs and non-financial end users in order to document whether margin is to be exchanged (even if such margin is not required) and, if so, the methodology and data sources for calculating margin, the valuation of positions and margin, dispute resolution and applicable thresholds below which margin is not required.
With respect to valuation and dispute resolution, the Margin Rules contain inconsistencies with other CFTC rules. For instance, CFTC Rule 23.504 requires swap documentation to include "methods, procedures, rules and inputs" for swap valuation and a dispute resolution process, and CFTC Rule 23.431(d)(3) requires disclosure of "the methodology and assumptions used to prepare the daily mark" for each uncleared swap. When the Margin Rules are finalized, CSEs and financial end users will need to review their swap documentation and credit support annexes to determine if they satisfy the proposed documentation requirements.