The Regulatory Margin Self-Disclosure Letter, published on June 30, by the International Swaps and Derivatives Association Inc. (ISDA) (the Letter), represents one of the first major steps taken by the derivatives industry toward facilitating compliance with the rules of various regulatory regimes for the exchange of margin for noncleared derivatives. These rules have been proposed or adopted in the U.S., Canada, the EU, Japan and Switzerland, and are based on the framework jointly published by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. Other regulators around the globe, such as those in Hong Kong and Australia, are expected to follow suit.
While these rules will not come into effect on the same time lines (notably given the recent announcement of a delay in implementation in the EU and Switzerland), compliance dates in the U.S. remain imminent for the time being, and market participants need to prepare. Accordingly, with respect to each non-cleared swap (and each non-cleared swap’s trading relationship more generally), each party to that non-cleared swap will need to determine if and when that swap will become subject to margin requirements. This determination will be based on which regime(s) will apply to that particular trading relationship.
Whether a regime is applicable (and which particular rules or exemptions are applicable under that regime) depends both on the status of the party making the determination and on the status of its counterparty. These determinations will dictate the particular margin and segregation documentation that will need to be put in place to govern in scope non-cleared swaps. It is possible that a particular swap is subject to more than one margin regime, in which case the question of substituted compliance or equivalence would be relevant. At this stage regulators have made little progress, if any, on equivalence or substituted compliance determinations. Pending progress on this front, parties are considering applying the stricter version of the rules that would satisfy the rules of all applicable margin regimes.
These determinations will often be difficult to make given the complexity of OTC derivatives trading relationships that can arise as a result of, among other factors, booking entities within a group being organized in different jurisdictions (whether as a branch or a subsidiary), intra-group guarantees and back-to-back trades between group entities, consolidated groupings, and the location of booking of particular trades within a group. Accordingly, ISDA has been working with market participants to create a tool to facilitate the exchange of information between counterparties and, where necessary, the opening of a dialogue between parties to enable the parties to make these determinations.
To that end, ISDA has published the Letter as a standard form for the sharing of information regarding an entity’s status under each applicable regime with that entity’s non-cleared swaps trading counterparties. While market participants are not obliged to complete and deliver a Letter to any of their counterparties, the information disclosed in the Letter is likely to be necessary for determining if and when the rules under a particular margin regime will apply. The Letter is designed to be completed by a party to a non-cleared swap (as Principal) and delivered to each counterparty (as Recipient). For example, with respect to a non-U.S. investment fund trading non-cleared swaps with a CFTC-registered swap dealer, the investment fund will complete and provide a Letter as Principal to the CFTC-registered swap dealer as Recipient, and the CFTC-registered swap dealer will complete and provide a Letter as Principal to the investment fund as Recipient. In the first case, the CFTC-registered swap dealer will likely need the fund to complete the U.S. CFTC section of the Letter in order to determine whether and how the CFTC rules will apply to that relationship. In the second case, given that the regulatory requirements to collect and post initial and variation margin in the U.S. fall on the covered swap dealer, it is unlikely that the investment fund would need the CFTC-registered swap dealer to complete any sections of the Letter for the fund’s purposes.
With respect to the structure of the Letter, the first section is intended to be completed by all market participants delivering a Letter as Principal, as it sets out general information for the Principal including contact information and whether the Principal is a multibranch entity. The remaining sections set out jurisdiction or regulator-specific information about the Principal and are organized by jurisdiction. Separate sections are provided for Canada, the EU, Japan, Switzerland and the U.S. (both CFTC and U.S. prudential regulators). Each of these sections seeks to collect information on (1) a group’s average aggregate notional amount (AANA) of OTC derivatives, which is necessary to determine whether an entity and/or group will be subject to a particular regime’s margin requirements based on jurisdictional thresholds and calculation methodology, (2) the cross-border status of a party and (3) the applicability of any available entity or transaction-specific exemptions (such as the hedging exemption in the U.S.). Definitions are included for each jurisdiction in order to guide a Principal completing a form, but it is likely that a party will have to perform additional commercial and legal analysis to complete the Letter. For example, under the CFTC rules, the Letter does not give guidance as to how the AANA calculation should be undertaken. For a more detailed explanation of the calculation of AANA in the U.S. and other related definitions and considerations, see our previous client alert.
While the parties can exchange paper versions of the Letter, the Letter will also be available on ISDA Amend. Both the Letter and the ISDA Amend build-out are structured in a modular fashion so that market participants can complete as much or as little of the Letter as they wish. A market participant will also be able to deliver a different version of the Letter to each of its counterparties if only portions of the Letter apply to a particular trading relationship. On ISDA Amend, it is expected that the Recipient will be able to identify which sections of the Letter should be completed by a Principal from which it expects to receive a Letter, but the Principal should complete all applicable sections. Returning to the previous example of a non-U.S. investment fund and a CFTC-registered swap dealer, the CFTC-registered swap dealer will be able to communicate to the investment fund via ISDA Amend which jurisdictional information it would like the fund to complete given the regimes that the dealer expects will apply to the trading relationship, and the fund should in any case consider whether any additional information should be provided. We understand that the ISDA Amend service will be available two to three months from publication of the Letter. This may miss the initial compliance date of Sept. 1, at least for the U.S. regime, unless the time line is postponed similar to the EU postponement. That said, it is only the largest swap dealers and their non-cleared swaps with other such dealers that will be subject to the Sept. 1 compliance date. If bilateral communication is necessary between the parties outside of ISDA Amend, the Principal to each Letter should provide contact information in the general information section for such purpose.
Completion of the Letter is going to be time-consuming and less than straightforward for many market participants, particularly where multiple jurisdictional sections are relevant and/or where the organizational structures of the Principal and the Recipient are complex. Investment managers acting on behalf of multiple funds will, we think, be particularly challenged, as they will have to reach out separately to each of their fund clients in order to obtain the required information.