On October 12, 2017, the Division of Clearing and Risk (Division) of the US Commodity Futures Trading Commission (CFTC) issued an interpretative letter in response to a request for clarification on whether payments of variation margin (VM) on cleared swap positions would constitute settlement payments or the exchange of collateral under the Commodity Exchange Act (CEA) and related CFTC regulations.1
Parties invest in derivative contracts such as futures and swaps cleared through clearinghouses to minimize exposure and to guard against valuation volatility during the life of a derivative contract. These cleared derivative contracts are generally subject to margin requirements that are assessed by clearinghouses at the beginning of the derivative transaction and throughout the life of the derivative contract.
However, unlike futures contracts, parties to cleared swaps have, until recently, characterized variation margin exchanges throughout the life of a cleared derivative contract as collateral exchanges, which the in-the-money party held on behalf of the out-of-the-money party, akin to the manner in which collateral may be exchanged in uncleared over-the-counter transactions. Consistent with this treatment, the in-the-money party receiving the margin paid interest on the collateral to the out-of-the-money party posting the collateral, much like the interest paid by holders of collateral in the over-the-counter market. These interest payments were known as price alignment interest (PAI).
In 2013 and 2014, in line with a comprehensive set of suggested reform measures issued by the Basel Committee on Banking Supervision, the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) issued more stringent regulatory capital rules for certain financial entities. Under these regulatory capital rules, the trade exposure amount for cleared derivatives determines, in part, the regulatory capital amount that such financial entities are required to hold. As a result, these financial entities have looked for ways to limit their trade exposure amount and, therefore, decrease the amount of capital they are required to hold under the regulatory capital rules.
One way of limiting one’s trade exposure amount is by recharacterizing VM exchanges as settlement, because final payments decrease the remaining maturity on a derivative contract to the next margin payment date. The practice of recharacterizing cleared swap VM as settlement for purposes of the regulatory capital rules was recently permitted by the OCC, the Board and the FDIC. 2
Instead of allowing VM exchanges to be recharacterized settlement, the Division’s interpretative letter declares that it has always considered VM and all other payments made in satisfaction of outstanding exposures on cleared swap position settlements of such outstanding exposure.3 The Division based its conclusion on CFTC Regulations 39.14 and 22.3, which require daily settlement and allow derivative clearing organizations to use VM to settle variation for offsetting swaps, respectively.4 The Division’s conclusion aligns with the wishes of financial entities that are subject to the regulatory capital rules, because it is in line with the guidance from the federal banking regulators discussed above. As a result, the combined guidance likely gives the financial entities that are subject to the regulatory capital rules an even stronger basis to realize capital savings under such rules. In addition to financial intermediaries that are subject to the capital rules, end users need to consider to what extent these changes may affect their characterization of cleared swap VM, including from a tax and accounting perspective, particularly if they have been treating VM payments as collateral transfers rather than settlement payments.
Ultimately, whether the Division is characterizing or recharacterizing VM as settlement is less important than its conclusion that VM is a final settlement of any outstanding exposure. Therefore, clearinghouses that have not yet definitively addressed the issue and that are subject to CFTC regulations may have to examine their rulebooks. For example, LCH’s US-facing Futures Commission Merchant (FCM) Rulebook currently characterizes VM as settlement but its FCM Procedures5 continue to call for the payment of price alignment interest, which would support the view that VM is collateral. As a result of the CFTC’s guidance, LCH is in the process of undertaking to amend its FCM Rulebook and FCM Procedures to align with the CME’s recent rule changes.6 This, in turn, may require market participants that characterize variation margin for derivative contracts trading through LCH as collateral to reevaluate their positions.