What the Buy-Side Needs to Know about the OTC Margin Rules
- It is expected that CFTC and the Prudential Regulators will issue final rules with respect to initial margin and variation margin for OTC derivatives in 2015.
- The implementation schedule set forth in the 2014 reproposed rules is expected to be pushed back to September 2016 for variation margin and to September 2016-September 2020 for phased-in compliance for initial margin.
- Each buy-side entity will need to decide if and to what extent the U.S. margins rules will apply to it and, if so, it will need to enhance operational capacity and enter into new documentation.
This guide is designed to provide in a concise format the principal information that the buy-side needs to know about the U.S. margin rules. The format of the guide is question-and-answer, with most answers followed by the relevant regulatory background.
1. What is the status of U.S. regulation with respect to initial and variation margin for OTC swaps? Are there any final rules?
There are no final rules. However, certain proposed rules are expected to be finalized in the near future.
Sections 731 and 764 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) mandate that rules be implemented requiring minimum initial and variation margin in connection with uncleared swaps and security-based swaps entered into by swap dealers, security-based swap dealers, major swap participants and major security-based swap participants (collectively known as "Swap Entities"). Such rules are to be promulgated by certain regulators, known as the "Prudential Regulators," for Swap Entities for which there is a Prudential Regulator.1 For Swap Entities for which there is not a Prudential Regulator, the rules are to be promulgated by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) with respect to swaps and security-based swaps, respectively. In 2014, the Prudential Regulators and the CFTC each issued revised proposed rules: the "Prudential Regulator Rule" and the "CFTC Rule," respectively, and, collectively, the "reproposed rules," which revised their initial proposed margin rules published in 2011. The reproposed rules are substantially similar, and certain differences are noted in this guide. The SEC issued a proposed rule in December 2012 but has not issued a reproposed rule. Except where indicated, this guide is based on the reproposed rules.2
In remarks before the Coalition for Derivatives End-Users on Feb. 26, 2015, Timothy G. Massad, chairman of the CFTC, stated that he expected the CFTC Rule to be finalized by summer 2015. In view of the potential delay in the implementation schedule discussed in question 2, the finalization of the reproposed rules may be pushed back.
2. When the final rules are effective, what is the expected implementation schedule?
It is expected that the implementation schedule set forth in the reproposed rules will be pushed back to September 2016 for variation margin and to September 2016-September 2020 for phased-in compliance for initial margin.
In response to the economic and financial crisis that began in 2007, the Group of Twenty in 2009 initiated a reform program to reduce the systemic risk in the over-the-counter derivatives market. The program includes the development of consistent global standards for margin requirements. Towards this end, a Working Group on Margining Requirements (WGMR) was formed that includes representatives of the CFTC, the SEC, the Federal Deposit Insurance Corporation, the Federal Reserve Bank and the Office of the Comptroller of the Currency.
In September 2013, the work of the WGMR was published by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) as a final policy framework establishing minimum margin requirements for uncleared swaps. The framework does not have the force of law but is intended to reflect the consensus view of the participant regulators and foster cross-border regulatory harmonization.
The framework provides a phase-in schedule for margin requirements that have been adopted in each of the reproposed rules. The phase-in schedule provides that:
- Variation margin only applies to new contracts entered into after Dec. 1, 2015.
- Phase-in of the initial margin will be required on:
- Dec. 1, 2015, for uncleared swaps between a Swap Entity and its counterparty, each of which together with their affiliates have average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps over the measuring period in excess of $4 trillion
- Dec. 1, 2016, where the average daily aggregate notional amount described above is in excess of $3 trillion
- Dec. 1, 2017, where the average daily aggregate notional amount described above is in excess of $2 trillion
- Dec. 1 2018, where the average daily aggregate notional amount described above is in excess of $1 trillion
- Dec. 1, 2019, for all other Swap Entities and relevant counterparties
On March 18, 2015, the BCBS and IOSCO announced a revision to the framework that delayed the start date for posting of variation margin to September 2016 for Swap Entities whose aggregate average notional non-cleared derivatives exceeds €3 trillion to September 2016 and to March 2017 for all other entities. The phase-in dates for initial margin set forth in the schedule above were each extended nine months to Sept. 1 of the year subsequent to the dates noted above.
Neither the Prudential Regulators or the CFTC have implemented the timeline in the revised framework. However, on March 2, 2015, in an address before the Institute of International Bankers (the "Address"), Chairman Massad of the CFTC indicated that the final CFTC rule will incorporate a delay from the schedule included in the reproposed CFTC Rule.
3. What swaps will be exempt from variation margin requirements?
Swaps not involving a Swap Entity are not subject to variation margin or initial margin. Swaps that satisfy the end-user exception to clearing are exempt from variation margin (and initial margin). The reproposed rules provide that entities that are not "financial end users," as defined therein, will not be required to post variation margin.
The Business Risk Mitigation and Price Stabilization Act of 2015 (the "2015 act") amended the applicable provisions of the Commodity Exchange Act (CEA) and the analogous provisions of the Securities Exchange Act to provide that variation margin and initial margin requirements shall not apply to a swap with respect to which the counterparty qualifies for an exception from clearing pursuant to section 2(h)(7)(A) of the CEA – the end-user exception to clearing. The end-user exception to clearing is available to an entity that: (i) is not a financial entity; (ii) uses swaps to hedge or mitigate commercial risk; and (iii) notifies the CFTC how it generally meets its financial obligations associated with uncleared swaps.3 Pursuant to the 2015 act, initial and variation margin are also not applicable to swaps that qualify for the exception from clearing for so-called treasury affiliates and the exception for cooperatives.
The exemption from margin requirements provided by the 2015 act is based on the definition of "financial entity" set forth in section 2(h)(7)(C) of the CEA (i.e., a person is predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956). Entities have had difficulty determining whether or not they fall within the vague parameters of "financial entity" as defined in section 2(h)(7)(C) of the CEA. The CFTC and the Prudential Regulators sought to provide clarity about whether particular entities would be subject to the margin rules by including in the reproposed rules an alternative definition of "financial end user." The definition of financial end user is based to a significant extent on federal statutes that impose registration or chartering requirements on entities that engage in specified financial activities. In light of the 2015 act, it is unclear whether the CFTC and the Prudential Regulators will continue the approach in their final rules of defining a financial end user as opposed to a "financial entity."
The reproposed rules provide that Swap Entities will not be required to pay variation margin to, or collect variation margin from, non-financial end users. Nevertheless, the Prudential Regulator Rule provides that a Swap Entity subject thereto shall collect variation margin from a non-financial end user if the Swap Entity determines it is appropriate to do so, in light of the credit risk posed by the counterparty. This provision would appear to conflict with the 2015 act to the extent to which it would be applied to swap subjects to the end-user exception, because the 2015 act states that variation margin "shall not" apply to such swaps.
4. What swaps will be exempt from initial margin requirements?
See the answer to question 3 for swaps and entities exempt from initial margin requirements. In addition, subject to the discussion is the second paragraph below, under the reproposed rules, a Swap Entity would not be required to exchange initial margin with a financial end user, unless such financial end user has "material swaps exposure," measured as the average daily aggregate notional amount for the financial end user and each of its affiliates of uncleared swaps, security-based swaps, foreign exchange forwards and foreign exchange swaps calculated over the measuring period. The reproposed regulations establish the level for "material swaps exposure" at $3 billion.
In contrast to the level set forth in the reproposed rules, the framework sets the level of "material swaps exposure" at €8 billion. The €8 level was also adopted in the Consultation dated April 14, 2014, with respect to Regulatory Technical Standards proposed by the European Supervisory Authorities. The $3 billion material swaps exposure level proposed by the U.S. regulators may be increased. Chairman Massad of the CFTC stated in the Address that "the threshold for when margin is required is currently lower in our proposed rule than in the proposal in Europe and Japan. I believe we should harmonize the threshold, even if it means increasing ours."
The Prudential Regulator Rule provides that a Swap Entity subject thereto shall collect initial margin from entities that are not Swap Entities or financial end users with material swaps exposure if the Swap Entity determines it is appropriate to do so, in light of the credit risk posed by the counterparty. Again, this provision would appear to conflict with the 2015 act to the extent to which it would be applied to swaps subject to the end-user exception, but would require margin to be collected from financial end users without material swaps exposure in certain circumstances.
5. How will the amount of required initial margin be determined?
Under the reproposed rules, Swap Entities would be required to post and collect on a gross basis initial margin with each other Swap Entity and with each financial entity having material swaps exposure. Under the reproposed rules, a Swap Entity could calculate initial margin using either a model-based method or a standardized table-based method. Since the standardized table-based method is expected to result in substantial higher values, it is not expected to be used. Posting of initial margin is subject to a $65 million threshold (taking into account all swaps of a Swap Entity and any of its affiliates with the counterparty and any of its affiliates) and subject to a minimum transfer amount of $650,000 for both initial margin and variation margin.
The reproposed rules require Swap Entities to obtain the written approval of any model from the relevant supervisory authority and require the model to satisfy the criteria set forth in the reproposed rules. The initial margin calculation may be made on an aggregate basis with respect to all swaps subject to an eligible master netting agreement, but netting is only permitted within specified asset categories.
In anticipation of the initial margin requirement, the International Swaps and Derivatives Association, Inc. (ISDA), with the understanding of the WGMR, has been preparing a standard initial margin model (SIMM) for use by market participants. The design of SIMM may not accommodate the variables for all bespoke swaps between a Swap Entity and a financial end user. Accordingly, a Swap Entity and a financial end user counterparty may be required to employ several initial margin models to accommodate all of their swaps.
6. What requirements are applicable for collateral to be posted for variation margin and initial margin?
Assets permitted for variation margin are limited to U.S. dollars and the currency in which payment under the swap is required. No haircuts are applied. The posting of variation margin is not subject to a threshold. Posting is required no less frequently than every business day.
Assets permitted for initial margin are: (i) U.S. dollars and other major currencies; (ii) the currency in which obligations under the swap are to be settled; (iii) U.S. Treasury securities; (iv) U.S. agency securities backed by the full faith and credit of the U.S. government; (v) certain securities issued by U.S. government-sponsored enterprises; (vi) securities issued by the European Central Bank, certain sovereigns, the Bank of International Settlement, the International Monetary Fund or other multilateral development banks; (vii) debt approved by a Prudential Regulator; (viii) equities included in certain indices; and (ix) gold. The reproposed rules include a standardized haircut schedule for permissible initial margin assets. See the answer to question 5 for the threshold and minimum transfer amount for initial margin. All initial margin posted and collected by a Swap Entity is subject to mandatory collateral holding requirements at an unaffiliated custodian and may not be rehypothecated. Posting is required no less frequently than every business day.
7. What will buy-side entities need to do to be prepared for the margin requirements?
Each buy-side entity will need to decide if, and to what extent, the U.S. margin rules will apply to it. If it is a financial end user, subject to the minimum transfer amount, it will be required to post and collect variation margin in its swap trading relationships with Swap Entities. If it is a financial end user with material swaps exposure, subject to the threshold and minimum transfer amount, it will be required to post and collect initial margin in its swap trading relationships with Swap Entities.
The requirements to exchange variation margin and initial margin will become applicable only with respect to swaps entered into after the respective compliance dates of the rules with respect to such entity. However, if swaps entered into prior to the respective compliance date for variation margin and initial margin are subject to the same eligible master netting agreement, those swaps must be included in the calculation of initial and variation margin. Buy-side entities subject to the margin rules will need to consider if it is advantageous to combine (or segregate under a new credit support annex) their pre-compliance date swaps with their post-compliance date swaps for the purpose of the calculation of variation margin and/or initial margin.
Buy-side entities subject to the initial margin rules will need to enter into new credit support annexes (CSAs) with their Swap Entity counterparties to provide for: (i) calculation of initial margin in accordance with the revised rules; (ii) variation margin calls separated from initial margin calls; (iii) designation of eligible collateral, haircuts, thresholds and minimum transfer amounts; (iv) netting across asset classes; and (v) third-party or tri-party custodial arrangements in connection with initial margin posted and received. ISDA is developing CSA templates to assist the industry in its adoption of regulatorily compliant CSAs.
Buy-side entities may also need to enhance operational capabilities in order to assess the accuracy of initial margin calls and to process the delivery and receipt of initial margin. Buy-side entities subject to initial margin requirements will also need to have the operational capacity to manage informational and collateral flows with custodians.
Buy-side entities may also want to consider changes to their business model to mitigate the impact of the margin rules, such as an increased use of exchange-traded and cleared derivative products instead of OTC derivatives, where feasible.