On September 3, 2014, five federal agencies1 (the “Agencies”) re-proposed a draft margin and capital requirements rule for uncleared swaps (the “Proposed Rule”).2 The Proposed Rule would impose capital, initial margin and variation margin requirements on prudentially regulated swap dealers, security-based swap dealers, major swap participants (“MSPs”) and major security-based swap participants (collectively, “Covered Swap Entities”) that enter into uncleared swaps and uncleared security-based swaps.

The Proposed Rule differs in many respects from an earlier 2011 proposal by the Agencies3 and is largely consistent with the international guidelines for uncleared margin finalized by the Basel Committee of Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) in September 2013 (the “2013 International Framework”).4

The Proposed Rule, like the 2013 International Framework, requires Covered Swap Entities to collect and post initial and variation margin with certain counterparties and limits the application of mandatory margin requirements to situations where Covered Swap Entities face another swap dealer, MSP or certain financial end users. The Proposed Rule also contains a new definition of “financial end user” to clarify the difference between financial and non-financial end users. The Proposed Rule would require significant changes to the current bilateral OTC swaps market by prescribing minimum initial margin amounts, mandating segregation of initial margin with a third party custodian, and in some instances, require dealers to post initial margin to derivatives end-users, all of which is likely to increase costs for all market participants, constrain liquidity and require large amounts of collateral to be held captive.

A draft of the Proposed Rule has been posted to the Board of Governors of the Federal Reserve System's website. Comments on the Proposed Rule will be due 60 days after the date it is published in the Federal Register. Below is a brief summary of key points of the Proposed Rule.

To Whom Does The Proposed Rule Apply?

The Proposed Rule would apply to Covered Swap Entities in respect of uncleared swaps with all counterparties. While the counterparties themselves may not be directly subject to the Proposed Rule, Covered Swap Entities would be required to both collect and post initial and variation margin when facing certain categories of counterparties.

  • Covered Swap Entities: Prudentially regulated swap dealers, security-based swap dealers, MSPs and major security-based swap participants.
  • Counterparties: The Proposed Rule would generally group swaps market participants into four types, with initial and/or variation margin applying as set forth in the chart below. The four types would be: (1) Covered Swap Entities (“CSE”); (2) financial end users (“FEU”) with material swaps exposure (“MSE”); (3) FEU without MSE; and (4) “other counterparties” including non-financial end users (such as commercial end users), sovereigns and multilateral development banks.

Click here to view table.

*Collateral posting/collection by Covered Swap Entities is subject to a minimum transfer amount of $650,000 (the cumulative amount of initial and variation margin).

**Eligible Collateral for posting would be (a) for initial margin, highly liquid assets; and (b) for variation margin, cash only.

Financial End Users

The Proposed Rule establishes a new definition for “financial end user.” Although the definition is fairly complex, it is intended to provide greater clarity regarding the difference between financial and non-financial end users and offers non-financial end users a broader carve-out than the rule proposed in 2011. The new definition (i) sets forth a list of entities that are financial end users, (ii) excludes sovereign entities, multilateral development banks and the Bank for International Settlements and (iii) excludes certain entities (e.g., finance affiliates) that are specially exempted or excluded from mandatory clearing pursuant to Commodity Exchange Act (“CEA”) Section 2(h)(7)(C)(iii) or (D). Where end users (such as non-financial, commercial end users) are exempted from the mandatory margin requirements, the swap entity may decide whether to collect margin from the counterparty, as is common practice today.

Material Swaps Exposure

The Proposed Rule differs from the 2011 proposal by distinguishing between swaps with financial end user counterparties that have a “material swaps exposure” and swaps with financial end user counterparties that do not have a “material swaps exposure.” The Proposed Rule defines material swaps exposure to mean a consolidated daily average notional amount (for the counterparty and all affiliates) of open, uncleared swaps, uncleared security-based swaps, foreign exchange (“FX”) forwards and FX swaps (collectively, “Covered Swaps”) with all counterparties, for June through August of the previous calendar year, of over $3 billion. Notably, that amount is substantially lower than the amount set forth in the 2013 International Framework, which defines smaller financial end users as those counterparties that have a gross aggregate amount of Covered Swaps below €8 billion (approximately $11 billion).

The definition of “affiliate” in the Proposed Rule would include any company that controls, is controlled by, or is under common control with, the entity.5

What Transactions Are Covered Under The Proposed Rule?

Uncleared Swaps, Uncleared Security-Based Swaps, FX Swaps and FX Forwards

The Proposed Rule’s initial margin and variation margin requirements would apply to all uncleared swaps and uncleared security-based swaps. Certain FX swaps and FX forwards are not subject to the margin requirements, as they are exempted from the definition of “swap” as a result of the Treasury determination,6 but they would be included for purposes of determining a financial end user’s material swaps exposure for determining whether such entity is subject to margin requirements. The Proposed Rule also includes different treatment for “cross-currency swaps,” which are counted only in part for purposes of initial margin requirements.

What Are The Margin Requirements?

Variation Margin Requirements

Under the Proposed Rule, variation margin requirements would generally apply to transactions where a Covered Swap Entity trades with either (a) another swap entity or (b) a financial end user (without regard to material swaps exposure). Covered Swap Entities would be required to collect variation margin from counterparties that are not financial end users only if the Covered Swap Entity determines variation margin to be appropriate to address the credit risk posed by that counterparty and/or the risks of the products traded.

  • Eligible Collateral: For variation margin, eligible collateral would be limited to cash in either USD or the currency in which payment obligations under the swap are required to be settled. As a result no haircuts would be imposed on collateral posted as variation margin.
  • Historical Trades: Historical trades would generally be grandfathered, though historical trades which are margined under a single eligible master netting agreement with new trades would need to be margined under the Proposed Rule.
  • Margin Transfer Timing: Variation margin would be required to be transferred on a daily basis.
  • Minimum Transfer Amounts: A minimum transfer amount of $650,000 would be allowed, with such minimum transfer amounts applying to initial and variation margin, combined.
  • Netting: Variation margin amounts for transactions under an eligible master netting agreement could be fully netted under the Proposed Rule.
  • Rehypothecation and Segregation: Variation margin could be rehypothecated and would not be required to be segregated at an independent third-party custodian.
  • Thresholds: No threshold amounts would be allowed.

Initial Margin Requirements

Under the Proposed Rule, initial margin requirements would apply to transactions with either (a) another swap entity or (b) financial end users with material swaps exposure. Covered Swap Entities would only be required to collect initial margin from counterparties that are not financial end users or are financial end users without material swaps exposure if the Covered Swap Entity determines that collecting initial margin is necessary to address the credit risk posed by the counterparty and/or the risks of the products traded.

  • Calculation: Initial margin may be calculated by (a) using a standardized margin schedule or (b) using an internal margin model that meets criteria specified in the Proposed Rule and approved by the relevant Prudential Regulator. Internal models would be required to be calculated to cover the potential future exposure of the swap consistent with a one-tailed 99 percent confidence level over a 10-day liquidation horizon. If market participants are unable to use internal models, they would be required to use a standardized formula-based risk model to calculate initial margin.
  • Eligible Collateral: For initial margin, eligible collateral would be assets deemed to be highly liquid —
    • cash (in either USD or the currency in which payment obligations under the swap are required to be settled);
    • high-quality government securities, central bank and multilateral development bank securities;
    • U.S. obligations;
    • publicly traded debt securities or asset-backed securities fully guaranteed by a U.S. government-sponsored enterprise;
    • any major currency;
    • publicly traded debt securities for which the issuer has adequate capacity to meet financial commitments including those issued by a U.S. government-sponsored enterprise not covered elsewhere;
    • equities included in major stock indices; and
    • gold.

Collateral would be subject to risk-based haircuts specified in Appendix B to the Proposed Rule.

  • Historical Trades: Historical trades would generally be grandfathered from initial margin requirements, though under certain circumstances if an internal margin model is being used historical trades which are covered under a single eligible master netting agreement with new trades would need to be margined under the Proposed Rule.
  • Netting: Netting initial margin collected or posted against other margin requirements would not be possible given the segregation requirements.
  • Margin Transfer Timing: Initial margin must be posted or collected on a daily basis to reflect changes in portfolio composition or other factors that result in a change in initial margin amounts.
  • Minimum Transfer Amounts: A minimum transfer amount of $650,000 would be allowed, with such minimum transfer amounts applying to initial and variation margin, combined.
  • Rehypothecation and Segregation: Initial margin could not be rehypothecated and would be required to be segregated at an independent third-party custodian.7
  • Thresholds: Covered Swap Entities would be permitted to apply thresholds up to $65 million. Thresholds would be applied on a consolidated basis, meaning that each Covered Swap Entity and its affiliates would be required to allocate the threshold cap among all swap relationships with a relevant counterparty and its affiliates.8 Further, separate $65 million caps would apply to the initial margin both collected and posted on a bilateral, consolidated basis with a particular counterparty.

The Proposed Rule’s requirement that initial margin be segregated at a third-party custodian and complete prohibition on rehypothecation differ from the 2013 International Framework. The Proposed Rule’s prohibition on rehypothecation and requirement of segregation would cause market participants to incur additional costs to segregate collateral, would restrict the use of pledged collateral and are likely to constrain liquidity in the capital markets.

As described above, the Proposed Rule would allow for an expansive list of eligible collateral acceptable as initial margin, which would allow institutions with large amounts of non-agency/non-standard collateral to use such assets to satisfy their margin obligations, thereby reducing the strain on prime liquid securities.

Capital Requirements

The Proposed Rule requires a Covered Swap Entity to comply with regulatory capital rules already made applicable to that Covered Swap Entity as part of its prudential regulatory regime.9 Given that those existing regulatory capital rules specifically take into account and address the unique risks arising from swap transactions and activities, the Agencies are proposing to rely on those existing rules as appropriate and sufficient to offset the greater risk to the Covered Swap Entity and the financial system arising from the use of swaps that are not cleared and to protect the safety and soundness of the covered swap entity.

When Does The Proposed Rule Apply?

  • Variation Margin: The proposed compliance date for two-way posting of variation margin is December 1, 2015 for all Covered Swap Entities with respect to Covered Swaps with any counterparty (consistent with the 2013 International Framework).
  • Initial Margin: Initial margin requirements would be phased in over a five-year period, based on the Covered Swap Entity’s and counterparty’s (and such counterparty’s affiliates’) consolidated average daily aggregate open notional amount of Covered Swaps from June through August of each year. During each year of the phase-in, the threshold would be as follows:

Click here to view table.

Initial margin requirements would apply in the first year in which both parties to a trade have exceeded the relevant threshold for that year, and both parties would remain subject to the margin requirements from that point forward, irrespective of their average aggregate daily notional amount. As with the calculation of material swaps exposure, for purposes of this calculation, each party would be required to aggregate open uncleared swap transactions of all “affiliates,” which would include any company that controls, is controlled by, or is under common control with, that party.

The initial margin compliance dates are broadly consistent with the 2013 International Framework and the delayed compliance schedule would provide market participants more time to enhance their operational/technological infrastructures and margin methodologies, thereby reducing the cost and resourcing constraints participants would have faced in order to implement compliance with the regulations immediately. The schedule would also require the largest and most technologically and operationally savvy Covered Swap Entities to comply first. Though much of the market requires variation margin, it is not universal, and, therefore the variation margin compliance date may be too aggressive for market participants to appropriately establish the necessary operational capabilities in a timely manner.

Additionally, aggregating open transactions of all affiliates for purposes of threshold allocation could create operational and conflict issues across legal entities that may operate independently with differing ownership while meeting the definition of being under common “control” under the Proposed Rule.

Where Does The Proposed Rule Apply

Cross-Border Application

The Proposed Rule excludes from coverage any foreign uncleared swap of a foreign Covered Swap Entity. Further, substituted compliance may be available to a foreign Covered Swap Entity, a non-U.S. bank, or a U.S. branch of a non-U.S. bank, where such entity is not guaranteed by an entity organized under U.S. or State law, if and when the relevant foreign regulations are deemed “comparable” by the U.S.

  • Foreign Covered Swap Entity: Any Covered Swap Entity that is not:
    • an entity organized under U.S. or State law, including a U.S. branch, agency, or subsidiary of a foreign bank;
    • a branch or office on an entity organized under U.S. or State law; or
    • an entity controlled by an entity organized under U.S. or State law. 
  • Foreign Non-Cleared Swaps/Security-Based Swaps: Uncleared swaps or uncleared security-based swaps of a Foreign Covered Swap Entity to which neither the counterparty nor any guarantor of either party is:
    • organized under U.S. or State law (including a U.S. branch, agency or subsidiary of a foreign bank);
    • a branch or office of an entity organized in the U.S.; or
    • a Covered Swap Entity, that is controlled, directly or indirectly, by an entity that is organized under U.S. or State law.