Summary 

Swap dealers (“SDs”) are required to post and collect initial margin (“IM”) for uncleared swaps with other SDs and counterparties that are financial end users[1] with “material swap exposure” (“MSE”) in accordance with a compliance schedule that has been phasing in for the last three years.[2] The final phase of that implementation, “Phase V,” was scheduled to take effect in September 2020 and to result in a substantial number of investment funds and other financial end users coming into the scope of the IM requirements. However, on July 23, 2019, the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) issued a statement advising that they have agreed to extend by one year, until September 1, 2021, the final implementation of the IM requirements. The extension is a welcome development given the compliance and documentation issues that have been of concern for many market participants in recent months.[3]

Separately, on July 9, 2019, the CFTC issued a Staff Advisory to make clear to CFTC registrants that documentation requirements pertaining to uncleared swaps (also referred to as “non-centrally cleared derivatives”) will not apply until a firm exceeds a $50 million IM threshold for uncleared swaps between a particular SD and counterparty (the “CFTC Advisory”).[4]

Practical Implications

  • The practical impact of these two changes is significant for investment funds and other financial end users that trade uncleared swaps.
  • Financial end users with a notional amount of non-centrally derivative exposure between €8 billion and €50 billion will enjoy a one-year delay of the effective date of the IM requirements.
  • The one-year delay will afford most financial end users and their advisers ample time to assess their exposure to the IM requirements and adjust trading practices accordingly.
  • Although the final IM effective date is still more than two years away, financial end users must determine their exposure in the year preceding the upcoming effective date, and a financial end user subject to the IM requirements will need to substantially revise derivatives documentation in order to trade derivatives once it becomes subject to the IM requirements.
  • The CFTC Advisory provides further relief to financial end users that will ultimately be subject to the IM requirements. As a result of the CFTC Advisory, a counterparty may be able to avoid the onerous documentation process associated with the IM requirements as long as its IM requirement with an SD remains below $50 million.
  • This relief will be particularly helpful for financial end users that are deemed to have MSE but that primarily trade instruments (such as FX forwards), which do not create significant IM requirements, and/or enter into limited transactions with certain SDs.

The remainder of this Alert provides details on the regulatory background of margin requirements for uncleared swaps and the impacts of the recent action by BCBS and IOSCO, as well as the CFTC Advisory.

In the July 23 notice, BCBS and IOSCO stated that “[t]he final [IM] implementation phase will take place on September 1, 2021, at which point covered entities with an aggregate average notional amount (“AANA”) of non-centrally cleared derivatives greater than €8 billion will be subject to the requirements.”[5] To facilitate this extension, BCBS and IOSCO introduced an additional implementation phase whereby, as of September 1, 2020, covered entities with an AANA of non-centrally cleared derivatives greater than €50 billion will be subject to the requirements. BCBS and IOSCO provided a summary table to note the changes, which is reproduced below, with changes[6] to the implementation phases in bold:

Summary of changes to the implementation of the margin requirements for non-centrally cleared derivatives

Initial Margin

Covered entities belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds:
€3.0 trillion 1 September 2016 to 31 August 2017 (based on average notional amounts for March, April, and May 2016) 1 September 2016 to 31 August 2017 (based on average notional amounts for March, April, and May 2016)
€2.25 trillion 1 September 2017 to 31 August 2018 (based on average notional amounts for March, April, and May 2017) 1 September 2017 to 31 August 2018 (based on average notional amounts for March, April, and May 2017)
€1.5 trillion 1 September 2018 to 31 August 2019 (based on average notional amounts for March, April, and May 2018) 1 September 2018 to 31 August 2019 (based on average notional amounts for March, April, and May 2018)
€0.75 trillion 1 September 2019 to 31 August 2020 (based on average notional amounts for March, April, and May 2019) 1 September 2019 to 31 August 2020 (based on average notional amounts for March, April, and May 2019)
Covered entities belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds €8.0 billion From 1 September 2020 onwards (based on average notional amounts for March, April, and May that year) From 1 September 2021 onwards (based on average notional amounts for March, April, and May that year)

The CFTC and U.S. Prudential Regulators are expected to take action to implement the phases noted above shortly, as are regulators in other developed markets.

BCBS and IOSCO also issued a statement earlier this year noting that “the framework does not specify documentation, custodial or operational requirements if the bilateral initial margin amount does not exceed the framework’s €50 million initial margin threshold,” and the recent CFTC Advisory aligns with that statement.[7]

The CFTC Advisory builds on the CFTC’s prior regulatory response and that of other financial regulators to the 2008/2009 financial crisis. The Group of Twenty (“G20”), which includes the United States and other countries with the world’s largest economies, were in agreement that improved transparency in the over-the-counter (“OTC”) derivatives markets and further regulation of OTC derivatives and market participants would be necessary to limit excessive and opaque risk-taking through OTC derivatives and to mitigate the systemic risk posed by OTC derivatives transactions, markets, and practices. The G20 2009 Pittsburgh communiqué initiated a series of reforms to reduce these risks.[8] That G20 communiqué called for Finance Ministers and Central Bank Governors to reach agreement on an international framework to enhance regulation of swaps by requiring that standardized swaps be traded on exchanges or electronic trading platforms, cleared through central counterparties, and reported to trade repositories. In addition, the communiqué indicated that non-centrally cleared contracts “should be subject to higher capital requirements.”[9]

In 2011, the G20 further indicated that the BCBS and IOSCO, together with other relevant organizations, should develop margin standards for non-centrally cleared derivatives.[10]

On behalf of the United States, the CFTC and other regulators participated in a Working Group with BCBS and IOSCO to create an international framework of minimum standards for margin for uncleared swaps.[11] In 2016, the CFTC issued final regulations governing margin requirements for uncleared swaps, which were generally consistent with the international framework.[12]

The margin requirements for uncleared swaps may apply where both counterparties are SDs or the counterparties are an SD and a financial end user with MSE. As noted above, financial end users include, among others, private funds, commodity pools, registered investment companies, employee benefit plans, insurance companies, and money services businesses.[13]

SDs are required to post and collect IM with counterparties in accordance with a phased compliance schedule as outlined in CFTC Regulation 23.161. As noted above, BCBS and IOSCO announced on July 23, 2019, that the so-called “Phase V,” which was due to take effect on September 1, 2020, has been postponed for a year.[14] Accordingly, on September 1, 2021, financial end users with MSE greater than $8 billion in daily AANA may be required to comply with the IM requirements.[15] As a financial end user counterparty comes within the scope of the IM regulations, an SD is required to execute margin documentation.[16] Under CFTC Regulation 23.154(a)(3), SDs are not required to post or collect IM until the “initial margin threshold amount” has been exceeded. The term “initial margin threshold amount” is defined in CFTC Regulation 23.151 to mean “an aggregate credit exposure of $50 million resulting from all uncleared swaps between an SD and its margin affiliates on the one hand, and a covered counterparty and its margin affiliates on the other.” The Advisory clarifies that documentation governing the posting, collection, and custody of IM is not required to be completed until such time as the IM amount between particular counterparties exceeds $50 million.

Although the CFTC has indicated that no specific IM documentation is required prior to reaching the $50 million IM threshold, SDs and their counterparties should take appropriate preparatory steps to have the documentation ready upon reaching the IM threshold. CFTC Regulation 23.504 requires SDs to establish, maintain, and follow written policies and procedures reasonably designed to ensure the execution of IM documentation. SDs must also comply with Section 4s(j)(2) of the Commodity Exchange Act and implementing CFTC Regulation 23.600, pursuant to which SDs must establish a risk management system to monitor and manage risk associated with their swap activities, including legal risk, such as the failure to comply with applicable CFTC regulations.[17]

The CFTC Advisory applies only to SDs because the CFTC margin requirements for uncleared swaps do not require financial end users to establish custodial services, document margin relationships, or operationalize the exchange of IM. Although the regulatory obligations of the CFTC’s margin requirements for uncleared swaps are placed directly upon SDs, which must undertake the major share of the preparatory work for such transactions, financial end users will be indirectly impacted by the SD documentation requirements and should not be passive observers of this process. As necessary, financial end users will have to review and negotiate any credit support, collateral transfer, or custodial arrangement documentation presented by an SD. A financial end user that may be subject to IM requirements may wish to review the IM regulations, including what is acceptable collateral, and consider what steps it may need to take to assure that its systems and operations would be sufficient to assure compliance.

Based on the recent BCBS and IOSCO announcement, many financial end users will have an additional year to prepare for these new requirements. However, it is not too early for such entities to engage in at least preliminary calculations of whether they would have MSE based upon their swaps activity in 2019, which may be conducted with greater precision during the relevant months of 2020 and 2021. Such exercises will provide entities with a clearer picture of potential exposure and modifications in swap activities to plan for any IM requirements. Financial end users should also be mindful that the demand upon resources of third parties to assist with compliance may increase as Phase V draws nearer in 2020 and 2021.

The addition of an intermediate AANA threshold in 2020 and an additional year to comply with the final implementation of IM regulations is a welcome development for those entities that are substantial participants in swap markets. That extension and the CFTC Advisory should provide for a smoother transition to final implementation and greater compliance by market participants, which should be the goals of international regulators. Even though financial end users are not directly impacted by these regulatory pronouncements, those that are active participants in swap markets should use the additional time provided before Phase V becomes effective to prepare for the potential operational changes that could be applicable at that time.

The global futures and derivatives team at K&L Gates continues to follow these and other upcoming developments at the CFTC, including changes to the swaps trading rules, cross-border guidance, and position limits given the arrival of a new Chairman of the CFTC, Heath Tarbert, on July 15, 2019.[18] Our futures and derivatives team stands ready to assist market participants in the navigation of these developments and the new CFTC and global derivatives regulatory agenda.