On April 12, 2011, the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Farm Credit Administration and Federal Housing Finance Agency (the Prudential Regulators) proposed rules pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) establishing capital and margin requirements for swaps not cleared through clearing organizations. That same day, the Commodity Futures Trading Commission (CFTC) proposed rules establishing margin requirements for uncleared swaps.1 Both the Prudential Regulators’ and CFTC’s proposed rules would apply only to swaps entered into after the rules become effective. The Prudential Regulators’ proposed rules will become effective 180 days after they publish the final rules in the Federal Register, and comments on the proposed rules are due by June 24, 2011. The CFTC has indicated that it will coordinate the effectiveness date and comment deadline of its proposed rules with those of its forthcoming rules imposing capital requirements on participants in uncleared swap transactions.
Requirements of the Dodd-Frank Act
The Dodd-Frank Act completely remodeled the regulatory framework for derivatives, which it defines as “swaps.” Swaps now are subject to CFTC regulation, and swap dealers and major swap participants (Swap Entities) now must register with the CFTC. The SEC now has authority over security-based swaps, and security-based swap dealers and major security-based swap participants (Security-Based Swap Entities, and, generically with Swap Entities, Covered Swap Entities) now must register with the SEC.2 The Dodd-Frank Act generally requires swaps to be cleared through clearing organizations, with the CFTC and SEC determining the specific types that must be cleared. Commercial end users that use swaps to hedge risk rather than speculate (Commercial End Users) are exempt from this clearing requirement.
Sections 731 and 764 of the Dodd-Frank Act require regulators to set margin and capital requirements for Covered Swap Entities that trade in swaps that are not cleared (either because the CFTC or SEC has determined not to require their clearance or a counterparty is a Commercial End User). These capital and margin requirements aim to reduce the risk of Covered Swap Entities and their counterparties taking on excessive risks posed by uncleared swaps without having adequate financial backing to fulfill their obligations under the swap contract. Specifically, the Prudential Regulators must issue margin and capital rules for Covered Swap Entities under their jurisdiction, such as banks, thrifts, foreign banks and bank and thrift holding companies (Bank Swap Entities). The CFTC and SEC must issue margin and capital rules for Covered Swap Entities not regulated by the Prudential Regulators (Non-Bank Swap Entities).3
The Prudential Regulators noted in their proposing release that Bank Swap Entities already are subject to various capital requirements, including those required to address risks posed by over-the-counter derivatives. Believing those existing capital requirements are sufficient to offset the greater risk to Bank Swap Entities and the financial system arising from the use of uncleared swaps, the Prudential Regulators have proposed not to impose new, additional capital requirements on Bank Swap Entities. However, the Prudential Regulators noted that they expect to enhance existing capital requirements to conform with the recent revisions to the capital framework for internationally active banks instituted by the Basel Committee on Banking Supervision. The CFTC has indicated that it will propose rules imposing capital requirements on Non-Bank Swap Entities in the near future.
The proposed rules require initial and variation margin requirements that differ based on the counterparty to the transaction, reflecting the regulators’ belief that different counterparties pose different levels of risk. The proposed rules categorize three classes of swap counterparties: (i) other Covered Swap Entities, (ii) financial end users and (iii) Commercial End Users.
Swaps with Other Covered Swap Entities
If each party to a swap is a Covered Swap Entity, then each party must collect initial and variation margin from the other party, with variation margin being calculated and paid or collected at least once each business day. An independent, third-party custodian must hold the margin collected. The rules proposed by the Prudential Regulators and CFTC are generally the same for swaps between Covered Swap Entities, although the Prudential Regulators’ proposed rules would not require a counterparty to post variation margin until the cumulative transfer amount exceeds $100,000.
Swaps with Financial End Users
Covered Swap Entities must collect initial and variation margin from financial end user counterparties but need not post margin to them. The Prudential Regulators have proposed to allow a “low-risk” financial end user to forego posting margin until it crosses a credit exposure threshold established by its Bank Swap Entity counterparty. A low-risk financial end user is one that does not have significant swaps exposure, uses swaps primarily to hedge its commercial risk and is subject to regulatory capital requirements. Bank Swap Entities must collect variation margin at least once per week from low-risk financial end user counterparties and at least once per business day from all other financial end users. The CFTC did not indicate a similar distinction. Pursuant to the Dodd-Frank Act, financial end users may choose to require their Covered Swap Entity counterparties to segregate their initial margin with an independent, third party.
Swaps with Commercial End Users
The rules proposed by the Prudential Regulators and the CFTC differ with respect to margin requirements applicable to Commercial End Users. The Prudential Regulators’ proposed rules require Bank Swap Entities to calculate a credit exposure limit for Commercial End User counterparties, and to collect initial and variation margin if this limit is exceeded. The CFTC’s proposed rules do not require Commercial End Users to post margin, but would require them to enter into credit support agreements with their Non-Bank Swap Entity counterparties.
Initial Margin Calculations
The rules proposed by both the Prudential Regulators and the CFTC allow Covered Swap Entities to calculate initial margin using their own models. The Prudential Regulators’ proposed rules allow a Bank Swap Entity to use an internal model that its primary regulator first approves. The CFTC’s proposed rules allow a Non-Bank Swap Entity to use an internal model that the CFTC approves and is (i) used by a derivatives clearing organization for clearing swaps, (ii) used by an entity subject to oversight by a Prudential Regulator or (iii) made available for licensing to any market participant by a vendor. Both proposed rules require models to cover 99 percent of 10-day price moves.
Both proposed rules also allow alternative methods of calculating initial margin. The rules proposed by the Prudential Regulators allow Bank Swap Entities to refer to a standardized “lookup” table that specifies the minimum initial amount of margin that must be collected, expressed as a notional amount of the swap and varying by type of swap. The rules proposed by the CFTC would allow a Non-Bank Swap Entity to apply a multiplier to the initial margin required by a comparable cleared swap or future to reflect the greater risk posed by the uncleared swap.
Variation Margin Calculations
The Prudential Regulators’ proposed rules require a Bank Swap Entity to calculate the amount of variation margin it collects to be equal to or greater than (i) the cumulative mark-to-market change in the swap’s value, as measured from the date it is entered into, less (ii) the value of all collected but unreturned variation margin. Bank Swap Entities may calculate variation margin requirements on an aggregate basis across all transactions with a counterparty that are executed under the same “qualifying master netting agreement.” The CFTC’s proposed rules require Non-Bank Swap Entities to calculate variation margin to cover the current exposure arising from changes in the market value of the swap since the trade was executed or the previous time the position was marked to market based on valuation methods agreed to in the swap documentation.
The Prudential Regulators’ proposed rules limit collateral that a counterparty may use to satisfy the margin requirements to cash, Treasuries and senior debt obligations of government-sponsored enterprises, with such non-cash collateral requiring a haircut. The CFTC’s proposed rules allow a Covered Swap Entity and financial end user to post only cash, Treasuries and senior debt obligations of government-sponsored enterprises, but allows a Commercial End User to post non-traditional forms of collateral agreed to by the Non-Bank Swap Entity counterparty.
Pepper Points: The most notable difference between the two sets of proposed rules relates to margin requirements applicable to Commercial End Users. As proposed, a Commercial End User entering into a swap with a bank is required to post initial and variation margin if its credit exposure exceeds limits established by the bank counterparty, while a Commercial End User entering into a swap with a non-bank will not have to post margin. CFTC Commissioner Scott D. O’Malia cited this “lack of harmonization” as a primary reason for his voting against the CFTC’s proposed rules.
Hedging by Commercial End Users represents a large portion of the over-the-counter swaps market, underscored by the intensive lobbying efforts aimed at curbing any margin requirements in this arena. Commercial End Users are well aware that posting margin will significantly increase their costs of entering into swaps and will affect their overall liquidity. Most likely, they will pass the resulting increased costs on to their customers. The Prudential Regulators did request comment on whether their final rules should exempt Commercial End Users from posting margin on uncleared swaps. At the very least, Commercial End Users have another chance to dissuade regulators from imposing margin requirements on them.