Swap dealers have started to send out the first “Notification of Right to Segregation of Initial Margin posted in Respect of Uncleared Swaps” (the ISDA form notification is here). We have prepared the Q&A to cover some common questions arising from the Collateral Segregation rules. The Q&A does not cover every aspect of collateral segregation, but should help to cover the basics.
Q: Wait! I thought the margin rules were not final- Do I have to post initial margin now?
A: These notices do not mean that swap dealers must now collect initial margin, those rules are still in proposed form; but, we expect the CFTC to publish final rules this year.
Q: Why will I be getting these notices?
A: The Dodd Frank Act provided the customers of swap dealers the “right” to segregate initial margin for uncleared swaps, instead of posting such margin directly with the swap dealer. In November, the CFTC released the final rules implementing collateral segregation for initial margin on uncleared swaps. CFTC Rule 23.701 requires that swap dealers send out notifications to their counterparties informing them of the right to segregate initial margin with an independent third party.
Q: What is the “right” to segregation initial margin?
A: At a counterparty’s option, the counterparty’s “initial margin” must be segregated with an independent third-party pursuant to a custodial arrangement. Generally, CFTC Rule 23.700 defines “initial margin” as margin posted by the counterparty in excess of its swap obligations. By way of example, such margin would include the Independent Amount under the ISDA 1994 New York Law Credit Support Annex.
Q: Who can be a custodian?
A: Although the custodian must be a legal entity separate from the swap dealer, it may be an affiliate of the swap dealer. The swap dealer’s notice must identify at least one potential custodian that is creditworthy and not affiliated with the swap dealer.
Q: Why would I want to segregate initial margin?
A: Under US insolvency laws, typically, margin posted by a swap counterparty can be netted against outstanding swap obligations (without permission from the bankruptcy court or a bankruptcy official). Margin in excess of those swap obligations posted directly to a swap dealer, however, may be at risk upon the dealer’s insolvency. The purpose of segregation initial margin is to protect the counterparty’s rights with respect to that margin in the event of a swap dealer's insolvency.
*** As a caution and a brief aside, we note that in a Lehman SIPC proceeding, the collateral (including excess margin) held in a tri-party account with an independent custodian became Customer Property under SIPA (See the Fifth Third decision here).
Q: Why would I not want to segregate margin?
A: Generally, we would expect there to be a cost to the segregation. If you are using a custodian, then they will charge fees for their services. Additionally, we expect that swap dealers would also price the swap higher, because they would not be able earn income by investing or rehypothecating the segregated margin.
Q: I am a mutual fund or already use tri-party accounts for my margin requirements, do I have to renegotiate all of my control agreements?
A: No. Just as a counterparty can elect not to segregate initial margin, a mutual fund can continue to use its existing control agreement arrangements. We would expect that many funds will want to keep their existing control agreements (which cover both initial and variation margin) in place. However, the right to segregate initial margin subject to the CFTC rules may provide an opportunity to update control agreements, because the CFTC rules have a few requirements that depart from current market practice (see below).
Q: What are the CFTC requirements on segregation, if chosen?
- The segregation must be in an account segregated for and on behalf of the counterparty, and designated as such;
- The agreement for the account must be in writing;
- If either the swap dealer or the counterparty is entitled to control of the margin pursuant to a swap agreement, then that party may issue a written notice to the custodian to take control of the margin;
- Any such notice of control must be made under penalty of perjury;
- Before any such notice of control, withdrawals of margin may only be made by joint instructions; and
- Margin segregated may only be invested in accordance with CFTC Rule 1.25.
Q: What steps would I have to take to segregate initial margin?
A: After notifying your swap dealer of the election, you would have to set up an account at a custodian. Then, you would enter into an account control agreement with the swap dealer and the independant custodian in order to perfect the swap dealer's security interest in the account and the margin. We note that the CFTC requirements (see above) differ in some respects from what has become standard in most current account control agreements (such as those for mutual funds). For instance, the ability for the counterparty to access the collateral is a counterparty right that is only recently gaining traction. To this extent, ISDA has prepared a standard account control agreement form, located here, where you can see what such an agreement would entail. However, we note that control agreements are typically negotiated among the three parties and custodians may have existing forms that they will use.