New variation margin rules will take effect for uncleared derivatives with all financial counterparties as of March 1, 2017. As hedge funds and other market participants in the buy-side community gear up to tackle the project, they must pay attention to the substantive terms of the new margin rules and the ways in which the new terms are implemented. While it is abundantly clear that market participants will have to enter into new documentation, there are different paths to take and choices to make along the way.


In response to the financial crisis, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions recommended minimum standards for the margining of uncleared derivatives. As a result, rules have been proposed or adopted in the U.S., the European Union, Australia, Canada, Switzerland and Japan. In the U.S., both the Prudential Regulators1 and the Commodity Futures Trading Commission (the "CFTC") published final margin rules in 2015 and 2016, respectively. 2 The Securities and Exchange Commission has not yet finished its rulemaking and recently suggested that rulemaking will not be a priority given the new administration in the U.S. 

In accordance with the final margin rules, as of September 2016, financial market participants in the U.S. with the largest volumes of derivatives activities began exchanging variation margin on uncleared derivatives transactions. All other financial counterparties (with the exception of a few)3, including hedge funds, will  be required to exchange variation margin on uncleared derivatives starting on March 1, 2017. It should be noted that in practice most hedge funds have been exchanging variation margin with their swap dealer counterparties in connection with derivatives transactions for years. In those instances, parties will modify existing margin practice and amend or replace margin documentation to comply with the new margin requirements. 


The margin rules apply directly to Covered Swap Entities ("CSEs"), which are either swap dealers subject to the jurisdiction of the CFTC or banks subject to the jurisdiction of the U.S. Prudential Regulators. While the margin rules do not directly apply to most hedge funds or buy-side firms that are not otherwise a CSE, the rules will indirectly apply insofar as the trading counterparty is a CSE. Most hedge funds will fall into the category of a Financial End User (which term includes private funds  and commodity pools). This is of importance to CSEs as they strive to categorize their trading counterparties in order to determine whether and when variation margin and initial margin will be exchanged. 


The margin rules require that a CSE must collect and post variation margin to another CSE or Financial End User. In addition, the following is a list of notable changes required by the margin rules: 

  • Zero Threshold - variation margin must be exchanged subject to a zero threshold. Traditionally the threshold amount with respect to a party to thederivatives transaction is the amount of credit risk that the counterparty is willing to take. 
  • Minimum Transfer Amount - the minimum transfer amount (known as the MTA) is subject to a $500,000 maximum. The minimum transfer amount is the amount below which, for administrative ease, margin need not be posted or returned. 
  • Transfer Timing - margin transfer timing in the existing CSA is shortened by one day so that if a margin call is made prior to certain timeframes (the "Notification Time"), transfers of collateral must be made by the close of business on the day the margin call is made. If the margin call is made after the Notification Time, transfers can be made the following day. 
  • Eligible Collateral - eligible collateral will be restricted to certain types (including non-cash collateral) and subject to haircuts depending on type and currency.


The International Swaps and Derivatives Association, Inc. (" ISDA") recently published the 2016 Variation Margin Protocol (the "VM Protocol") to assist the market in its effort to update documentation and comply with the new margin rules. The VM Protocol includes an adherence letter, a questionnaire, the protocol agreement, and amendments or new Credit Support Annexes ("CSAs"). In essence, the VM Protocol provides a path for parties to amend existing margin documentation or enter into new documentation in order to be margin rule-compliant. Similar to existing protocols, the VM Protocol requires parties to complete questionnaires where certain elections need to be made. The following is a summary of the important elections: 


  • Allows counterparties to amend existing CSAs to include modified margin terms that comply with the new variation margin requirements. 
  • Practical Effect: Legacy or existing trades will not be excluded from the margin requirements. In other words, there will one margin-rule compliant CSA, which includes both existing trades and trades entered into after March 1, 2017. 


  • Allows counterparties to replicate existing CSAs (the "Replicated CSAs") and amend the Replicated CSAs (but not the existing CSAs) to include modified margin terms that comply with the new variation margin requirements, resulting in an end user having multiple CSAs, each covering a defined subset of transactions. 
  • Practical Effect: Legacy or existing trades will be excluded from the margin requirements. In other words, there will multiple CSAs and multiple margin calls - a CSA for trades prior to March 1, 2017, and a CSA for trades after March1,2017. 


  • Allows counterparties to enter into new CSAs that comply with the new variation margin requirements. 
  • Practical Effect: This method is for market participants that do not have or would like to replace existing CSAs. There will be one margin rule-compliant CSA. 

In addition, some swap dealers and buy-side firms have opted for a bilateral amendment approach instead of using the VM Protocol as a more efficient way to update their margin documentation to meet the regulatory deadline. 

As hedge funds and other buy-side firms consider their preferences and elections, they should take into account important operational considerations. If, for example, a firm chooses to have multiple CSAs (Replicate and Amend Method), it would need to ensure collateral systems and staff are able to support this practice as there would be multiple netting sets, margin calls, and varying terms across more than one CSA that could present a new level of risk. 


The new margin rules, and the associated looming compliance date, are presenting challenges for all market participants. Hedge funds and other buy-side firms will need to take action and, to the extent they have not done so, they should engage in dialogue with swap dealer counterparties as soon as possible, as trading may be restricted for those who do not have margin-rule compliant documentation by the March 1 compliance date. Buy-side firms should review the terms of the proposed documentation to ensure that they do not go beyond the regulatory requirements without a reasonable explanation. Equally important, buy-side firms should evaluate the operational and practical consequences as a result of each documentation option presented by the swap dealer counterparties, and try to adopt an approach that will prove to be efficient and less prone to error going forward. With the window for compliance closing rapidly, there is a general concern in the market that some may be left behind. Don't be one of them.