Last week the Federal Reserve Bank and four other federal agencies proposed margin rules for uncleared swaps entered into by swap entities they regulate—so-called “covered swap entities” (CSEs). These are the second set of proposed margin rules; the initial set of rules was proposed by the five agencies in April 2011.
In general the new proposed rules address (1) when, in connection with uncleared swaps, CSEs must collect from and post with their counterparties initial and variation margin; (2) calculation methodologies; (3) eligible collateral; and (4) the treatment of collateral. The proposed rules exempt non-financial end users from mandatory margin requirements, but authorize a CSE to collect margin from such a counterparty consistent with its overall credit risk management.
The other agencies involved in this rulemaking are the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Agency and the Office of the Comptroller of the Currency (OCC).
According to the five agencies, the new rules are warranted to better safeguard the financial system:
During the financial crisis, the opacity of swap transactions among dealers and between dealers and their counterparties created uncertainty about whether market participants were significantly exposed to the risk of a default by a swap counterparty. By imposing a regulatory margin requirement on non-cleared swaps, the Dodd-Frank Act reduces the uncertainty around the possible exposures arising from non-cleared swaps.
The proposed rules also address capital requirements for CSEs. However, the proposel rules solely would require CSEs to comply with existing regulatory capital rules to which they currently are subject as part of their prudential regulatory regime. This is because "these existing regulatory capital rules specifically take into account and address the unique risks arising from swap transactions and activities."
In connection with margin requirements for uncleared swaps, the proposed rules require that (1) with other swap entities, a CSE must collect initial margin, and collect and post variation margin; (2) with financial end users with US $3 billion of notional swaps, a CSE must collect and post initial and variation margin; (3) with other financial end users, a CSE must collect and post variation margin, but there are no requirements for initial margin; and (4) with all other end users, a CSE is neither required to post nor collect initial or variation margin, but may do so if appropriate. In all cases, more than minimum margin requirements may be assessed.
It is also proposed that CSEs may use a standardized model to establish the minimum amount of initial margin they are required to post or collect (calculated as a percentage of notional amount depending on asset class) or their own model containing certain minimum attributes and approved by their prudential regulator. Cetain types of netting and offsetting of exposures are contemplated under the standardized model.
Finally, according to the proposed rules, only cash or certain high-grade securities (subject to haircuts) are eligible for initial margin, and only cash is acceptable for variation margin. Initial margin must be segregated at third-party custodians that are not affiliated with either party. Among the high-grade securities that are proposed to be acceptable for initial margin are certain US government and agency issued securities, certain publicly-traded debt and common equity securities, and gold.
Obligations regarding variation margin are proposed to be effective December 1, 2015, while requirements regarding initial margin would be phased-in from December 1, 2015 to December 1, 2019.
OCC estimates that the fully phased-in proposed rule would require approximately US $644 billion of initial margin while the annual cost of the required initial margin would range from US $2.9 to $6.4 billion each year. (Click here to access the OCC's economic analyis in the For More Information section, below.)
The FRB and other agencies consulted with the Commodity Futures Trading Commission and the Securities and Exchange Commission in connection with this proposal as required by law. Comments are due in response to the proposed rules within 60 days after their publication in the Federal Register.
(Click here to access further information on the proposed margin requirements for CSEs in the article “US Banking Regulators Propose Margin Requirements for Uncleared Swaps” in the Corporate and Financial Weekly Digest edition of September 5 by Katten Muchin Rosenman LLP.)