On February 23, 2017, U.S. federal banking regulators (Prudential Regulators), European regulators and the International Organization of Securities Commissions (IOSCO) issued statements clarifying their expectations on compliance with the March 1, 2017, variation margin (VM) requirements for uncleared swaps.1 This guidance follows a U.S. Commodity Futures Trading Commission (CFTC) announcement on February 13, 2017, that provides time-limited no-action relief to swap dealers subject to CFTC VM requirements.2 Under the VM requirements, covered counterparties must exchange margin with respect to non-cleared swaps (defined below) entered into on or after the requirements' effective date, absent an exception. The VM requirements are already effective for the largest swap counterparties and become effective for all remaining counterparties3 on March 1, 2017.
Various market participant groups had asked for extensions of the March 1 deadline because of the challenges swap entities and their counterparties face in implementing the documentation and underlying operational processes needed to comply with the VM requirements.4 While most U.S. and European regulators declined to postpone the March 1 date, their statements and guidance expressed the regulators' understanding that documentation and operational processes may not be completed by the deadline. Faced with this reality, the regulators expressed an intention to prioritize the exercise of their supervisory authority in accordance with the risks of counterparties and to take into account good faith efforts by covered entities to comply with the VM requirements.5
U.S.VM Requirements and Guidance. In November 2015, the Prudential Regulators finalized rules for initial and VM requirements for certain swaps and security-based swaps that are not centrally cleared through a registered derivatives clearing organization or a registered clearing agency (non-cleared swaps). The CFTC finalized its substantially similar rulemaking in January 2016.6 The VM rules necessitate that all covered swap entities review and, if needed, amend their current swap documentation to comply with the VM requirements. Such requirements limit certain aspects of non-cleared swap agreements, such as the types of collateral that may be posted as margin, valuation percentages that must be applied to posted collateral and minimum transfer amounts. The VM requirements also call for operational changes, as the requirements dictate timelines for making margin transfers.
On February 13, 2017, the CFTC responded to industry concerns about meeting the March 1 deadline by issuing two forms of relief,7 including time-limited, transitional no-action relief from enforcement recommendations for non-compliance with the VM requirements until September 1, 2017.8
The Prudential Regulators do not provide relief as extensive as that provided by the CFTC. However, the Prudential Regulators acknowledged the scope and scale of the changes that entities covered by the VM requirements are required to make to comply with the March 1, 2017, effective date9 and indicated that they would take a risk-based approach when examining for compliance. Seemingly acknowledging that swap dealers would not be able to modify every affected swap agreement before March 1, the Federal Reserve and the Office of the Comptroller of the Currency (OCC)10 recommended prioritizing compliance efforts based on the size and risk of credit and market risk exposures presented by each counterparty.11 The joint statement noted that the Prudential Regulators expect swap dealers to comply with the VM requirements with respect to non-cleared swaps with "counterparties that present significant credit and market risk exposures" by the March 1 date.12 Swap dealers are expected to make good faith efforts to comply with the VM requirements in a timely manner with respect to their non-cleared swaps with all other counterparties, but they must fully comply with the VM requirements no later than September 1, 2017.13 The guidance also stated that Federal Reserve examiners would be expected to evaluate management systems and compliance programs; assess governance processes that assess and manage current and potential future credit exposure to non-cleared swap counterparties and related market risk; and consider covered swap entities' implementation plans, such as steps taken to update documentation, policies, procedures, processes and training on a case-bycase basis during initial examinations for compliance with the VM requirements.14
European Margin Requirements and Guidance. In a similar approach to the U.S. Prudential Regulators, the European Supervisory Authorities (ESAs) issued a guidance statement but declined to postpone the March 1 effective date for the European VM requirements. The ESAs statement noted that ESAs have no formal power to disapply the European VM requirements, which were established by EU law,15 through mechanisms like no-action letters. Consequently, the ESAs also declined to set a hard deadline of September 1, 2017, for full compliance with the VM requirements. The ESAs, however, acknowledged that they "have been made aware of operational challenges in meeting the [VM] deadline."16 The ESA guidance explained that the ESAs expect competent authorities to evaluate compliance in a risk-based fashion, taking into account the size of a counterparty's exposure, plus its default risk as well as covered entities' documentation of the steps taken toward compliance with the European VM requirements (e.g., putting in place alternative arrangements, such as using existing credit support annexes to exchange VMs).
The U.K.'s primary regulator, the Financial Conduct Authority (FCA), also issued a statement that it intends to take a similar approach, explaining that "[w]here a firm has not been able to comply fully, [the FCA] will expect it to be able to demonstrate that it has made best efforts to achieve full compliance, and be ready to explain how it will achieve compliance in as short a time as practicable for all in-scope transactions entered into from 1 March 2017."17
International Organizations Guidance. In its statement on VM implementation, IOSCO addressed operational challenges faced by swap dealers and market participants in the context of IOSCO's interest in creating consistent standards of regulation across jurisdictions. IOSCO did not recommend that its members delay the upcoming VM effective date, stating that it expects all covered entities to make every effort to comply with the VM requirements by the March 1 effective date. However, IOSCO said that to the extent legally permitted, IOSCO members should consider taking appropriate measures available to them to ensure fair and orderly markets during the introduction and application of VM requirements.18