TECHNIC AL
US Regulators Adopt Final Rule On Margin
Requirements For Non–Cleared Swaps CRAIG STEIN, PARTNER and SEAN D. LOCKLEAR, CO-HEAD OF THE STRUCTURED FINANCE & DERIVATIVES GROUP, SCHULTE ROTH & ZABEL
O
n 22 October 2015 a group of five banking regulators (the “prudential regulators”) adopted a final rule establishing minimum
margin and capital requirements for non-cleared swaps and non-cleared security-based swaps.1
The
Final Rule, which does not begin phasing in until September 2016, applies to swaps executed by swap dealers, major swap participants, security- based swap dealers and major security-based swap participants for which one of the federal agencies is the prudential regulator (each, a “covered swap entity”).2
Although most investment managers
and other buy-side firms are already margining non-cleared swaps under ISDA master agreements and credit support annexes, the Final Rule imposes material obligations on swap dealers that diverge from current industry practice. This likely will require amendments to current trading documentation and result in increased costs for many market participants.
In Brief • Dealers soon will be required to collect and post initial margin with certain swap counterparties with high levels of exposure to non-cleared swaps, and such initial margin must be segregated with a third-party custodian.
• Dealers may impose an initial margin threshold of up to $50 million, lessening the rule’s impact.
• Parties to non-cleared swaps generally will be required to exchange variation margin on a daily basis regardless of the counterparty’s non-cleared swap exposure level.
• Investment managers will be required to make certain determinations in order to establish the Final Rule’s applicability and relevant compliance dates.
• Entities managed by the same investment manager are unlikely to be considered “affiliates,” and managers therefore will be required to make entity-level determinations.
• Even funds with limited exposure to non-cleared swaps likely will be required to amend trading documentation, which may eventually be incorporated as a new ISDA protocol.
Background The Dodd-Frank Act requires the prudential regulators to adopt joint rules for covered swap entities under their respective jurisdictions imposing initial and variation margin requirements for all swaps not centrally cleared.3
The prudential regulators issued
proposed rules in May 2011 and again in September 2014, each of which garnered extensive comments from the derivatives community.4
The Final Rule
is largely based on these proposals, but differs in several material respects as described in this Alert.
In addition to the prudential regulators’ rule, the Dodd-Frank Act requires the CFTC and SEC separately
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to adopt rules imposing margin requirements for swap entities for which there is no prudential regulator. While the SEC has yet to act, the CFTC issued its own proposed rule in April 2011, and a final rule is expected to be adopted in short order. On an international level, the Basel Committee on Banking Supervision (“BCBS”) and the board of the International Organisation of Securities Commissions (“IOSCO”) in July 2012 proposed a framework for margin requirements on non-cleared swaps with the intention of creating an international standard.5
Margin Requirements by Counterparty Covered swap entities must both collect and post initial margin for swaps entered into with financial end users that have a material swaps exposure.8
This Although gaps persist between the various
frameworks, the prudential regulators modified many provisions from the proposed rule to more closely align with the BCBS/IOSCO framework.
‘Financial End Users’ and ‘Material Swaps Exposure’ The Final Rule imposes varying obligations on covered swap entities depending on whether their counterparty is a “financial end user.” The prudential regulators defined this term by reference to an enumerated list of entity types in an attempt to provide more certainty than was offered by the corresponding CFTC definition of “financial entity.” The expansive list casts a wide net over various forms of pooled investment vehicles, including registered funds, private funds and commodity pools.
The Final Rule further distinguishes between financial end users based on whether such entities have a “material swaps exposure.” A counterparty has a material swaps exposure if it and its affiliates (discussed below) have an average daily aggregate notional amount of non-cleared swaps with all counterparties for business days in June, July and August of the previous calendar year that exceeds $8 billion.6
deviates from current market practice as dealers would rarely, if ever, post initial margin under an ISDA relationship. However, the Final Rule permits covered swap entities to apply a threshold of up to $50 million, meaning that dealers will not be required to collect or post initial margin to the extent the aggregate un-margined exposure to or from a swap counterparty and its affiliates is below $50 million.9 Covered swap entities do not have any obligation to collect or post initial margin with a non-financial end user or a financial end user without a material swaps exposure.10
The Final Rule generally requires a covered
swap entity to collect and post variation margin for all swaps entered into with a financial end user regardless of material swaps exposure. Unlike initial margin, there is no allowable threshold for variation margin.
Margin Calculations and Eligible Collateral Initial margin must be calculated in one of two ways. Covered swap entities may use a proprietary margin model that meets certain requirements and is approved by the prudential regulators. Such internal models must categorise each swap by asset class and may not offset common risks across asset classes.11
Alternatively, covered swap entities may This figure represents an increase from the $3
billion threshold in the proposed rule and is intended to be consistent with the €8 billion threshold established in the BCBS/IOSCO framework. Covered swap entities are permitted to rely on representations from counterparties as to whether they have a material swaps exposure, so investment managers should be prepared to make this determination.
The Final Rule adopts a modified definition of “affiliate” based on accounting treatment instead of the 25-percent ownership/control framework used in the proposed rule. Two entities will be considered affiliated if either entity consolidates the other on financial statements prepared in accordance with US GAAP, the International Financial Reporting Standards or other similar standards. The prudential regulators noted in the text of the preamble that in most cases they would not expect separate funds of a single investment manager to be consolidated under relevant accounting standards and thus would not be considered affiliates for purposes of the Final Rule.7
impose initial margin requirements based on a standardised margin schedule set forth in the Final Rule. In order to prevent “cherry picking” between the two models, the prudential regulators noted that absent a significant change in the nature of a counterparty’s swap activities, covered swap entities should not switch between a proprietary model and the standardised model for a particular counterparty and should be able to provide a rationale for any such change upon request.
Covered swap entities must collect and post variation margin in an amount corresponding to the cumulative mark-to-market change in the value of the swap. The prudential regulators noted in the preamble that the pricing sources and methodology used to determine such mark-to-market change is left to the agreement of the parties.
Both initial and variation margin must be exchanged on each business day beginning with T+1. Covered swap entities are permitted to adopt a minimum transfer amount of up to $500,000 of combined initial margin and variation margin exposure.
For swaps between a covered swap entity and a financial end user, the Final Rule permits both initial and variation margin to be posted in immediately available cash funds denominated in any major currency (or the settlement currency). The parties may also exchange certain types of non-cash eligible
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