collateral, subject to a fixed haircut based on asset class. An additional 8-percent haircut is applied for non-cash variation margin denominated in a currency other than the currency of settlement. Initial margin denominated in a currency other than the currency of settlement is similarly subject to an 8-percent cross- currency haircut, except where it is the termination currency identified in an eligible master netting agreement between the parties (as further described in this article).
Initial Margin Segregation Generally, initial margin collected and posted by covered swap entities must be held by a non-affiliate third-party custodian.12
The covered swap entity is
required to have a custodial agreement that prohibits rehypothecation, which need not be a tri-party custody agreement with the counterparty. The regulators left this open as a point to be negotiated in the market. Managers of funds with a material swaps exposure may want to document this as a tri- party relationship in order to maximise access to the accounts in the event of the dealer’s bankruptcy.
The Final Rule imposes a limitation on the ability of parties to post initial margin with a custodian in the form of cash. For cash to be considered eligible collateral, it must consist of “immediately available cash funds.” However, it is impractical for custodian banks to hold cash in the name of the posting party, and current business practice is for custodians to accept funds as a general deposit. Because of this, counterparties posting cash as initial margin must direct the custodian to reinvest the cash into eligible non-cash collateral within a reasonable time period after posting, taking into account relevant haircuts for non-cash collateral.
Eligible Master Netting Agreement The Final Rule generally permits parties to an eligible master netting agreement (“EMNA”) to calculate initial margin or variation margin requirements on an aggregate net basis across all non-cleared swaps.13 In order to qualify as an EMNA, a master netting agreement must meet certain requirements, such as the absence of a walkaway clause permitting a non- defaulting counterparty to make a reduced payment following a default. A covered swap entity intending to rely on an EMNA is required by the terms of the Final Rule to conduct sufficient legal review in light of the relevant jurisdictions to satisfy itself of the enforceability of the EMNA in the event of a party’s insolvency.
A portfolio of swaps under an EMNA entered into prior to the applicable compliance date will not be subject to the requirements of the Final Rule. However, including a non-cleared swap in a netting portfolio following the compliance date will subject the entire portfolio to the margin rules. Covered swap entities
are permitted to create separate netting portfolios under a single EMNA so that the parties may maintain a separate set of legacy swaps that will not be subject to the margin rules. As such, parties to an ISDA master agreement that meets the requirements of an EMNA may want to consider maintaining a separate portfolio of legacy swaps if they wish to exempt such trades from the Final Rule’s requirements. This will likely entail separate credit support annexes for each portfolio.
Documentation Requirements Covered swap entities are required to execute swap documentation enabling them to collect and post margin in accordance with the Final Rule. The documentation must also specify the methods, procedures, rules and inputs for determining the value of each non-cleared swap for purposes of calculating variation margin and resolving disputes, and it must also include a description of the initial margin methodology.14
Existing credit support
annexes will need to be amended accordingly, and such amendments may or may not be adopted by the industry as part of a new ISDA protocol.
Cross-Border Applicability The Final Rule does not apply to a foreign non-cleared swap of a foreign covered swap entity. A “foreign non-cleared swap” is defined to mean a non-cleared swap between two counterparties, neither of which is (1) organised under the laws of any state in the United States, (2) a branch or office of an entity organised in the United States, or (3) a swap entity that is a subsidiary of an entity organised in the United States. This bright-line rule provides that an offshore investment fund will not be considered a US person for purposes of determining the applicability of the margin requirements to a particular swap. This significantly differs from the CFTC “US person” definition, which requires analysis of an entity’s principal place of business and includes many offshore investment funds managed by US-based fund managers. Regardless, a swap between a covered swap entity and an offshore investment fund will be subject to the requirements of the Final Rule.
Compliance Dates Compliance dates for initial margin requirements range from 1 September 2016 through 1 September 2020, depending on the average daily notional amount of non-cleared swaps for the relevant covered swap entity and its counterparty.15
The
variation margin requirements begin 1 September 2016 for swaps between covered swap entities and counterparties that each have average daily notional amounts of non-cleared swaps exceeding $3 trillion. Swaps between all other covered swap entities and counterparties are subject to a 1 March 2017 compliance date for the variation margin requirements. THFJ
FOOTNOTES
1. See Final Rule to Establish Margin and Capital Requirements for Covered Swap Entities (unofficial text) (the “Final Rule”). The Final Rule was jointly adopted by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency. For ease of reference, the term “swaps” as used herein will refer to both “swaps” and “security-based swaps” unless the context requires otherwise.
2. See Final Rule, at 5 n.4. Although the buy-side is generally not directly subject to the Final Rule, the requirements are imposed on all swaps entered into by a covered swap entity, and thus investment funds trading swaps with any covered swap entity will be impacted.
3. See 7 U.S.C. § 6s(e)(2)(A); § 15 U.S.C. 78o-10(e)(2)(A). 4. See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57348 (Sept. 24, 2014) (the “proposed rule”).
5. See Basel Committee on Banking Supervision & Board of the International Organisation of Securities Commissions, Consultative Document: Margin Requirements for Non- Centrally-Cleared Derivatives (September 2013).
6. The calculation includes non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps.
7. Where the assets of an investment fund are consolidated with the assets of its investment manager, such as during seeding, the entities would be considered affiliated for purposes of the Final Rule. Additionally, despite several requests from commenters, the regulators elected not to adopt a rule that would treat separately managed accounts of a single entity investment fund or pension fund as separate and distinct entities.
8. In order to determine the amount of initial margin a covered swap entity must post to a counterparty, the Final Rule provides that such amount must not be less than the amount of initial margin that it would be required to collect if the covered swap entity were in the place of the counterparty.
9. The Final Rule’s margin provisions represent only minimum requirements and do not prohibit covered swap entities from collecting initial margin in excess of what is required under the Final Rule.
10. In such situations, a covered swap entity is directed by the Final Rule to collect margin at such times and in such forms and amounts (if any) as it deems appropriate in its overall credit risk management.
11. The Final Rule recognises the following four asset classes: (1) commodity, (2) equity, (3) credit, and (4) foreign exchange and interest rate.
12. When a covered swap entity collects initial margin from a counterparty, the Final Rule obligates the covered swap entity to segregate only the amount of margin required to be collected under the rule. To the extent a covered swap entity collects initial margin in excess of the minimum amount required, it is permitted to hold and use such collateral pursuant to the terms of its credit support documentation.
13. Some exceptions to note: (1) Initial margin and variation margin may not be netted against one another; (2) a covered swap entity is not permitted to net initial margin amounts that it is required to post to a counterparty against initial margin amounts that it is required to collect from such counterparty; and (3) non-cleared swaps subject to the Final Rule may not be netted against any other products under an EMNA aside from other non-cleared swaps.
14. These documentation requirements are more burdensome than the documentation requirements imposed by the CFTC’s external business conduct rules, which the buy-side largely incorporated by adhering to the ISDA March 2013 Dodd-Frank Protocol. See 17 C.F.R. § 23.504 (Swap Trading Relationship Documentation).
15. Affiliates are included for purposes of calculating a party’s daily aggregate notional amount.
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