By Julian Hammar and James Schwartz, of counsel at Morrison & Foerster.
Last autumn, the Commodity Futures Trading Commission (CFTC) and five US prudential banking regulators released proposed rules for margin requirements for uncleared swap transactions for the entities subject to their regulation.
The margin requirements, when finalised, will play a significant role in determining the economics of the post-Dodd-Frank uncleared swaps market, including the extent to which market participants may favour or disfavour uncleared swaps in comparison with other types of transactions. If implemented in their proposed form, the rules will pose many challenges for market participants.
Both the CFTC and the Prudential Regulators released proposals for margin in 2011. Since that time, however, an international consensus has grown around the policy framework for margin, stated in a series of papers released by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions, the last of which was published in September, 2013 (BCBS/IOSCO Framework). With some significant exceptions, which we note below, the proposed rules are broadly consistent both with the BCBS/Iosco Framework and with each other.
Although the proposed rules by their terms apply directly to swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants (also known as covered swap entities or CSEs), the measures they would require of CSEs would significantly change the economics of the uncleared swaps market not only for CSEs, but also for many of their financial counterparties. Among other things, the proposed rules would address the following key areas.
Firstly, they would require CSEs to bilaterally exchange initial margin with other CSEs as well as a broad range of financial end users whose use of swaps meet a notional amount-based threshold or “material swaps exposure”. All such initial margin would need to be segregated and not subject to rehypothecation or other use.
The rules would also require CSEs to exchange variation margin with CSEs and with a broad array of financial end users, without regard to the existence of material swaps exposure. They would also require cash to be used as variation margin.
Under the proposed requirements, the calculation of initial margin could be made via either a model-based or table-based method. They would also permit offsets in relation to either initial margin calculations or variation margin calculations when such offsets relate to swaps that were subject to the same “eligible master netting agreement”.
Lastly, they would provide for staggered compliance dates for initial margin, and apply to swaps transacted prior to a relevant compliance date, if such swaps were subject to the same eligible master netting agreement as swaps transacted after a compliance date.
The proposed rules present a number of important issues for market participants. Perhaps most significant is the proposed rules’ definition of “material swaps exposure”--the aggregate notional amount at which initial margin requirements would become effective for financial end users. This amount is defined as $3 billion in the proposed US rules, as opposed to the much higher €8 billion in the BCBS/Iosco Framework. As a result, US parties to swaps may be disadvantaged in comparison with non-US market participants, and non-US parties could have good reason to shun the US market.
Moreover, several of the provisions contained in the proposed rules would require CSEs to aggregate notional amounts with affiliates. The aggregation requirement would affect not only the key “material swaps exposure” definition but also the definition of “initial margin threshold” (the amount of initial margin below which no transfer of initial margin is required), and the phase-in schedule for initial margin. Affiliation for these purposes would be defined to be as little as 25 percent ownership or control. Aggregation of notional amounts exposures across diverse affiliated entities, including those over which there is little ownership or control, would be difficult to accomplish, and would likely require the implementation of new systems.
Another key issue is the requirement that variation margin be provided in the form of cash, which is not required in other jurisdictions such as the European Union and Japan. This could help push swaps market liquidity into non-US jurisdictions and require investment managers to liquidate securities, thus causing tracking errors and, in certain cases, could even introduce currency basis risk.
Further, the manner in which initial margin is proposed to be calculated could lead to misleadingly high calculations of initial margin. The proposed rules would require calculations based on an assumed close-out period of 10 business days, an assumed period expressly intended to disfavor uncleared swaps, and more prolonged than the period that most closeouts of uncleared swaps actually require. The proposed rules also restrict the nature of the offsets available in initial margin calculations by requiring each swap to be placed in one category and not permitting offsets even of truly like exposures across such categories.
In addition to these issues, the important definition of “eligible master netting agreement” contained in the proposed rules, as well as the proposed rules’ requirement for custodial agreements for initial margin, would require CSEs to meet a poorly defined but apparently heavy due diligence burden. The manner in which the proposed rules may apply to pre-compliance date swaps also would incentivise parties to negotiate separate eligible master netting agreements for new swaps, and thus could increase risk rather than reduce it.
Whatever one might think of the proposed rules, they indicate the daunting complexity that regulators face in imposing margin requirements on uncleared swaps, to say nothing of the challenges of inter-jurisdictional harmonisation. Looking at the big picture, absent major and unexpected changes, the proposed rules, when finalised, will go a long way toward further de-risking one of the major markets blamed for exacerbating the financial crisis.
One hopes that the US regulators will determine they can responsibly discharge their duties without imposing on US market participants margin requirements exceeding those imposed by regulators in other jurisdictions -- whether by means of the US regulators’ definition of “material swaps exposure,” their unusually low bar for affiliation, or otherwise. Such deviations from the BCBS/Iosco Framework would likely disadvantage US market participants and further balkanise swaps trading activity.