Margin Proposal Outline 09_08_2014 On September 2nd, the Federal banking regulators (OCC, Federal Reserve, FDIC, FCA and FHFA) issued a new rule proposal and request for comment on rules that would govern the posting of margin on non-cleared swaps. The rules would apply, in pertinent part, to swap dealer banks (i.e, prudentially regulated banks that are registered as a swap dealer or a security-based swap dealer with the CFTC or SEC, respectively), a term that is used interchangably in this posting with the term “covered swap entity(ies)”. This posting will provide a summary of these proposed rules and related commentary as to their significance for end-users. Additional information can be found in the attached slide deck.
- Two-Way Margining– The proposed rule’s initial and variation margin requirements would generally apply to the posting and collection of margin for non-cleared swaps. There are exceptionss, trade volume requirements for certain types of counterparties, and a minimum transfer amount, each as more fully described below.
- Risk-Based Approach Distinguishes Among 4 Types of Counterparties– The proposed rule distinguishes among four separate types of counterparties:
- Swap Entity – A counterparty that is a swap dealer, security-based swap dealer, major swap participant, or a major security-based swap participant;
- Financial End-User w/ MSE – A counterparty that is a financial end user with a material swaps exposure (MSE).
- The proposed rule defines a financial end-user to cover entities subject to Federal or state statutes that impose registration or chartering requirements on entities that engage in specified financial activities, such as deposit taking and lending. The definition of a financial end-user also captures banks, broker-dealers, investment advisers, mutual funds, private funds, commodity pools, commodity pool operators, commodity trading advisors, employee benefit plans as defined in paragraphs (3) and (32) of ERISA, insurance companies, and an entity that would be a financial end-user or a swap entity, if it were organized under the laws of the United States. This definition is not based upon the definition of a financial entity under section 4(k) of the Bank Holding Company Act, but instead turns on the counterparty’s legal status as a financial entity.
- The proposed rule defines material swaps exposure for an entity to mean that such entity and its affiliates have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July and August of the previous calendar years that exceeds $3 billion (where such amount is calculated only for business days).
- Financial End-User, not MSE – A counterparty that is a financial end-user but that does not have an MSE; and
- Other Counterparty – A counterparty that is neither a swaps entity nor a financial end-user. For example, a typical commercial end-user would be likely to be an other counterparty.
- Different Initial Margin Requirements For Swaps With Different Types of Counterparties– Different initial margin requirements apply to non-cleared swaps entered into with the different types of counterparties. In summary, these are the requirements:
- Swap Entity – A swap dealer will collect and post initial margin on trades with a swap entity, if the amount of the required initial margin exceeds a $65 million initial margin threshold. The amount of required initial margin is determined: 1) by reference to either a) a standardized margin schedule published by the bank regulators (i.e., a look-up table that varies by swap category – rates, FX, equities, credit – and tenor) with adjustments made to account for risk offsets for non-cleared swaps entered into under the same netting agreement or b) an internal margin model that satisfies criteria published by, and has been approved by, the relevant bank regulator; and 2) on a consolidated entity basis, giving effect to trades entered into between the swap dealer and its affiliates, on the one hand, and the counterparty and its affiliates, on the other hand.
- Financial End-User w/MSE – The initial margin requirements for a financial end-user with a material swaps exposure are the same as the requirements for a swap entity. A swap dealer will collect and post initial margin on trades with a financial end-user with a major swaps exposure, if the amount of the required initial margin exceeds a $65 million initial margin threshold.
- Any Other Counterparty (Including a Financial End-User That Does Not Have MSE) – A swap dealer does not need to collect or post initial margin on trades entered into with a counterparty other than a swap entity or a financial end-user with a material swaps exposure. Put another way, there are no per se initial margin requirements for: 1) other counterparties, such as commercial end-user entering into the non-cleared trade to hedge or mitigate commercial risk pursuant to the end-user exception to central clearing or 2) a financial end-user that does not have a material swaps exposure. With any of these types of counterparties, the swap dealer has an obligation to collect initial margin at such times and in such forms and amounts (if any) that the swap dealer determines approrpriately address the credit risk posed by the particular counterparty and the risks of the particular non-cleared trades entered into with that counterparty.
- Variation Margin Requirements Applied Differently Than Initial Margin Requirements – The variation margin requirements differ by counterpaty type, but are applied in a manner that differs from the application of the initial margin requirements. In summary, these are the requirements:
- Swap Entity – No less frequently than once per business day, a swap dealer will collect and pay variation margin on trades with any swap entity. Variation margin can be determined on an aggregate net basis across all non-cleared swap transactions with a single counterparty that are executed under a single enforceable master netting agreement. The rule proposal is silent as to whether non-cleared swaps can be netted with other transactions, such as deliverable foreign exchange forwards that Treasury has exempted from the swap definition.
- Any Financial End-User – The variation margin requirements for ANY financial end-user are the same as the requirements for a swap entity. In other words, variation margin requirements apply to every financial end-user without regard to whether such counterparty has a material swaps exposure – this is different from the application of the initial margin requirements under the proposed rules.
- Any Other Counterparty – A swap dealer does not need to collect or pay variation margin margin on trades entered into with a counterparty other than a swap entity or a financial end-user. Put another way, there are no per se variation margin requirements for “pure” other counterparties, such as commercial end-user entering into the non-cleared trade to hedge or mitigate commercial risk pursuant to the end-user exception to central clearing. With any of these types of counterparties, the swap dealer has an obligation to collect variation margin at such times and in such forms and amounts (if any) that the swap dealer determines approrpriately address the credit risk posed by the particular counterparty and the risks of the particular non-cleared trades entered into with that counterparty.
- $650,000 Minimum Transfer Amount – A swap dealer will not be required to collect or post initial or variation margin from or to any counterparty unless and until the required cumulative amount of initial and variation margin exceeds $650,000. For purposes of initial margin, the minimum transfer amount only becomes relevant after consideration has been given to the $65 million IM Threshold Amount.
- Margin Requirements Do Not Apply to Existing Swaps, If New Agreements Executed – Under the proposed rules, no new initial and variation margin requirements would not apply to existing non-cleared swaps entered into prior to the compliance date, until those particular trades are rolled or renewed. This grandfathering provision is subject to the condition that the swap dealer has established a new enforceable master netting agreement to cover swaps entered into after the compliance date. If an existing netting agreement is amended to bring it into compliance with the new margin rules, then ALL non-cleared swaps under that agreement will be subject to the new initial and variation margin requirements.
- Eligible Collateral – Initial Margin – The proposal requires that initial margin posted in satisfaction of the rule’s requirements be in the form of cash, gold or another specifically enumerated security type. Cash collateral will not be subject to a haircut, if it is in the form of U.S. dollars or the currency in which payment obligations under the swap must settle. All other collateral will be subject to a haircut at rates set by the banking regulators. The following security types constitute eligible collateral: securities issued by U.S. Treasuries or Agencies; securities issued or guaranteed by Government-sponsored entities; securities issued by the European Central Bank or certain other approved soverign entities; securities issued or guaranteed by the Bank for International Settlements or the International Monetary Fund; securities issued by an issuer that has adequate capacity to meet its obligations in accordance with standards set by the relevant bank regulator; and securities that are included in the S&P Composite 1500 stock index (or equivalent to such component stocks). Securities issued by a counterparty or its affiliates will not qualify as eligible collateral. Excess collateral (that is, margin voluntarily collected or posted by a swap dealer in excess of the rule’s requirements) is not subject to these eligibility requirements.
- Eligible Collateral – Variation Margin – The proposal requires that variation margin payments consist of cash, denominated either in U.S. dollars or the currency in which payment obligations under the swap must be settle. There is no haircut on cash collateral.
- Segregation of Collateral – The proposal mandates segregation of initial margin and restricts re-hypothecation, lending and use of posted initial margin. The segregation requirements and related restrictions do not apply to variation margin.
- Swap Dealer Posts – A swap dealer that posts any non-cleared swap collateral other than variation margin to maintain that collateral at a custodian unaffiliated with either the swap dealer or the counterparty. The segregation requirement applies to initial margin that is voluntarily posted by the swap dealer, such as would be the case where the dealer posts collateral to a financial end-user that does not have a material swaps exposure.
- Counterparty Posts – But, in the case of the swap dealer’s counterparty, the segregation requirement only applies to initial margin that the swap dealer is required to collect from the counterparty.
- Custodian Agreement Requirement – If the segregation requirement applies, then the proposed rules also require that a custodian agreement be put into place that: 1) prohibits the custodian from rehypothecating, repledging, or using, or otherwise transferring the collateral; and 2) mandates that any re-investment or use of the collateral by the posting party be undertaken in a manner that satisfies the eligible collateral requirements.
- Exclusion for Certain Foreign Non-Cleared Swaps– The rule’s margin requirements would not apply to any foreign-non cleared swap of a foreign covered swap entity.
- Foreign non-cleared swap means a non-cleared swap of a foreign covered swap entity to which neither the counterparty nor any guarantor (on either side) is:(1) an entity organized under U.S. or State law (including a U.S. branch of a foreign bank); (2) a branch or office of an entity organized under U.S. or State law; or (3) a covered swap entity (SD, MSP) controlled by an entity organized under U.S. or State law. The banking regulators noted, in particular, that a swap with a foreign bank or with a foreign subsidiary of a U.S. bank could qualify as a foreign swap, as long as the subsidiary is not a covered swap entity (SD,MSP)
- Foreign covered swap entity means, in pertinent part, a swap dealer that is not:(1) an entity organized under U.S. or State law (including a U.S. branch of a foreign bank); (2) a branch or office of an entity organized under U.S. or State law; or (3) an entity controlled by an entity organized under U.S. or State law.
- Comparability Determination – The proposal would permit certain non-U.S. swap dealers to comply with a foreign regulatory framework for non-cleared swaps if the banking regulators determine that the foreign framework is comparable to the U.S. non-cleared swap margin rule. In order to be eligible to take advantage of a comparability determination, the foreign swap dealer’s obgliations must not be guaranteed by a U.S. entity. In addition, the proposal would allow U.S. branches and agencies of a foreign bank to comply with the foreign requirement for which a comparability determination has been made, again subject to there not being a guarantee from a U.S. entity. (Foreign branches and agencies of U.S. banks would be subject to compliance with the U.S. rule.) Also, a swap dealer that is required to post margin to a foreign counterparty can comply with the margin rules of the foreign jurisdiction, as long as a comparability determination has been made and the counterparty is subject to the foreign regulatory framework. Finally, the proposal seeks comment on whether the banking regulators should apply the proposed rules to swaps activities of foreign subsidiaries of U.S. banks that are conducted outside of the U.S. by those subsidiaries.
- Compliance Period – There is a staggered compliance period that begins in December 2015 and runs through December 2019. This compliance period is outlined in greater detail in the attached slides.
Comments are due no later than 60 days after the proposal has been published in the Federal Register. Good day. Good progress. DR2