On September 3, 2014, the Federal Reserve and four other prudential regulators (the Prudential Regulators)1 re-proposed rules (the Proposed Rules) that will implement Dodd-Frank’s margin requirements for uncleared swaps, as applied to swap dealers that are banks or that are otherwise subject to supervision by the Prudential Regulators. The Commodity Futures Trading Commission (CFTC), which is not one of the Prudential Regulators, is scheduled to meet on September 17, 2014 to consider re-proposing similar margin rules for certain other swap dealers.2 This Update briefly describes the Proposed Rules and the related proposing release (the Proposing Release).3 After the CFTC re-proposes its rules, we will issue a more detailed Update about the Proposed Rules and the CFTC’s action.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) created a new regulatory regime for the swaps markets. One key provision of the legislation requires that the CFTC and the SEC identify categories of standardized swap transactions that must be cleared through central counterparties. For swaps that are not subject to mandatory clearing, Dodd-Frank imposes margin requirements on swap dealers in order to protect market participants and to reduce systemic risk.4 The Proposed Rules represent an important step toward implementation of the statutory margin requirements for uncleared swaps.
- Relationship of Proposed Rules to Expected CFTC and SEC Actions. The Prudential Regulators are authorized to adopt rules implementing the margin requirements as they apply to swap dealers that are banks or other entities subject to their prudential oversight. The statute separately authorizes the CFTC and the SEC to adopt implementing rules for all other swap dealers. The statute requires that the Prudential Regulators consult with the CFTC and the SEC in connection with developing their rules and that the rules of the various agencies be comparable to the extent practicable. The expected CFTC re-proposal and an eventual SEC rule re-proposal (for which no release date has been announced) are expected to be similar to the Proposed Rules.
- Relationship of Proposed Rules to International Standards and Non-U.S. Laws. To a significant degree, the Proposed Rules follow the final standards for margining uncleared swaps that were adopted by a group of international regulators last fall (the International Standards).5 This overlap is critical, because differences between U.S. and non-U.S. regulation could create uncertainty for market participants and the potential for significant competitive asymmetries and regulatory arbitrage. The Proposed Rules address the limits of their cross-border application–they are generally not applicable to swaps between non-U.S. swap dealers and their non-U.S. counterparties–and also set forth standards by which the Prudential Regulators would evaluate applications for substituted compliance (e.g., to permit non-U.S. swap dealers to comply with comparable non-U.S. margin rules, in lieu of complying with U.S. margin rules, when dealing with U.S. counterparties). Under the Proposed Rules, swaps between a non-U.S. swap dealer subsidiary of a U.S. parent and a non-U.S. counterparty would be subject to the Proposed Rules even if the obligations of the non-U.S. swap dealer subsidiary were not guaranteed by its U.S. parent.6
- Relationship to Prior Proposals; Due Date for Comments. In addition to reflecting the strong influence of the International Standards, the Proposed Rules take into account comments received by the Prudential Regulators following their initial proposal of implementing rules in 2011 (the Original Proposal).7 Because of the significant changes from the Original Proposal–many of them related to the International Standards–the Prudential Regulators chose to re-propose their rules and to seek further comment instead of adopting final rules. Comments are due 60 days following publication of the Proposed Rules in the Federal Register, which has not yet occurred as of the date of this Sidley Update. The CFTC first proposed rules for the margining of uncleared swaps in 2011, and the SEC first proposed rules for the margining of uncleared swaps in 2012.8
- Margin Required by the Proposed Rules. The Proposed Rules generally would impose obligations on swap dealers both to post and to collect initial margin (IM) and variation margin (VM). The requirement that swap dealers to post margin to their counterparties (and not only collect margin from them) represents one of the most significant changes from the Original Proposal; this obligation is consistent with the International Standards. In determining IM amounts, a swap dealer would be permitted to use an internal model that calculates potential exposures, subject to various conditions (including approval of the model by the swap dealer’s regulator).9 In addition, swap dealers would be permitted to establish an IM threshold of up to $65 million in aggregate for a counterparty and its affiliates; this would effectively exclude the first $65 million of potential exposure from the calculation of IM that a swap dealer must collect from (or post to) a counterparty.10 IM (whether posted or collected) would be limited under the Proposed Rules to cash and certain specified categories of securities; VM would be required to be posted in cash.
- Swap Counterparties Subject to the Proposed Rules. The Proposed Rules generally apply only to swaps between swap dealers and their counterparties, and would impose the greatest margining obligations when swap dealers transact with their most significant counterparties. There are four levels to the counterparty hierarchy:
- other swap dealers;
- financial end users with “material swaps exposure;”11
- financial end users without material swaps exposure; and
- non-financial end users.
Whereas the Original Proposal used the term “financial entity,” which was based on the statutory term for entities that are not eligible for the end user exemption from mandatory clearing,12 the Proposed Rules use the term “financial end user.” That term is defined broadly but with much greater particularity than the defined term “financial entity.” The term “financial end user” generally includes a broad range of financial firms that are subject to federal or state regulation, licensing and/or registration. The term excludes both captive finance companies and affiliates that qualify for exemptions from mandatory clearing under CFTC rules; it also excludes certain sovereign entities, multilateral development banks and the Bank for International Settlements. Importantly, the term “financial end user” under the Proposal Rules would not rely on Section 4(k) of the Bank Holding Company Act, which covers a very broad, and far less specific, range of entities engaged in “activities that are financial in nature.”
- Application of Proposed Rule to Different Counterparty Categories. In the case of the first and second counterparty categories–other swap dealers and financial end users with material swaps exposure–the posting and collecting of both IM and VM would be mandated. In the case of the third category–financial end users without material swaps exposure – swap dealers would be required to collect and post VM, but specified minimum IM requirements would not apply. In the case of the fourth category–non-financial end users–there would be no specified minimum margining requirements (either IM or VM).13
- Segregation Requirements. All margin posted by a swap dealer, other than any required VM, would be required to be segregated via third-party custodial arrangements. Similar custodial requirements would apply to margin that a swap dealer collects, but only in respect of the required amount of IM. Thus, mandated IM must always be segregated, and mandated VM is never subject to mandatory segregation. However, excess margin–margin in excess of mandated IM and VM–would be treated asymmetrically: it would be required to be segregated when posted by a swap dealer, but not when collected by a swap dealer. In connection with any required third-party custodial arrangements, no rehypothecation of margin would be permitted (which would be at variance with the International Standards, under which “one-time” rehypothecation of IM is permitted in certain circumstances).14
- Phase-in Period. Because the Prudential Regulators view the Proposed Rules’ VM obligations as being generally consistent with current market practice, the VM obligations would be effective as of December 1, 2015. IM obligations, which the Prudential Regulators view as representing a departure from market practice, would be phased in over a four-year schedule, from December 1, 2015 to December 1, 2019. The earliest date would apply to a swap transaction if each of the swap dealer and the counterparty to the transaction (together with its respective affiliates) has swaps with an average daily aggregate notional amount of $4 trillion or more. Each of the subsequent four annual dates in the phase-in schedule reflects a reduction of this threshold ($3 trillion for December 2016, $2 trillion for December 2017, $1 trillion for December 2018, and all other dealer/counterparty pairs beginning in December 2019). This phase-in schedule is consistent with the International Standards.15
1 The five Prudential Regulators are the Comptroller of the Currency (OCC); Board of Governors of the Federal Reserve System (Federal Reserve); Federal Deposit Insurance Corporation (FDIC); Farm Credit Administration (FCA); and Federal Housing Finance Agency (FHFA). The Prudential Regulators do not include the CFTC or the Securities and Exchange Commission (SEC).
2 See CFTC, Press Release PR6994-14, CFTC to Hold an Open Meeting to Consider a Proposed Rule on Margin Requirements and a Final Rule on Utility Special Entities, available at http://www.cftc.gov/PressRoom/PressReleases/pr6994-14.
3 See Prudential Regulators, Margin and Capital Requirements for Covered Swap Entities (September 3, 2014).
4 See Dodd-Frank, Sections 731 (swaps) and 764 (security-based swaps). The margin requirements are imposed on “swap entities,” defined to include both swap dealers and major swap participants under CFTC rules, and security-based swap dealers and major security-based swap participants under SEC rules. For simplicity, this Update refers to “swap dealers” rather than “swap entities.” Moreover, the requirements cover both uncleared “swaps” under CFTC rules and uncleared “security-based swaps” under SEC rules. For simplicity, this Update refers to only uncleared “swaps.”
5 See BCBS and IOSCO, Margin requirements for non-centrally cleared derivatives (September 2013), available at: http://www.bis.org/publ/bcbs261.pdf.
6 This contrasts with the treatment of non-guaranteed swaps under the CFTC’s cross-border interpretation of its swap rules.
7 See Prudential Regulators, Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27564 (May 11, 2011), available at: http://www.gpo.gov/fdsys/pkg/FR-2011-05-11/pdf/2011-10432.pdf.
8 See CFTC, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (April 11, 2011), available at: http://www.gpo.gov/fdsys/pkg/FR-2011-04-28/pdf/2011-9598.pdf; SEC, Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, 77 Fed. Reg. 70214 (November 23, 2012), available at: http://www.gpo.gov/fdsys/pkg/FR-2012-11-23/pdf/2012-26164.pdf.
9 The Proposing Release noted that estimates of aggregate required IM under the Proposed Rules vary greatly depending on whether internal models or the provisions for standardized margin are assumed to apply, with the latter producing much higher IM requirements.
10 If a swap dealer maintains master agreements with two or more counterparties that are affiliates, the $65 million threshold must be allocated among the affiliated counterparties (such that the aggregate threshold does not exceed $65 million).
11 The Proposed Rules define “material swaps exposure”, as applied to a given financial end user counterparty, to require that the counterparty 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 year that exceeds $3 billion, where such amount is calculated only for business days.”
12 Sidley Update, End-User Exception from the Clearing Mandate and the Trade Execution Requirement Under Dodd-Frank Act (AUGUST 13, …2014); available at: http://www.sidley.com/08-12-2014-Derivatives-Update/.
13 As they did in connection with the Original Proposal, the Prudential Regulators continue to view Dodd-Frank as imposing margining requirements on all uncleared swaps entered into by swap dealers, including those with non-financial end users. However, unlike the Original Proposal, the Proposed Rules take a “risk-based approach” and require only that swap dealers “collect initial and variation margin at such times and in such forms and amounts (if any) as the [swap dealer] determines would appropriately address the credit risk posed by swaps entered into with” non-financial end users counterparties. The Proposing Release confirms that “the Agencies intend for the proposed requirements with respect to [non-financial end user counterparties] to be consistent with current market practice and understand that in many cases a [swap dealer] would exchange little or no margin with these counterparty types.”
14 See International Standards, paragraph 5(v). It is not clear how, if permitted, “one-time” rehypothecation would work in practice.
15 The Dodd-Frank statutory provisions underlying the Proposed Rules require that the Prudential Regulators also adopt rules implementing mandated capital requirements for swap dealers. However, the Proposed Rules do not address capital requirements because, as the Proposing Release explained, the Prudential Regulators “have determined that compliance with the regulatory capital rules [adopted in 2013 in response to the Basel III recommendations] is sufficient to offset the greater risk, relative to the risk of centrally cleared swaps, to the swap entity and the financial system arising from the use of non-cleared swaps, and helps ensure the safety and soundness of the covered swap entity. In particular, the Agencies note that the regulatory capital rules incorporated by reference into the proposed rule already address, in a risk-sensitive and comprehensive manner, the safety and soundness risks posed by a covered swap entity’s swaps positions.”
If you have any questions regarding this update, please contact one of the following or the Sidley lawyer with whom you usually work.
|Nathan A. Howell
|William A. Shirley
Sidley Derivatives Practice
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