CFTC Adopts Margin Rules for Uncleared Swaps

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CFTC Adopts Margin Rules for Uncleared Swaps

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On December 16, 2015, the CFTC voted to adopt final rules that will establish minimum initial margin and variation margin requirements for uncleared swaps entered into by swap dealers and major swap participants that are not overseen by federal banking regulators (collectively, Swap Entities). The CFTC rules are substantially similar to the margin rules recently adopted by the federal banking regulators for entities subject to their regulatory oversight.

Rules Apply to Swap Entities and Financial End Users

The CFTC’s margin requirements vary depending on the nature of the counterparties to the uncleared swap. The CFTC’s rules establish three categories of counterparties: (1) Swap Entities, (2) financial end users, and (3) non-financial end users.

The CFTC defines the term “financial end user” to include the following types of entities:

  • Banks, savings and loan companies, credit unions, and their holding companies.
  • State-licensed finance companies, money lenders, mortgage brokers, and currency dealers.
  • Securities brokers and dealers, investment advisers, and investment companies.
  • Private investment funds, commodity pools, commodity pool operators, commodity trading advisors, floor brokers, floor traders, introducing brokers, and futures commission merchants.
  • Insurance companies.
  • Employee benefit plans.
  • Any person or entity that raises money from investors or uses its own money primarily for investing or trading in securities, swaps, or other assets.

A “non-financial end user” is defined as a counterparty that is neither a Swap Entity nor a financial end user.

Requirements for Initial Margin and Variation Margin

The CFTC’s margin rules will require daily posting and collecting of initial margin for all new swaps after the applicable compliance date between two Swap Entities or between a Swap Entity and a financial end user that has over $8 billion in gross notional exposure in uncleared swaps. The initial margin can be in the form of cash, sovereign debt, corporate bonds, equities, gold, and certain fund shares, with appropriate haircuts as specified in the rules.

With respect to variation margin, the rules will require daily payments in cash for all new swaps between two Swap Entities. For swaps between a Swap Entity and a financial end user (regardless of how much gross notional exposure in uncleared swaps it has), the rules require daily posting of variation margin in one of the forms approved for initial margin.

When margin is required to be posted, the CFTC rules will require the initial margin collateral to be held in segregated accounts at an independent custodian. Rehypothecation of the margin collateral is prohibited.

No Margin Required for Non-Financial End Users

Notably, the CFTC rules will not require non-financial end users to post initial margin or variation margin for uncleared swaps. Because such entities generally use swaps to hedge commercial risks, the CFTC believes that they pose less risk of default than financial entities. This treatment for non-financial end users was mandated by an amendment to the Dodd-Frank Act adopted by Congress in January 2015 to provide an exception for non-financial companies from the requirement to post margin on uncleared swaps.

Special Treatment for Inter-Affiliate Swap Transactions

The aspect of the CFTC’s margin rules that was most controversial was how those rules should apply to a swap between a Swap Entity and one of its affiliates. The margin rules adopted by the federal banking regulators require two-way initial margin and variation margin for swaps between a Swap Entity and an affiliate that is either a Swap Entity or a financial end user. However, commenters argued that inter-affiliate swap transactions are not outward-facing and thus do not increase the overall risk exposure of the consolidated enterprise to third parties. A majority of the CFTC (Chairman Massad and Commissioner Giancarlo) accepted that argument. Commissioner Bowen issued a dissenting statement in which she stated her view that the CFTC should have adopted the same approach as the banking regulators on this issue.

Under the CFTC’s margin rules, a Swap Entity is not required to collect initial margin from an affiliate provided that (1) the swaps are subject to a centralized risk management program that is reasonably designed to manage the risks of inter-affiliate swaps and (2) the Swap Entity and its affiliate exchange variation margin payments. In addition, the Swap Entity will be required to collect initial margin from a non-U.S. affiliate that is a financial end user if the affiliate is not subject to initial margin requirements, under foreign margin rules that are comparable to those imposed on non-affiliates under the CFTC’s margin rules, with respect to the affiliate’s own outward facing swaps with financial end users. (This requirement is designed to prevent the potential use of affiliates to evade the requirement to collect initial margin from third parties as required under the CFTC’s rules if the swap were directly between the Swap Entity and the third party.)

Except as noted in the preceding paragraph with respect to non-U.S. affiliates of a Swap Entity, the recently-adopted CFTC margin rules do not address how those rules will apply when one or both of the swap counterparties are located outside of the U.S. That subject is being addressed in a separate rulemaking proceeding.

Implementation Schedule

The requirements to post and collect initial margin and variation margin will be phased in starting on September 1, 2016, in accordance with the following schedule:

  • September 1, 2016 – initial margin and variation margin required when both the Swap Entity and its counterparty (combined with their affiliates) have an average daily aggregate notional amount of covered swaps for the prior March, April, and May that exceeds $3 trillion.
  • March 1, 2017 – variation margin required for all covered swaps between two Swap Entities or between a Swap Entity and a financial end user.
  • September 1, 2017 – initial margin required when both the Swap Entity and its counterparty (combined with their affiliates) have an average daily aggregate notional amount of covered swaps for the prior March, April, and May that exceeds $2.25 trillion.
  • September 1, 2018 – initial margin required when both the Swap Entity and its counterparty (combined with their affiliates) have an average daily aggregate notional amount of covered swaps for the prior March, April, and May that exceeds $1.5 trillion.
  • September 1, 2019 – initial margin required when both the Swap Entity and its counterparty (combined with their affiliates) have an average daily aggregate notional amount of covered swaps for the prior March, April, and May that exceeds $0.75 trillion.
  • September 1, 2020 – initial margin required for all covered swaps between two Swap Entities or between a Swap Entity and a financial end user that has over $8 billion in gross notional exposure in uncleared swaps.

The CFTC’s margin rules do not have retroactive effect and will not apply to transactions executed before the applicable dates set forth above.

For more information on this subject, please contact the author or another member of Schiff Hardin’s Financial Markets and Products Practice Group.