The Commodity Futures Trading Commission (“CFTC”) has announced its adoption of final regulations to implement the sections of the Dodd-Frank Act that impose margin requirements for swaps involving certain registered swap dealers (“covered swap entities” or “CSEs”) that have not been cleared by a derivatives clearing organization (“uncleared swaps”).
These regulations are very similar to the regulations adopted by the US federal banking and housing agencies (referred to as the “Prudential Regulators”) for swaps of covered swap entities subject to the jurisdiction of one of those agencies. Please read our November 3, 2015, blog post here about those regulations.
As with the Prudential Regulators’ final rules, the effective date of the CFTC’s rules is April 1, 2016, with phased-in compliance dates for certain aspects of the rules between September 1, 2016 and September 1, 2020.
Under Dodd-Frank, not every swap is centrally cleared, and for covered swap entities, Dodd-Frank requires the Prudential Regulators and the CFTC to issue regulations imposing margin requirements on covered swap entities for all uncleared swaps. The CFTC’s rules apply to uncleared swaps by CSEs that are not subject to the jurisdiction of a Prudential Regulator (including nonbank subsidiaries of bank holding companies and certain foreign swap dealers).
Transactions with Nonfinancial Entities Also Excluded
As noted in our prior blog post, in January 2015, the President signed the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA), one provision of which excluded non-financial entities that enter into swaps to mitigate or hedge commercial risk from these margin requirements. These exclusions are incorporated into a CFTC interim final rule, comments on which are due on or before February 5, 2016. Although commercial companies are not subject to margin requirements directly, they may nevertheless be impacted by these rules to the extent that covered swap entities pass on the cost of their new margin obligations to their counterparties.
As with the Prudential Regulators’ rules, the margin requirements are divided into initial margin (calculating margin on an initial basis at the time of the transaction) and variation margin (additional margin depending upon the change in mark-to-market value of the swap over time).
Generally, the amount of margin will depend on the category of counterparty (to the extent not excluded under TRIPRA) – another swap entity, a financial end user with a “material swaps” exposure (these are certain specified financial businesses that are not registered as swap dealers), a financial end user without a “material swaps” exposure, or other counterparties (including sovereigns and multilateral development banks). The margin rules generally do not apply retroactively to pre-existing swaps.
Under the final rules, CSEs generally must collect and post initial margin only for swaps with counterparties that are other swap entities, or financial end users with “material swaps” exposure (defined generally as an average daily aggregate notional amount of covered swaps over a defined time period that exceeds $8 billion), with a maximum initial margin threshold amount of $50 million, below which it does not need to collect or post initial margin. CSEs must collect and post variation margin for swaps with other swap entities and all financial end users (including financial end users without “material swaps” exposure).
Eligible collateral for variation margin under both sets of rules is limited to immediately available cash funds denominated in certain specified currencies. Eligible collateral for initial margin includes, in addition to the foregoing, certain enumerated securities, though haircuts may be required.
Differences between CFTC’s and Prudential Regulators’ Rules
While the CFTC rules are generally similar to the Prudential Regulators’ final rules, there are some differences, including those noted below:
Use of Models: Both sets of rules allow covered swap entities to use a standardized approach or an internal model approach to calculate initial margin. A covered swap entity must receive regulatory approval to use its internal model. Under the Prudential Regulators’ rules, only the relevant Prudential Regulator may approve the use of the model. Under the CFTC’s rules, approval can be provided by the CFTC or the National Futures Association.
Variation Margin: The two sets of rules are largely consistent regarding when variation margin is required, but the CFTC’s rules are more detailed as to how the amount of variation margin is to be calculated. The CFTC’s rules prescribe that CSEs rely “to the maximum extent practicable” on recently-executed transactions, valuations by independent parties, or other objective criteria in calculating variation margin. The Prudential Regulators’ rules do not contain these requirements.
Inter-Affiliate Swaps: There are several issues with respect to margin requirements for inter-affiliate swaps between a CSE and its affiliates:
1) The definition of “affiliate” in both sets of rules (the term used is “margin affiliate” in the CFTC’s rules) generally focuses on companies with consolidated financial statements. However, the Prudential Regulators added another definition of “affiliate” to include a company that a Prudential Regulator otherwise determines is an affiliate because it provides significant support to the other company, or is materially subject to the risks or losses of the other company.
2) The two sets of rules also differ in the collection and posting of margin for swaps with affiliates of a CSE. Generally, both sets of rules require variation margin to be collected from affiliates that are swap entities or financial end users. But, under the CFTC’s rules, a CSE generally does not have to collect initial margin from an affiliate provided that (i) the swap is subject to a centralized risk management program reasonably designed to monitor and manage the risks associated with inter-affiliate swaps and (ii) the CSE exchanges variation margin with the affiliate. (However, the CSE will have to collect initial margin from a non-US affiliate that is a financial end user if the affiliate is not subject to similar initial margin collection requirements on its own swaps with unaffiliated financial end users.)
By contrast, under the Prudential Regulators’ rules, covered swap entities are required to collect initial margin from affiliates that are other swap entities or financial end users. So, if a CSE subject to the CFTC’s rules enters into a swap with an affiliated covered swap entity that is subject to the Prudential Regulators’ rules, it will need to post (but not collect) initial margin with its affiliate.
3) When initial margin is required to be posted in connection with an inter-affiliate swap, under the CFTC’s rules, collateral collected by the CSE may be maintained with an affiliated entity. Under the Prudential Regulators’ rules, only non-cash collateral may be maintained with an affiliate.
4) Under both sets of rules, swaps entered into by a corporate Treasury affiliate as agent for its non-financial affiliates are exempt from margin requirements. The CFTC has stated that it intends, through a separate rulemaking, to permit the same result for Treasury affiliates when entering into swaps as principal; the Prudential Regulators have stated that this would exempt such swaps from margin requirements under their rules, too. However, the CFTC has not yet issued such a rulemaking.
Capital and cross-border transactions: The Prudential Regulators’ rules address capital requirements and the cross-border application of the margin regulations. The CFTC will address these matters in separate rulemakings.
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The CFTC staff consulted with the Prudential Regulators in developing its final rules. With the issuance of the CFTC’s final rules, this leaves only the SEC with the requirement to finalize similar regulations for covered security-based swap entities under its direct jurisdiction.