On October 22, 2015, U.S. prudential regulators published final and interim final margin rules governing swaps that are not centrally cleared (the “PR margin rule”) and on December 16, 2015, the Commodity Futures Trading Commission published its corresponding final margin rules (the “CFTC margin rule” and together with the PR margin rule, the “Margin Rule”). The Margin Rule requires financial end users to back their uncleared OTC derivatives transactions with cash or liquid securities.
Who is Affected?
Financial end users that may face these requirements include private equity, real estate, infrastructure, and microfinance fund vehicles, as well as banks and insurance companies, among others. These Financial end users could face substantial new requirements mainly as a result of the variation margin (“VM”) obligations. In contrast, banks are not required to impose margin requirements on nonfinancial end users which includes corporate end users of derivatives. In addition, funds hedging at the special purpose vehicle (“SPV”), asset or acquisition level likely will not be subject to the Margin Rule.
Financial end users that are subject to the Margin Rule will need to have appropriate policies and procedures in place to comply with this obligation. The challenges will include having to post and receive collateral as well as making the required changes to trading documentation. Additionally, financial end users should begin to consider whether and how the obligation may affect their hedging strategies. The Margin Rule is not retroactive to pre-existing transactions; however, certain life-cycle events may bring a pre-existing transaction within the scope of the Margin Rule. The Margin Rule provides entities with two options to document their trading relationships. First, entities may enter into new ISDA agreements and Credit Support Annexes to functionally separate the trades that are subject to the Margin Rules from their pre-existing trades. However, the rule also provides with the option to create separate portfolios within their pre-existing ISDA documentation for trades that would be subject to the Margin Rule and pre-existing trades that are not subject to the Margin Rule.
Most Impacted Entities will be subject to VM beginning on March 1, 2017 with the largest market participants being required to comply with the Margin Rule beginning on September 1, 2016. While many market participants may not be immediately subject to the Margin Rule, their dealer banks will require these market participants to make certain representations and amend trading documentation prior to the September 1, 2016 implementation date.
The impact of the margin rule varies depending on a market participant’s entity classification. The rule establishes four entity classifications: (1) covered swap entities (e.g., swap dealers, major swap participants), (2) financial entities with material swaps exposure, (3) financial entities without material swaps exposure, and (4) other counterparties (e.g., nonfinancial end users, sovereigns).
Inclusion in one of these categories determines whether initial or variation margin may apply. Broadly speaking, variation margin applies to the first three categories and initial margin to the first two.
The “financial end user” definition includes a broad list of entity types (see Appendix A). It is worth noting that this definition may be narrower than the “financial entity” definition used to determine whether an entity is subject to central clearing requirements. The “financial entity” definition included, among other things, a reference to section 4k of the Bank Holding Company Act of 1956 and captured entities whose revenue or assets were generated predominantly by financial activities, including, for example, certain leasing companies. The margin rule’s “financial end user” definition does not include these entities.
Moreover, the CFTC margin rule signaled its intent to codify No Action Relief Letters 13-22 and 14-144 and exclude eligible treasury affiliates acting as principal from the financial end user definition. Eligible treasury affiliates were not excluded from the PR margin rule; however, the preamble to PR margin rule suggests that the prudential regulators intend to incorporate this exclusion in a subsequent rulemaking. Finally, the interim final rule to the PR margin rule clarifies that nonfinancial end users and small banks with total assets of $10 billion and under eligible for the end-user clearing exception and certain finance affiliates of nonfinancial end users are not subject to the margin rule. The CFTC margin rule incorporates this exclusion as well.
For financial end users, the “material swaps exposure” definition applies to those with average daily aggregate gross notional amounts exceeding $8 billion. Transactions of both an entity and its affiliates1 are to be included in determining whether an entity exceeds this notional threshold. Additionally, this threshold is to include both swaps and FX forwards/swaps that were otherwise exempted from the definition of swap.
1 An entity is an affiliate of another entity if 1) either entity consolidates the other on a financial statement or 2) both companies are consolidated with a third company on a financial statement. The financial statement must be prepared in accordance with U.S. Generally Accepted Accounting Principles, the International Financial Reporting Standards or a similar standard.
Variation margin is collected to collateralize the mark-to-market value of a swap. VM requirements are 2-way – that is, VM must be both posted and collected, as dictated by the value of the swap. Nonfinancial end users are not required to post variation margin unless otherwise required by their swap dealer counterparties.
Financial end users – both those with and without material swaps exposure – are required to fully collateralize the mark-to-market value of their swaps on a daily basis beginning March 1, 2017.2 Under these rules, no variation margin is required for deliverable foreign exchange forwards and swaps, which are exempt from the definition of “swap” pursuant to the Secretary of Treasury’s determination under section 1a(47)(E) and 1(b) of the Commodity Exchange Act.
Financial end users are not permitted unsecured thresholds, but rather are required to have zero thresholds. They are, however, permitted minimum transfer amounts of $500,000.3 Financial end users are permitted to collect and post variation margin in the form of cash or other non-cash forms of collateral, and there are no third party segregation requirements for VM.
2 Financial end users that combined with their affiliates have an average daily aggregate notional amount of uncleared swaps and FX forwards/swaps that exceeds $3 trillion are required to begin posting and collecting variation margin on September 1, 2016.
3 Applies to initial and variation margin combined.
Initial margin is an amount collected above and beyond that necessary to collateralize the mark-to-market value of the swap. It is an additional buffer of collateral used to cover potential losses in a closeout scenario.4 IM only applies to financial end users with material swaps exposure and to covered swap entities.5 The application of IM requirements occurs according to a phase-in schedule, wherein the largest market participants begin exchanging IM on September 1, 2016, and others begin exchanging as late as September 1, 2020.
IM amounts are to be exchanged daily, but are subject to thresholds below which no IM is required to be exchanged. Specifically, an entity whose gross notional amounts exceed the above levels is only required to post IM if the IM calculation amount exceeds $50 million – an amount that must be allocated across all swap relationships with a swap counterparty and its affiliates. The initial margin calculation amount is based on the degree to which a swaps portfolio could change in value over a 10-day period.6 Eligible IM collateral includes cash and a range of liquid securities, which are subject to haircuts depending on the type of collateral. IM must be segregated and held by an independent third party custodian.
4 A close-out scenario is one in which a dealer requests collateral when due, the counterparty fails to post collateral and the dealer exhausts cure periods before closing out the swap. Initial margin is intended to cover an extreme change in market value that could occur during the time period between the most recent collateral posting and the swap termination.
5 i.e., swap dealers, major swap participants, security-based swap dealers, major security-based swap participants.
6 Based on a 99% confidence interval.
The margin rule does not apply to foreign transactions. Under the PR margin rule, foreign transactions are those in which counterparties and guarantors are not organized under US law or related to entities organized under US law. No cross-border guidance was included in the final CFTC margin rule because the CFTC intends to publish its cross-border guidance under a separate rule making. As of February 9, 2016, the CFTC has not published its final cross-border guidance supplementing the CFTC margin rule.
When one entity to a transaction (or its guarantor) is subject to US law, substituted compliance may be available. Substituted compliance would apply when US prudential regulators recognize a foreign regulatory regime’s margin requirements as comparable to those established by the US margin rule. A substituted compliance determination by US prudential regulators would permit an entity to satisfy US margin requirements by adhering to the margin requirements of an approved non-US regulatory regime.7
7 Cross border swaps negotiations between the US and Europe are reported to be contentious, raising timing and substantive questions about when these determinations will be made. Additionally, these determinations are considered on a rule-by-rule, country-by-country basis – a process that could take years to complete.
Aside from the direct impacts applied to particular parties (as described above), the margin requirements are also likely to have indirect impacts that could influence hedging decisions. In particular, because an end user’s hedging transactions with a swap dealer may cause the swap dealer to post initial margin to a third party, we expect that swap dealers will increase transaction pricing on swaps that are not centrally cleared. Regulators expect that these indirect costs will cause some market participants to consider margining or clearing their derivatives transactions, even if they are not required to do so. In practice, these pricing effects will not apply immediately, but rather are likely to apply as initial margin requirements phase-in over the next five years. How a market participant responds to these pricing changes will depend on a range of factors, including an entity’s cost of capital, access to liquidity, and transaction volumes.
The PR margin rule applies where the dealer counterparty is regulated by a prudential regulator. Where the dealer counterparty is not prudentially regulated, the CFTC margin rule applies. Financial end users should receive a representation from their dealer counterparties as to whether the dealer counterparty is subject to the PR margin rule or the CFTC margin rule. It is not always obvious whether a dealer counterparty is prudentially regulated (e.g., certain foreign banks may not be prudentially regulated in the US and certain subsidiaries of prudential regulated bank holding companies may not fall within the purview of the holding company’s prudential regulator).
Financial end users will need to enter into documentation with their dealer counterparties in order to comply with the margin rule. It is likely that this documentation will be standardized and effected via a protocol; however, it will take some time before relevant documentation is available to be completed. Additionally, all financial and non-financial end users will be required to provide representations to their dealer counterparties as to their classification under the PR margin rule, the CFTC margin rule as well as the EU margin rule and the Japanese margin rule.
Financial end users may have increased motivation to invest in systems that allow them to track collateral exchanges in accordance with the rules. Further, market participants will need to assess the potential liquidity impact of these requirements, and begin to prepare for this impact. Finally, these requirements will likely affect hedging strategies for many market participants, who are now in a better position to begin considering whether and how to alter their hedging strategies.
Definition of Financial End User
Because the requirements that apply to financial end users are substantial, it is important for all parties to understand the financial end user definition. Following is the relevant section of the final rule.
Financial end user means —
(1) Any counterparty that is not a swap entity and that is:
(i) A bank holding company or an affiliate thereof; a savings and loan holding company; a U.S. intermediate holding company established or designated for purpose of compliance with 12 CFR 252.153; or a nonbank financial institution supervised by the Board of Governors of the Federal Reserve System under Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5323);
(ii) A depository institution; a foreign bank; a Federal credit union or State credit union as defined in section 2 of the Federal Credit Union Act (12 U.S.C. 1752(1) & (6); an institution that functions solely in a trust or fiduciary capacity as described in section 2(c)(2)(D) of the Bank Holding Company Act (12 U.S.C. 1841(c)(2)(D)); an industrial loan company, an industrial bank, or other similar institution described in section 2(c)(2)(H) of the Bank Holding Company Act (12 U.S.C. 1841(c)(2)(H));
(iii) An entity that is state-licensed or registered as—
(A) A credit or lending entity, including a finance company; money lender; installment lender; consumer lender or lending company; mortgage lender, broker, or bank; motor vehicle title pledge lender; payday or deferred deposit lender; premium finance company; commercial finance or lending company; or commercial mortgage company; except entities registered or licensed solely on account of financing the entity’s direct sales of goods or services to customers;
(B) A money services business, including a check casher; money transmitter; currency dealer or exchange; or money order or traveler’s check issuer;
(iv) A regulated entity as defined in section 1303(20) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C. 4502(20)) and any entity for which the Federal Housing Finance Agency or its successor is the primary federal regulator;
(v) Any institution chartered and regulated by the Farm Credit Administration in accordance with the Farm Credit Act of 1971, as amended, 12 U.S.C. § 2001 et. seq.;
(vi) A securities holding company; a broker or dealer; an investment adviser as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)); an investment company registered with the SEC under the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.); or a company that has elected to be regulated as a business development company pursuant to section 54(a) of the Investment Company (15 U.S.C. 80a-53(a));
(vii) A private fund as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)); an entity that would be an investment company under section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3) but for section 3(c)(5)(C); or an entity that is deemed not to be an investment company under section 3 of the Investment Company Act of 1940 pursuant to Investment Company Act Rule 3a-7 (17 CFR 270.3a-7) of the U.S. Securities and Exchange Commission;
(viii) A commodity pool, a commodity pool operator, or a commodity trading advisor as defined, respectively, in section 1a(10), 1a(11), and 1a(12) of the Commodity Exchange Act (7 U.S.C. 1a(10), 1a(11), and 1a(12)); or a futures commission merchant;
(ix) An employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974 (29 U.S.C. 1002);
(x) An entity that is organized as an insurance company, primarily engaged in writing insurance or reinsuring risks underwritten by insurance companies, or is subject to supervision as such by a State insurance regulator or foreign insurance regulator;
(xi) An entity, person or arrangement that is, or holds itself out as being, an entity, person or arrangement that raises money from investors, accepts money from clients, or uses its own money primarily for the purpose of investing or trading or facilitating the investing or trading in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets10;
(xii) An entity that would be a financial end user described in paragraph (1) of this section, if it were organized under the laws of the United States or any State thereof; or
(xiii) Notwithstanding paragraph (2) below, any other entity that [Agency] has determined should be treated as a financial end user.
(2) The term “financial end user” does not include any counterparty that is:
(i) A sovereign entity;
(ii) A multilateral development bank;
(iii) The Bank for International Settlements;
(iv) An entity that is exempt from the definition of financial entity pursuant to section 2(h)(7)(C)(iii) of the Commodity Exchange Act (7 U.S.C. 2(h)(7)(C)(iii)) and implementing regulations; or
(v) An affiliate that qualifies for the exemption from clearing pursuant to section 2(h)(7)(D) of the Commodity Exchange Act (7 U.S.C. 2(h)(7)(D)) or section 3C(g)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 78c-3(g)(4)) and implementing regulations.
10 The entire paragraph, including the underlined text, of the Prong XI definition appears in the PR margin rule. The text that underlined does not appear in the Prong XI definition in the CFTC margin rule.