[Federal Register Volume 81, Number 3 (Wednesday, January 6, 2016)]
[Rules and Regulations]
[Pages 636-709]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-32320]
[[Page 635]]
Vol. 81
Wednesday,
No. 3
January 6, 2016
Part III
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Commodity Futures Trading Commission
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17 CFR Parts 23 and 140
Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap
Participants; Final Rule
Federal Register / Vol. 81 , No. 3 / Wednesday, January 6, 2016 /
Rules and Regulations
[[Page 636]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 23 and 140
RIN 3038-AC97
Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule and interim final rule.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is adopting regulations to implement a particular provision
of the Commodity Exchange Act (``CEA''), as added by the Dodd-Frank
Wall Street Reform and Consumer Protection Act (``Dodd-Frank Act'').
This provision requires the Commission to adopt initial and variation
margin requirements for certain swap dealers (``SDs'') and major swap
participants (``MSPs''). The final rules would establish initial and
variation margin requirements for SDs and MSPs but would not require
SDs and MSPs to collect margin from non-financial end users.
The Commission is also adopting and inviting comment on an interim
final rule that will exempt certain uncleared swaps with certain
counterparties from these margin requirements. This interim final rule
implements Title III of the Terrorism Risk Insurance Program
Reauthorization Act of 2015 (``TRIPRA''), which exempts from the margin
rules for uncleared swaps certain swaps for which a counterparty
qualifies for an exemption or exception from clearing under the Dodd-
Frank Act.
DATES: The rules will become effective April 1, 2016. Comments on the
interim final rule (Sec. 23.150(b)) must be received on or before
February 5, 2016.
ADDRESSES: You may submit comments on the interim final rule by any of
the following methods:
CFTC Web site: http://comments.cftc.gov. Follow the
instructions for submitting comments through the Comments Online
process on the Web site.
Mail: Send to Christopher Kirkpatrick, Secretary of the
Commission, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581.
Hand Delivery/Courier: Same as Mail, above.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Please submit your comments using only one of these methods.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the Commission to consider
information that may be exempt from disclosure under the Freedom of
Information Act, a petition for confidential treatment of the exempt
information may be submitted according to the procedures established in
Sec. 145.9 of the Commission's regulations.\1\
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\1\ 17 CFR 145.9. Commission regulations referred to herein are
found at 17 CFR Chapter I.
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The Commission reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse or remove any or all of your
submission from www.cftc.gov that it may deem to be inappropriate for
publication, such as obscene language. All submissions that have been
redacted or removed that contain comments on the merits of the
rulemaking will be retained in the public comment file and will be
considered as required under the Administrative Procedure Act and other
applicable laws, and may be accessible under the Freedom of Information
Act.
FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director,
Division of Clearing and Risk, 202-418-5480, [email protected]; Thomas
J. Smith, Deputy Director, Division of Swap Dealer and Intermediary
Oversight, 202-418-5495, [email protected]; Rafael Martinez, Senior
Financial Risk Analyst, Division of Swap Dealer and Intermediary
Oversight, 202-418-5462, [email protected]; Francis Kuo, Special
Counsel, Division of Swap Dealer and Intermediary Oversight, 202-418-
5695, [email protected]; Paul Schlichting, Assistant General Counsel,
Office of General Counsel, 202-418-5884, [email protected]; Stephen
A. Kane, Research Economist, Office of the Chief Economist, 202-418-
5911, [email protected]; or Lihong McPhail, Research Economist, Office of
the Chief Economist, 202-418-5722, [email protected]; Commodity Futures
Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,
Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
A. Statutory Authority
B. International Standards
C. Proposed Rules
D. Subsequent Amendment to Dodd-Frank
II. Final Rules
A. Overview
B. Products
C. Participants
D. Nature and Timing of Margin Requirements
E. Calculation of Initial Margin
F. Calculation of Variation Margin
G. Forms of Margin
H. Custodial Arrangements
I. Inter-Affiliate Trades
J. Implementation Schedule
III. Interim Final Rule
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
V. Cost Benefit Considerations
Appendix A to the Preamble
Appendix B to the Preamble
I. Background
A. Statutory Authority
On July 21, 2010, President Obama signed the Dodd-Frank Act.\2\
Title VII of the Dodd-Frank Act amended the CEA \3\ to establish a
comprehensive regulatory framework designed to reduce risk, to increase
transparency, and to promote market integrity within the financial
system by, among other things: (1) Providing for the registration and
regulation of SDs and MSPs; (2) imposing clearing and trade execution
requirements on standardized derivative products; (3) creating
recordkeeping and real-time reporting regimes; and (4) enhancing the
Commission's rulemaking and enforcement authorities with respect to all
registered entities and intermediaries subject to the Commission's
oversight.
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\2\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. L. 111-203, 124 Stat. 1376 (2010).
\3\ 7 U.S.C. 1 et seq.
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Section 731 of the Dodd-Frank Act added a new section 4s to the CEA
setting forth various requirements for SDs and MSPs. Section 4s(e)
mandates the adoption of rules establishing margin requirements for
uncleared swaps of SDs and MSPs.\4\ Each SD and MSP for which there is
a Prudential Regulator, as defined below, must meet margin requirements
for their uncleared swaps established by the applicable Prudential
Regulator, and each SD and MSP for which there is no Prudential
Regulator must comply with the Commission's regulations governing
margin.
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\4\ Section 4s(e) also directs the Commission to adopt capital
requirements for SDs and MSPs. The Commission proposed capital rules
in 2011. Capital Requirements for Swap Dealers and Major Swap
Participants, 76 FR 27802 (May 12, 2011). The Commission will
address capital requirements in a separate release.
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The term Prudential Regulator is defined in section 1a(39) of the
CEA, as amended by Section 721 of the Dodd-
[[Page 637]]
Frank Act. This definition includes the Federal Reserve Board
(``FRB''); the Office of the Comptroller of the Currency (``OCC''); the
Federal Deposit Insurance Corporation (``FDIC''); the Farm Credit
Administration; and the Federal Housing Finance Agency.
The definition specifies the entities for which these agencies act
as Prudential Regulators. These consist generally of federally insured
deposit institutions, farm credit banks, federal home loan banks, the
Federal Home Loan Mortgage Corporation, and the Federal National
Mortgage Association. The FRB is the Prudential Regulator under section
4s not only for certain banks, but also for bank holding companies,
certain foreign banks treated as bank holding companies, and certain
subsidiaries of these bank holding companies and foreign banks.
The FRB is not, however, the Prudential Regulator for nonbank
subsidiaries of bank holding companies, some of which are required to
be registered with the Commission as SDs or MSPs. Therefore, the
Commission is required to establish margin requirements for uncleared
swaps for all registered SDs and MSPs that are not subject to a
Prudential Regulator. These include, among others, nonbank subsidiaries
of bank holding companies, as well as certain foreign SDs and MSPs.
Specifically, section 4s(e)(1)(B) of the CEA provides that each
registered SD and MSP for which there is not a Prudential Regulator
shall meet such minimum capital requirements and minimum initial margin
and variation margin requirements as the Commission shall by rule or
regulation prescribe.
Section 4s(e)(2)(B) provides that the Commission shall adopt rules
for SDs and MSPs, with respect to their activities as an SD or an MSP,
for which there is not a Prudential Regulator imposing (i) capital
requirements and (ii) both initial and variation margin requirements on
all swaps that are not cleared by a registered derivatives clearing
organization (``DCO'').
Section 4s(e)(3)(A) provides that to offset the greater risk to the
SD or MSP and the financial system arising from the use of swaps that
are not cleared, the requirements imposed under section 4s(e)(2) shall
(i) help ensure the safety and soundness of the SD or MSP and (ii) be
appropriate for the risk associated with the uncleared swaps.
Section 4s(e)(3)(C) provides, in pertinent part, that in
prescribing margin requirements the Prudential Regulator and the
Commission shall permit the use of noncash collateral the Prudential
Regulator or the Commission determines to be consistent with (i)
preserving the financial integrity of markets trading swaps and (ii)
preserving the stability of the United States financial system.
Section 4s(e)(3)(D)(i) provides that the Prudential Regulators, the
Commission, and the Securities and Exchange Commission (``SEC'') shall
periodically (but not less frequently than annually) consult on minimum
capital requirements and minimum initial and variation margin
requirements.
Section 4s(e)(3)(D)(ii) provides that the Prudential Regulators,
Commission and SEC shall, to the maximum extent practicable, establish
and maintain comparable minimum capital and minimum initial and
variation margin requirements, including the use of noncash collateral,
for SDs and MSPs.
B. International Standards
In October 2011, the Basel Committee on Banking Supervision
(``BCBS'') and the International Organization of Securities Commissions
(``IOSCO''), in consultation with the Committee on Payment and
Settlement Systems (``CPSS'') and the Committee on Global Financial
Systems (``CGFS''), formed a working group to develop international
standards for margin requirements for uncleared swaps. Representatives
of more than 20 regulatory authorities participated. From the United
States, the CFTC, the FDIC, the FRB, the OCC, the Federal Reserve Bank
of New York, and the SEC were represented.
In July 2012, the working group published a proposal for public
comment.\5\ In addition, the group conducted a Quantitative Impact
Study (``QIS'') to assess the potential liquidity and other
quantitative impacts associated with margin requirements.\6\
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\5\ BCBS/IOSCO, Consultative Document, Margin requirements for
non-centrally cleared derivatives (July 2012).
\6\ BCBS/IOSCO, Quantitative Impact Study, Margin requirements
for non-centrally cleared derivatives (November 2012).
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After consideration of the comments on the proposal and the results
of the QIS, the group published a near-final proposal in February 2013
and requested comment on several specific issues.\7\ The group
considered the additional comments in finalizing the recommendations
set out in the report.
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\7\ BCBS/IOSCO, Consultative Document, Margin requirements for
non-centrally cleared derivatives (February 2013).
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The final report was issued in September 2013.\8\ This report (the
``2013 international framework'') articulates eight key principles for
non-cleared derivatives margin rules, which are described below. These
principles represent the minimum standards approved by BCBS and IOSCO
and their recommendations to the regulatory authorities in member
jurisdictions of these organizations.
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\8\ BCBS/IOSCO, Margin requirements for non-centrally cleared
derivatives (September 2013) (``BCBS/IOSCO Report'').
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C. Proposed Rules
The Commission initially proposed margin requirements for SDs and
MSPs in 2011. In response to the 2013 international framework, the
Commission re-proposed margin requirements in September 2014.\9\
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\9\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants, 79 FR 59898 (Oct. 3, 2014).
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In developing the proposed rules, the Commission staff worked
closely with the staff of the Prudential Regulators.\10\ In most
respects, the proposed rules would establish a framework for margin
requirements similar to the Prudential Regulators' proposal. The
proposed rules were consistent with the 2013 international framework.
In some instances, as contemplated in the framework, the proposed rules
provided more detail than the framework. In a few other instances, the
proposed rules were stricter than the framework.
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\10\ As required by section 4s of the CEA, the Commission staff
also has consulted with the SEC staff.
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D. Subsequent Amendment to Dodd-Frank
On January 12, 2015, the President signed Title III of TRIPRA.
Title III amends sections 731 and 764 of the Dodd-Frank Act to exempt
certain transactions of certain commercial end users and others from
the Commission's capital and margin requirements.\11\ Specifically,
section 302 of Title III amends sections 731 and 764 of the Dodd-Frank
Act to provide that the Commission's rules on margin requirements under
those sections shall not apply to a swap in which a counterparty: (1)
Qualifies for an exception under section 2(h)(7)(A) of the Commodity
Exchange Act; (2) qualifies for an exemption issued under section
4(c)(1) of the Commodity Exchange Act for cooperative entities as
defined in such exemption, or (3) satisfies the criteria in section
2(h)(7)(D) of the Commodity Exchange Act.
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\11\ Pub. L. 114-1, 129 Stat. 3.
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Section 303 of TRIPRA requires that the Commission implement the
provisions of Title III, ``Business Risk Mitigation and Price
Stabilization Act of 2015,'' by promulgating an interim final rule, and
seeking public comment on the interim final rule. The Commission is
adopting Sec. 23.150(b) as part of this final rule. These exemptions
are
[[Page 638]]
transaction-based, as opposed to counterparty-based. The Commission
will be requesting comment, as required by TRIPRA. If necessary, the
Commission will amend Sec. 23.150(b) after receiving comments on the
interim final rule.
II. Final Rules
A. Overview
The discussion below addresses: (i) The products covered by the
proposed rules; (ii) the market participants covered by the proposed
rules; (iii); the nature and timing of the margin obligations; (iv) the
methods of calculating initial margin; (v) the methods of calculating
variation margin; (vi) permissible forms of margin; (vii) custodial
arrangements; (viii) documentation requirements; (ix) the treatment of
inter-affiliate swaps; \12\ and (x) the implementation schedule. The
Commission received 59 written comments on the proposal.\13\ They are
discussed in the applicable sections.
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\12\ Where appropriate, the preamble uses the term affiliate to
mean a margin affiliate and the term subsidiary to mean margin
subsidiary, as they are defined in Sec. 23.151.
\13\ The written submissions from the public are available in
the comment file on www.cftc.gov. They include, but are not limited
to those listed in Appendix B. In citing these comments, the
Commission used the abbreviations set forth in the Appendix B.
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The rules adopted herein essentially provide for the same treatment
as the rules recently adopted by the Prudential Regulators \14\ with a
few exceptions. The areas where there are differences are (i) the anti-
evasion provision in the definition of margin affiliate, (ii) the model
approval process, (iii) the calculation of variation margin and related
documentation requirements, and the (iv) treatment of inter-affiliate
trades. Each of these differences is discussed in the applicable
section below.
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\14\ Margin and Capital Requirements for Covered Swap Entities,
80 FR 74840 (Nov. 30, 2015).
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The Prudential Regulators also issued a provision addressing cross-
border application of their margin rule. The Commission will address
this aspect of the rule in a separate rulemaking.\15\
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\15\ Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants, 80 FR 41376 (July 14, 2015).
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B. Products
1. Proposal
As noted above, section 4s(e)(2)(B)(ii) of the CEA directs the
Commission to establish both initial and variation margin requirements
for certain SDs and MSPs ``on all swaps that are not cleared.'' As a
result, the Commission's proposal covered swaps that are uncleared
swaps \16\ and that are executed after the applicable compliance
date.\17\
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\16\ The term uncleared swap is defined in proposed Regulation
23.151.
\17\ A schedule of compliance dates is set forth in proposed
Regulation 23.160.
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The term ``cleared swap'' is defined in section 1a(7) of the CEA to
include any swap that is cleared by a DCO registered with the
Commission. The Commission notes, however, that SDs and MSPs also clear
swaps through foreign clearing organizations that are not registered
with the Commission. The Commission believes that a clearing
organization that is not a registered DCO must meet certain basic
standards in order to avoid creating a mechanism for evasion of the
uncleared margin requirements. Accordingly, the Commission proposed to
include in the definition of cleared swaps certain swaps that have been
accepted for clearing by an entity that has received a no action letter
or other exemptive relief from the Commission to clear such swaps for
U.S. persons without being registered as a DCO.
As a result of the determination by the Secretary of the Treasury
to exempt foreign exchange swaps and foreign exchange forwards from the
definition of swap,\18\ under the proposal the following transactions
would not be subject to the requirements: (i) Foreign exchange swaps;
(ii) foreign exchange forwards; and (iii) the fixed, physically settled
foreign exchange transactions associated with the exchange of principal
in cross-currency swaps.
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\18\ Determination of Foreign Exchange Swaps and Foreign
Exchange Forwards Under the Commodity Exchange Act, 77 FR 69694
(Nov. 20, 2012).
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In a cross-currency swap, the parties exchange principal and
interest rate payments in one currency for principal and interest rate
payments in another currency. The exchange of principal occurs upon the
inception of the swap, with a reversal of the exchange of principal at
a later date that is agreed upon at the inception of the swap. The
foreign exchange transactions associated with the fixed exchange of
principal in a cross-currency swap are closely related to the exchange
of principal that occurs in the context of a foreign exchange forward
or swap. Accordingly, the Commission proposed to treat that portion of
a cross-currency swap that is a fixed exchange of principal in a manner
that is consistent with the treatment of foreign exchange forwards and
swaps. This treatment of cross-currency swaps was limited to cross-
currency swaps and did not extend to any other swaps such as non-
deliverable currency forwards.
2. Comments
The Commission received several comments involving products.
Commenters expressed support for the Commission's decision to exempt
foreign exchange forwards and swaps \19\ and swaps cleared by an exempt
derivatives clearing organization from margin requirements.\20\ One
commenter asked for clarification that commodity trade options are not
subject to the margin requirements.\21\
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\19\ See GFXD (initial margin should not apply to physically-
settled foreign exchange swaps and forwards and variation margin
should be applied via supervisory guidance or national regulation)
and CPFM.
\20\ See ISDA and Sifma (any swap cleared by a derivatives
clearing organization whether registered or not should be exempt
from margin requirements).
\21\ See BP. To the extent that any financial instrument is an
uncleared swap, it will be covered under the final rule.
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3. Discussion
The Commission is adopting this aspect of the final regulations
substantially as proposed. The Commission is modifying the definition
of uncleared swap to eliminate the reference to no-action letters and
to require that any exemptive relief be provided by Commission order.
Under sections 4s(e), the Commission is directed to impose initial
and variation margin requirements on all swaps that are not cleared by
a registered derivatives clearing organization. The Commission is
interpreting this statutory language to mean all swaps that are not
cleared by a registered derivatives clearing organization or a
derivatives clearing organization that the Commission has exempted from
registration as provided under the CEA.
In particular, the CEA prohibits persons from engaging in a swap
that is required to be cleared unless they submit such swaps for
clearing to a derivatives clearing organization that is either
registered with the Commission as a derivatives clearing organization
or exempt from registration. Section 5b(h) of the CEA allows the
Commission to exempt, conditionally or unconditionally, a DCO from
registration for the clearing of swaps, where the DCO is subject to
``comparable, comprehensive supervision and regulation'' by the
appropriate government authorities in its home country. The Commission
has granted, by order, relief from registration to derivatives clearing
organizations pursuant to section 5b(h) \22\ and is considering whether
to
[[Page 639]]
grant relief to other derivatives clearing organizations before the
implementation date of these rules. Accordingly, the Commission is
excluding from the definition of uncleared swap, those swaps that are
cleared by a derivatives clearing organization that is either
registered with or has received an exemption by order or rule from
registration.
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\22\ See In the Matter of the Petition of ASX Clear (Futures)
Pty Limited for Exemption from Registration as a Derivatives
Clearing Organization (Aug. 18, 2015); In the Matter of the Petition
of Japan Securities Clearing Corporation (JSCC) for Exemption from
Registration as a Derivatives Clearing Organization (Oct 26, 2015);
In the Matter of the Petition of Korea Exchange, Inc (KRX) for
Exemption from Registration as a Derivatives Clearing Organization
(Oct. 26, 2015).
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C. Participants
1. Proposal
Section 4s(e)(3)(A)(2) states that the margin requirements must be
``appropriate to the risks associated with'' the swaps. Because
different types of counterparties can pose different levels of risk,
the proposed rules established three categories of counterparty: (i)
SDs and MSPs, (ii) financial end users,\23\ and (iii) non-financial end
users.\24\ The nature of an SD/MSP's obligations under the rules
differed depending on the nature of the counterparty.
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\23\ This term is defined in Regulation 23.151.
\24\ This term is defined in Regulation 23.151 to include
entities that are not SDs, MSPs, or financial entities.
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2. Comments
Commenters generally urged the Commission to exclude certain
entities from the definition of ``financial end user.'' For example,
commenters urged the Commission to exclude foreign funds \25\ and
employee benefit plans such as pension plans,\26\ structured finance
special purpose vehicles,\27\ certain captive finance units,\28\
entities guaranteed by a foreign sovereign,\29\ small financial
institutions (such as small banks) that qualify for an exemption from
clearing,\30\ certain financial cooperatives,\31\ covered bond
issuers,\32\ and multilateral banks (e.g., International Monetary Fund
and World Bank Group).\33\ Commenters also urged the Commission to
exclude from margin requirements certain other entities that are exempt
from clearing.\34\ One commenter also supported the exclusion of
certain payment card networks and payment solution providers from the
definition of a ``financial end user.'' \35\
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\25\ See ISDA (contending that it will be difficult for a non-
U.S. entity to determine which Investment Company Act exemption
would apply if it were organized in the U.S.).
\26\ See ABA (pension plans should not be subject to margin and
should be treated as non-financial end users); AIMA (benefit plans
should not be subject to margin and there is ambiguity involving
whether non-U.S. public and private employee benefit plans would be
financial end users); JBA (securities investment funds should be
exempt from variation margin).
\27\ See ISDA (structured finance vehicles should be excluded
because they do not pose systemic risk, have credit support
arrangements to protect counterparties, and lack ready access to
liquid collateral for initial and variation margin), JBA (securities
investment funds and securitization vehicles are not set up to
exchange variation margin and should be treated as non-financial end
users), JFMC, Sifma-AMG, SFIG, and Sifma. See also FSR (the
Commission should explore conditions to minimize risk rather than
impose variation margin). See SFIG and Sifma (requesting the
Commission to exclude structured finance vehicles from the payment
of variation margin).
\28\ See CDEU (wholly owned centralized treasury units of non-
financial end users that execute swaps on behalf of those non-
financial end users should not be treated as financial end users for
margin purposes).
\29\ See KfW and ICO (entities backed by the full faith and
credit and irrevocable guarantee of a sovereign nation should be
either within the definition of a sovereign entity or excluded from
the definition of a financial end user and hence not subject to
margin requirements). See also FMS-WM (legacy portfolio entity
backed by the full faith and credit of a sovereign government should
be included in the definition of a sovereign).
\30\ See ABA (small banks that qualify for the clearing
exemption should be excluded from margin requirements as subjecting
them to margin requirements would incentivize them to clear their
trades while imposing monitoring costs on them to ensure that they
do not have material swaps exposure).
\31\ See CFC.
\32\ See ISDA (arguing that the EU proposal has special criteria
for covered bond issuers and that covered bond issuers should be
able to use collateral arrangements other than the requirements in
the Commission's proposal).
\33\ See Sifma (the Commission should align the definition of
multilateral banks in the margin regulations to the definition in
the clearing exemption and specify that the United Nations and
International Monetary Fund are included among multilateral banks)
and MFX (MFX contends that it, as a fund, should be considered a
multilateral development bank because the U.S. government is a
shareholder through the Overseas Private Investment Corporation's
involvement in the fund, the fund poses a similar risk profile as
that of a multilateral development bank, and the fund engages in the
same types of activities as a multilateral development bank).
\34\ See W&C (initial and variation margin should not apply to
an eligible treasury affiliate as defined in Commission No-Action
Letter No. 13-22); ABA; CFC (entities that are exempt from clearing
such as exempt cooperatives should be exempt from margin
requirements); and CDEU (special purpose vehicles that are
subsidiaries of captive finance companies that are exempt from
clearing should be exempt from margin). But see AFR (cautioning
against the scope of the exemption provided to non-financial end
users in the proposal and urging the Commission to separate the
clearing and margin exemptions).
\35\ See MasterCard.
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Commenters pointed out that the exclusion from financial end user
for a person that qualifies for the affiliate exemption from clearing
pursuant to section 2(h)(7)(D) of the Commodity Exchange Act requires
an entity to be acting as agent for an affiliate and thus would not
capture equivalent entities that act as principal for an affiliate.\36\
These commenters contended that many such entities act as principal for
an affiliate and that the Commission has issued a no-action letter
effectively exempting such entities from clearing.\37\
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\36\ See CEWG; Sifma; W&C.
\37\ See CFTC No-Action Letter No. 13-22 (June 4, 2013).
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With respect to employee benefit plans, commenters generally argued
that these plans should not be subject to margin requirements because
they are highly regulated, highly creditworthy, have low leverage and
are prudently managed counterparties whose swaps are used primarily for
hedging and, as such, pose little risk to their counterparties or the
broader financial system. One commenter urged the Commission to exclude
both U.S. and non-U.S. public and private employee benefit plans where
swaps are hedging risk. This commenter also contended that there may be
ambiguity whether certain pension plans are financial end users if they
are not subject to the Employee Retirement Income and Security Act of
1974 (``ERISA'') (29 U.S.C. 1002). Another commenter argued that
current market practice is not to require initial margin for pension
plans.
A number of commenters also requested that the Commission exclude
from financial end user structured finance vehicles including
securitization special purpose vehicles (``SPVs'') and covered bond
issuers. These commenters argued that imposing margin requirements on
structured finance vehicles would restrict their ability to hedge
interest rate and currency risk and potentially force these vehicles to
exit swap markets since these vehicles generally do not have ready
access to liquid collateral. These commenters contended that it is
impossible for the vast majority of these entities to exchange margin,
including variation margin, and that subjecting them to margin
requirements would severely restrict the ability of securitization
vehicles to hedge interest rate risk and currency risk.
Moreover, commenters argued that covered swap entities, as defined
below, that enter a swap may be protected by other means--e.g., a
security interest granted in the assets of a securitization SPV.
Commenters also noted that these types of entities make payments on a
monthly payment cycle using collections received on the underlying
assets during the previous month and would not be able to make daily
margin calls. These commenters argued that
[[Page 640]]
significant structural changes would be necessary for securitization
vehicles to post and collect variation margin.
These commenters urged the Commission to follow the approach of the
proposed European rules under which securitization vehicles would be
defined as non-financial entities and would not be required to exchange
initial or variation margin. Certain of these commenters also expressed
concerns about consistency with the treatment under the EU proposal.
One commenter stated that the EU proposal has special criteria for
covered bond issuers and that covered bond issuers should be able to
use collateral arrangements other than the requirements in the
Commission's proposal. Commenters similarly urged the Commission to
follow the EU margin proposal which provided a special set of criteria
for covered bond issuers and requested that the Commission develop
rules that would permit covered bond issuers to use other forms of
collateral arrangements. One commenter, however, argued that requiring
SPVs and other asset-backed security issuers to post full margin
against all swap contracts would defuse commonly used ``flip clauses''
and decrease the loss exposure of investors in asset-backed
securities.\38\
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\38\ See William J. Harrington.
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A few commenters urged the Commission to remove a provision in the
proposal allowing the Commission to designate entities as financial end
users due to concerns that it would allow the Commission to re-
categorize nonfinancial entities as financial end users.\39\ These
commenters argued that in order for an entity to be treated as a
financial end user, the Commission would have to provide adequate
notice and propose an amendment to the rule to address such
concerns.\40\
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\39\ See CDEU; Joint Associations; IECA.
\40\ See CDEU.
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Commenters also pointed out miscellaneous concerns with the
proposal. They have asked for clarification with respect to the process
for determining whether an entity is a financial end user,\41\
suggested that the change in status of a counterparty over the life of
a swap should not affect the classification of the counterparty,\42\
and urged the Commission to align its definition of ``financial end
user'' with the definition put forth by the Prudential Regulators
regarding business development companies.\43\ With respect to foreign
counterparties, a few commenters argued that the test in the proposal
concerning whether a foreign counterparty would be a financial end user
if it were organized under the laws of the U.S. or any State is
difficult to apply because it would require a covered swap entity to
analyze a foreign counterparty's business activities in light of a
broad array of U.S. regulatory requirements.\44\ Finally, a commenter
commended the Commission on its definition of financial end user.\45\
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\41\ See CDEU.
\42\ See ISDA and Sifma.
\43\ See JBA.
\44\ See ISDA (contending that it will be difficult for a non-
U.S. entity to determine which Investment Company Act exemption
would apply if it were organized in the U.S.); see also AIMA
(arguing that there is ambiguity regarding whether non-U.S. public
and private pension plans would be treated as financial end users).
\45\ See MasterCard (the definition in the margin regulations is
commendable because it is narrower than the definition in Commission
Regulation 50.50. Entities that engage in financial activities
within the meaning of Section 4(k) of the Bank Holding Company Act
that are not a financial end user should be allowed to rely on the
end user exception).
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3. Discussion
a. Covered Swap Entities
As noted above, section 4s(e)(2)(B) of the CEA directs the
Commission to impose margin requirements on SDs and MSPs for which
there is no Prudential Regulator. These entities are defined in
proposed Sec. 23.151 as ``covered swap entities'' or ``CSEs.'' The
final rule adopts the definition as set forth in the proposal. The
final rule also includes special provisions for inter-affiliate swaps
between a CSE and its affiliates. The following sections provide a
discussion of other significant market participants and applicable
standards set forth in the final rule.
b. Financial End Users
(i) Definition
In order to provide certainty and clarity to counterparties as to
whether they would be financial end users for purposes of this final
rule, the financial end user definition provides a list of entities
that would be financial end users as well as a list of entities
excluded from the definition. In the final rule, as under the proposed
rule, the Commission is relying, to the greatest extent possible, on
the counterparty's legal status as a regulated financial entity. The
definition lists numerous entities whose business is financial in
nature.
In developing the definition, the Commission sought to provide
clarity to CSEs and their counterparties about whether particular
counterparties would be financial end users and subject to the margin
requirements of the final rule. The definition is an attempt to capture
all financial counterparties without being overly broad and capturing
commercial firms and sovereigns.
The Commission believes that this approach is consistent with the
risk-based approach of the final rule, as financial firms generally
present a higher level of risk than other types of counterparties
because their profitability and viability are more tightly linked to
the health of the financial system than other types of counterparties.
Because financial counterparties are more likely to default during a
period of financial stress, they pose greater systemic risk and risk to
the safety and soundness of the CSE.
In developing the list of financial entities, the Commission sought
to include entities that engage in financial activities that give rise
to Federal or State registration or chartering requirements, such as
deposit taking and lending, securities and swaps dealing, or investment
advisory activities.
The Commission notes that an entity or person would be classified
as a financial end user based on the nature of the activities of that
entity or person regardless of the source of the funds used to finance
such activities. For example, an entity or person would be a financial
entity if it raises money from investors, uses its own funds, or
accepts money from clients or customers to predominately engage in
investing, dealing, or trading in loans, securities, or swaps.
The list also includes asset management and securitization
entities. For example, certain investment funds as well as
securitization vehicles are covered, to the extent those entities would
qualify as private funds defined in section 202(a) of the Investment
Advisers Act of 1940, as amended (the ``Advisers Act''). In addition,
certain real estate investment companies would be included as financial
end users as entities that would be investment companies under section
3 of the Investment Company Act of 1940, as amended (the ``Investment
Company Act''), but for section 3(c)(5)(C), and certain other
securitization vehicles would be included as entities deemed not to be
investment companies pursuant to Rule 3a-7 of the Investment Company
Act.
Because Federal law largely looks to the States for the regulation
of the business of insurance, the definition of financial end user in
the final rule broadly includes entities organized as insurance
companies or supervised as such by a State insurance regulator. This
element of the final rule's definition
[[Page 641]]
would extend to reinsurance and monoline insurance firms, as well as
insurance firms supervised by a foreign insurance regulator.
The Commission intends to cover, as financial end users, a broad
variety and number of nonbank lending and retail payment firms that
operate in the market. To this end, the Commission has included State-
licensed or registered credit or lending entities and money services
businesses under the final rule's provision incorporating an inclusive
list of the types of firms subject to State law. However, the
Commission recognizes that the licensing of nonbank lenders in some
states extends to commercial firms that provide credit to the firm's
customers in the ordinary course of business. Accordingly, the
Commission is excluding an entity registered or licensed solely on
account of financing the entity's direct sales of goods or services to
customers.
Under the final rule, those cooperatives that are financial
institutions,\46\ such as credit unions, Farm Credit System banks and
associations,\47\ and other financial cooperatives \48\ are financial
end users because their sole business is lending and providing other
financial services to their members, including engaging in swaps in
connection with such loans.\49\ The treatment of the uncleared swaps of
these financial cooperatives may differ under the final rule due to
TRIPRA, which became law after the proposal was issued. More
specifically, almost all swaps of the cooperatives that are financial
end users qualify for an exemption from clearing if certain conditions
are met,\50\ and therefore, these uncleared swaps also would qualify
for an exemption from margin requirements under Sec. 23.150(b) of the
final rule. Uncleared swaps of financial cooperatives that do not
qualify for an exemption would be treated as uncleared swaps of
financial end users under the final rule.
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\46\ The Commission expects that state-chartered financial
cooperatives that provide financial services to their members, such
as lending to their members and entering into swaps in connection
with those loans, would be treated as financial end users, pursuant
to this aspect of the final rule's coverage of credit or lending
entities. However, these cooperatives could elect an exemption from
clearing under Regulation 50.51, 17 CFR 50.51, and as a result,
their uncleared swaps would also be exempt from the margin
requirements of the final rule pursuant to Regulation 23.150(b).
\47\ The preamble more fully discusses the status of Farm Credit
System institutions as financial end users and their exemptions from
clearing and the margin requirements.
\48\ The National Rural Utility Cooperative Finance Cooperation
(``CFC'') is an example of another financial cooperative. The CFC's
comment letter requested that the Commission exempt swaps entered
into by nonprofit cooperatives from the margin requirement to the
extent they that are already exempt from clearing requirements.
Regulation 23.150(b) of the final rule responds to the CFC's
concerns.
\49\ Most cooperatives are producer, consumer, or supply
cooperatives and, therefore, they are not financial end users.
However, many of these cooperatives have financing subsidiaries and
affiliates. These financing subsidiaries and affiliates would not be
financial end users under this final rule if they qualify for an
exemption under sections 2(h)(7)(C)(iii) or 2(h)(7)(D) of the CEA.
Moreover, certain swaps of these entities may be exempt pursuant to
TRIRA and Regulation 23.150(b) of the final rule.
\50\ Section 2(h)(7)(C)(ii) of the CEA authorizes the Commission
to exempt small depository institutions, small Farm Credit System
institutions, and small credit unions with total assets of $10
billion or less from the mandatory clearing requirements for swaps.
See 7 U.S.C. 2(h)(7) and 15 U.S.C. 78c-3(g). Additionally, the
Commission, pursuant to its authority under section 4(c)(1) of the
CEA, enacted 17 CFR part 50, subpart C, Sec. 50.51, which allows
cooperative financial entities, including those with total assets in
excess of $10 billion, to elect an exemption from mandatory clearing
of swaps that: (1) They enter into in connection with originating
loans for their members; or (2) hedge or mitigate commercial risk
related to loans or swaps with their members.
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The final rule's definition of ``financial end user'' is largely
similar to the proposed definition, with a few modifications. In the
final rule, the Commission added as a financial end user a U.S.
intermediate holding company (``IHC'') established or designated for
purposes of compliance with the Board's Regulation YY (12 CFR 252.153).
Pursuant to Regulation YY, a foreign banking organization with U.S.
non-branch assets of $50 billion or more must establish a U.S. IHC and
transfer its ownership interest in the majority of its U.S.
subsidiaries to the IHC by July 1, 2016. As not all IHCs will be bank
holding companies, the Commission is explicitly identifying IHCs in the
list of financial end users to clarify that they are included. To the
extent an IHC that is not itself registered as a swap entity enters
into uncleared swaps with a CSE, the IHC would be treated as a
financial end user like other types of holding companies that are not
swap entities (e.g., bank holding companies and saving and loan holding
companies).
In response to the commenters request to align its definition of
financial end user with the Prudential Regulators' definition, the
Commission also added business development companies in subparagraph
(vi) of the definition of financial end user.
The Commission also has added three entities registered with the
Commission to the enumerated list of financial end users: floor
brokers, floor traders, and introducing brokers. As defined in section
1a(22) of the CEA, a floor broker generally provides brokering services
on an exchange to clients in purchasing or selling any future,
securities future, swap, or commodity option. As defined in section
1a(23) of the CEA, a floor trader generally purchases or sells on an
exchange solely for that person's account, any future, securities
future, swap, or commodity option. As defined in section 1a(31) of the
CEA, an introducing broker generally means any person who engages in
soliciting or in accepting orders for the purchase and sale of any
future, security future, commodity option, or swap. In addition, it
also includes anyone that is registered with the Commission as an
introducing broker.
In deciding to add these entities to the definition of financial
end user, the Commission determined that these entities' services and
activities are financial in nature and that these entities provide
services, engage in activities, or have sources of income that are
similar to financial entities already included in the definition. In
this vein, the Commission is also adding to the list of financial end
user security-based swap dealers and major security-based swap
participants. The Commission believes that by including these financial
entities in the definition of financial end user, the definition
provides additional clarity to CSEs when engaging in uncleared swaps
with these entities. As noted above, financial entities are considered
more systemic than non-financial entities and as such, the Commission
believes that these entities, whose activities, services, and sources
of income are financial in nature, should be included in the definition
of financial end user. The Commission notes, however, that if a
commercial end user falls within the definition of financial end user
under this rule because of, for example, its registration as a floor
broker or otherwise, so long as its swaps qualify for an exemption
under TRIPRA, those swaps will not be subject to the margin
requirements of these rules.
In the proposal, the Commission included in the definition of a
financial end user ``An entity that is, or holds itself out as being,
an entity or arrangement that raises money from investors primarily for
the purpose of investing in loans, securities, swaps, funds or other
assets for resale or other disposition or otherwise trading in loans,
securities, swaps, funds or other assets.'' In addition to asking
whether the definition was too broad or narrow, as noted above, the
Commission asked questions as to whether this prong of the definition
was broad enough to capture other types of pooled investment
[[Page 642]]
vehicles that should be treated as financial end users.
After reviewing all comments, the Commission is broadening section
(xi) of the definition of a ``financial end user'' to include other
types of entities and persons that primarily engage in trading,
investing, or in facilitating the trading or investing in loans,
securities, swaps, funds, or other assets. In broadening the
definition, the Commission believes that the enumerated list in the
proposal of financial end users was under-inclusive, not covering
certain entities that provide or engage in services and activities that
are financial in nature. Specifically, the Commission is concerned that
the proposed definition did not cover certain financial entities that
are not organized as pooled investment vehicles and that trade or
invest their own or client funds (e.g., high frequency trading firms)
or that provide other financial services to their clients. The
Commission's approach also addresses concerns, now or in the future,
that one or more types of financial entities might escape
classification under the specific Federal or State regulatory regimes
included in the definition of ``financial end user.''
In order to address concerns raised by commenters, the final rule
removes the provision in the definition of ``financial end user'' that
included any other entity that the Commission has determined should be
treated as a financial end user. The Commission will monitor the margin
arrangements of swap transactions of CSEs to determine if certain types
of counterparties, in fact, are financial entities that are not covered
by the definition of ``financial end user'' in the final rule. In the
event that the Commission finds that one or more types of financial
entities escape classification as financial end users under the final
rule, the Commission may consider another rulemaking that would amend
the definition of ``financial end user'' so it covers such entities.
In the proposal, the Commission stated that ``[f]inancial firms
present a higher level of risk than other types of counterparties
because the profitability and viability of financial firms is more
tightly linked to the health of the financial system than other types
of counterparties.'' \51\ Accordingly, it is crucial that the
definition of financial end user include the types of firms that engage
in the activities described above.
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\51\ 79 FR at 57360 (September 24, 2014).
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Many of the provisions in the financial end user definitions rely
on whether an entity's financial activities trigger Federal or State
registration or chartering requirements. In its proposal, the
Commission included in the definition of ``financial end user'' any
entity that would be a financial end user if it were organized under
the laws of the United States or any State. A few commenters argued
that the proposed test is difficult to apply because it would require a
CSE to analyze a foreign counterparty's business activities in light of
a broad array of U.S. regulatory requirements.
The Commission has not modified this provision in the final rule.
The Commission acknowledges that the test imposes a greater incremental
burden in classifying foreign counterparties than it does in
identifying U.S. financial end users. The burdens associated with
classifying counterparties as financial or non-financial has been a
recurring theme during the rulemaking. To reduce the burden, in this
instance, the Commission believes that CSEs may rely on good faith
representations from their counterparties as to whether they are
financial end users under the final rule. The Commission believes the
approach in the final rule captures the kinds of entities whose
profitability and viability are most tightly linked to the health of
the financial system.
In this respect, the Commission's financial end user definition is
broad by design. Exclusion from the financial end user definition for
any enterprise engaged extensively in financial and market activities
should, as a practical matter, be the exception rather than the rule.
The Commission believes it is appropriate to require a CSE that seeks
to exclude a foreign financial enterprise from the rule's margin
requirements to ascertain the basis for that exclusion under the same
laws that apply to U.S. entities.
The Commission has included in the final rule not only an entity
that is or would be a financial end user but also an entity that is or
would be a swap entity, if it were organized under the laws of the
United States or any State. Since a financial end user is defined as
``a counterparty that is not a swap entity,'' the purpose of this
addition is to make clear that an entity that is not a registered swap
entity in the U.S. but acts as a swap entity in a foreign jurisdiction
would be treated as a financial end user under the final rule.
As noted above, the Commission believes that financial firms
present a higher level of risk than other types of counterparties
because the profitability and viability of financial firms is more
tightly linked to the health of the financial system than other types
of counterparties. Accordingly, the Commission has adopted a definition
of financial end user that includes the types of firms that engage in
the activities described above.
The final rule, like the proposal, excludes certain types of
counterparties from the definition of financial end user. The
definition of financial entities \52\ excludes the government of any
country, central banks, multilateral development banks,\53\ the Bank
for International Settlements, captive finance companies,\54\ and agent
affiliates.\55\ The exclusion for sovereign entities, multilateral
development banks and the Bank for International Settlements is
consistent with the 2013 international framework and the definition of
the Prudential Regulators.\56\
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\52\ Regulation 23.151.
\53\ Some commenters requested additional clarity that certain
entities would be included as multilateral development banks. See
SIFMA; MFX. The definition in the final rule includes an enumerated
list of entities in addition to any other entity that provides
financing for national or regional development in which the U.S.
government is a shareholder or contributing member or which the
relevant Agency determines poses comparable credit risk. Entities
that meet this part of the definition would be treated as
multilateral development banks for purposes of the final rule.
\54\ A captive finance company is an entity that is excluded
from the definition of financial entity under section
2(h)(7)(c)(iii) of the CEA for purposes of the requirement to submit
certain swaps for clearing. That section describes it as ``an entity
whose primary business is providing financing, and uses derivatives
for the purpose of hedging underlying commercial risks related to
interest rate and foreign currency exposures, 90 percent or more of
which arise from financing that facilitates the purchase or lease of
products, 90 percent or more of which are manufactured by the parent
company or another subsidiary of the parent company.''
\55\ An agent affiliate is an entity that is an affiliate of a
person that qualifies for an exception from the requirement to
submit certain trades for clearing. Under section 2(h)(7)(D) of the
CEA, ``an affiliate of a person that qualifies for an exception
under subparagraph (A) (including affiliate entities predominantly
engaged in providing financing for the purchase of the merchandise
or manufactured goods of the person) may qualify for the exception
only if the affiliate, acting on behalf of the person and as an
agent, uses the swap to hedge or mitigate the commercial risk of the
person or other affiliate of the person that is not a financial
entity.''
\56\ As discussed below, captive finance companies and agent
affiliates are excluded by TRIPRA from the definition of financial
entity.
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The Commission believes that this approach is appropriate as these
entities generally pose less systemic risk to the financial system as
their activities generally have a different purpose in the financial
system leading to a lower risk profile in addition to posing less
counterparty risk to a swap entity. Thus, the Commission believes that
application of the margin requirements that would apply for financial
end users to swaps with these counterparties is
[[Page 643]]
not necessary to achieve the objectives of this rule.
The Commission notes that States would not be excluded from the
definition of financial end user, as the term ``sovereign entity''
includes only central governments. This does not mean, however, that
States are categorically classified as financial end users. Whether a
State or particular part of a State (e.g., counties, municipalities,
special administrative districts, agencies, instrumentalities, or
corporations) would be a financial end user depends on whether that
part of the State is otherwise captured by the definition of financial
end user. For example, a State entity that is a ``governmental plan''
under ERISA would meet the definition of financial end user.
As noted above, commenters requested that the Commission exclude a
number of other entities from the definition of financial end user
including small banks that qualify for an exception from clearing,\57\
certain financial cooperatives,\58\ pension plans,\59\ structured
finance vehicles,\60\ and covered bond issuers.\61\ Depository
institutions, financial cooperatives, employee benefit plans,
structured finance vehicles, and covered bond issuers are financial end
users for purposes of the final rule. The interim final rule addresses
the comments raised regarding the uncleared swaps of small banks and
certain financial cooperatives by providing an exemption for such swaps
that qualify for an exemption from clearing. The uncleared swaps of
small banks or financial cooperatives that do not qualify for the
exemptive treatment would be treated as swaps of financial end users
under the final rule.
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\57\ See ABA.
\58\ See CFC.
\59\ See ABA; AIMA. These commenters generally argued that
pension plans should not be subject to margin requirements because
they are highly regulated, highly creditworthy, have low leveraged
and are prudently managed counterparties whose swaps are used
primarily for hedging and, as such, pose little risk to their
counterparties or the broader financial system.
\60\ See FSR; ISDA; JBA; JFMC; SIFMA AMG; SFIG. Commenters
argued that imposing margin requirements on structured finance
vehicles would restrict their ability to hedge interest rate and
currency risk and potentially force these vehicles to exit swaps
markets since these vehicles generally do not have ready access to
liquid collateral. Certain of these commenters also expressed
concerns about consistency with the treatment under the EU proposal.
\61\ See ISDA (arguing that the EU proposal has special criteria
for covered bond issuers and that covered bond issuers should be
able to use collateral arrangements other than the requirements in
the Commission's proposal).
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The Commission has not modified the definition of financial end
user to exclude pension plans, structured finance vehicles, or covered
bonds issuers.
Congress explicitly listed an employee benefit plan as defined in
paragraph (3) and (32) of section 3 of the ERISA in the definition of
``financial entity'' in the Dodd-Frank Act, meaning that a pension plan
would not benefit from an exclusion from clearing even if the pension
plan used swaps to hedge or mitigate commercial risk. The Commission
believes that, similarly, when a pension plan enters into an uncleared
swap with a CSE, the pension plan should be treated as a financial end
user and subject to the requirements of the final rule.
The definition of employee benefit plan in the final rule is the
same as in the proposal and is defined by reference to paragraphs (3)
and (32) of the ERISA. Paragraph (3) provides that the term ``employee
benefit plan'' or ``plan'' means an employee welfare benefit plan or an
employee pension benefit plan or a plan which is both an employee
welfare benefit plan and an employee pension benefit plan. Paragraph
(32) describes certain governmental plans. In response to concerns
raised by commenters, the Commission believes that these broad
definitions would cover all pension plans regardless of whether the
pension plan is subject to the ERISA. In addition, non-U.S. employee
benefit plans would be included as an entity that would be a financial
end user, if it were organized under the laws of the United States or
any State thereof.
The Commission believes that all of these entities should qualify
as financial end users; their financial and market activities comprise
the same range of activities as the other entities encompassed by the
final rule's definition of financial end user. The Commission notes
that the increase in the size of positions necessary to constitute
material swaps exposure in the final rule should address some of the
concerns raised by these commenters with respect to the applicability
of initial margin requirements.
(ii) Small Banks
As noted above, banks would be financial end users under the final
rule. They would be subject to initial margin requirements if they
entered into uncleared swaps with CSEs and, as discussed below, had
material swaps exposure. However, TRIPRA also excluded certain swaps
with small banks from the margin requirements of this rule. In
particular, section 2(h)(7)(A) of the Commodity Exchange Act excepts
from clearing any swap where one of the counterparties is not a
financial entity, is using the swap to hedge or mitigate commercial
risk, and notifies the Commission how it generally meets its financial
obligations associated with entering into uncleared swaps.\62\ As
authorized by the Dodd-Frank Act, the Commission has excluded
depository institutions, Farm Credit System Institutions, and credit
unions with total assets of $10 billion or less, from the definition of
``financial entity,'' thereby permitting those institutions to avail
themselves of the clearing exception for end users.\63\ Uncleared swaps
with those entities would be eligible for the TRIPRA exemption in the
Commission's margin rules, provided they meet other requirements for
the clearing exception. As a consequence of TRIPRA, if a small bank
with total assets of $10 billion or less enters into a swap with a CSE
that meets the requirements of the exception from clearing, that swap
will not be subject to the margin requirements of these rules.
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\62\ A ``financial entity'' is defined to mean (i) a swap
dealer; (ii) a security-based swap dealer; (iii) a major swap
participant; (iv) a major security-based swap participant; (v) a
commodity pool; (vi) a private fund as defined in section 202(a) of
the Investment Advisers Act of 1940; (vii) an employee benefit plan
as defined in sections 3(3) and 3(32) of the Employment Retirement
Income Security Act of 1974; (viii) a person predominantly engaged
in activities that are in the business of banking, or in activities
that are financial in nature, as defined in section 4(k) of the Bank
Holding Company Act of 1956. See 7 U.S.C. 2(h)(7)(C)(i).
\63\ See 7 U.S.C. 2(h)(7)(C)(ii) and 77 FR 42560 (July 19,
2012); 77 FR 20536 (April 5, 2012).
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When a bank with total assets greater than $10 billion enters into
a swap with a CSE, the CSE will be required to post and collect initial
margin pursuant to the rule only if the bank had a material swaps
exposure and is not otherwise exempt.\64\ The final rule requires a CSE
to exchange daily variation margin with a bank with total assets above
$10 billion, regardless of whether the bank has material swaps
exposure. However, the CSE will only be required to collect variation
margin from a bank when the amount of both initial margin and variation
margin required to be collected exceeds the minimum transfer amount of
$500,000.
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\64\ The final rule defines material swaps exposure as an
average daily aggregate notional amount of uncleared swaps,
uncleared 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 $8 billion, where
such amount is calculated only for business days.
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[[Page 644]]
(iii) Multilateral Development Banks
The proposed definition of the term ``multilateral development
bank,'' includes a provision encompassing ``[a]ny other entity that
provides financing for national or regional development in which the
U.S. government is a shareholder or contributing member or which the
Commission determines poses comparable credit risk.''
As described above, the final rule excludes from the definition of
financial end user a ``sovereign entity'' defined to mean a central
government (including the U.S. government) or an agency, department, or
central bank of a central government. An entity guaranteed by a
sovereign entity is not explicitly excluded from the definition of
financial end user in the final rule, unless that entity qualifies as a
central government agency, department, or central bank. The existence
of a government guarantee does not in and of itself exclude the entity
from the definition of financial end user.
(iv) Material Swaps Exposure
The Commission proposed a ``material swaps exposure'' level of $3
billion. This threshold is lower than the guidelines contained in WGMR
and also in the EU's consultation paper. The Commission proposed a
lower threshold based on data it analyzed concerning the required
margin on cleared swaps.
A number of commenters argued that the Commission should raise the
level of material swaps exposure to the threshold of [euro]8 billion
set out in the 2013 international framework to be consistent with the
EU and Japanese proposals.\65\ A commenter suggested that adopting
different exposure levels may result in the failure of an international
framework.\66\ Commenters suggested that the Commission conduct further
studies on the uncleared swaps markets before adopting a threshold.\67\
Some commenters expressed the view that the international
implementation of material swaps exposure threshold treats the
threshold more as a scope provision, to define the group of financial
firms in the swaps market whose activities rise to a level appropriate
to the exchange of initial margin as a policy matter.\68\
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\65\ See ABA; AIMA; CEWG, CPFM; CCMR; FHLB; FSR; GPC; IFM, ISDA;
ICI; IIB; JBA; MFA: Sifma AMG; Sifma; Shell TRM; NERA; and Vanguard.
By contrast, one commenter suggested reducing the threshold below $3
billion. CME. Another commenter expressed concerns that entities
below $3 billion could have considerable exposures. AFR. One
commenter cautioned against the aggressive use of thresholds to
manage liquidity. Barnard.
\66\ See JBA (financial institutions will abide by different
rules depending on their counterparties' jurisdiction).; see also
MFA (competitive discrepancies may result).
\67\ See IFM; Sifma; ABA. See also ISDA (Commission's
calculations assume that a covered swap counterparty has all its
swaps with one party).
\68\ For example, one commenter acknowledged data described by
the Commission in the proposed rule indicating that bilateral
initial margin exposures between one CSE and a financial end user
could exceed $50 million for a portfolio with a gross notional value
well below the USD-equivalent of the international [euro]8 billion
threshold. But the commenter urged the Commission to shift its focus
from the $65 million amount, as a bilateral constraint, and
recognize that a financial end user will often use multiple dealers.
Accordingly, the commenter urged the Commission to treat the
material swaps exposure threshold as a focus on a financial end
user's multilateral exposures with all its dealers, which provides
the rationale for the higher international threshold.
---------------------------------------------------------------------------
Commenters representing public interest groups and CCPs expressed
policy concerns about whether the $3 billion threshold was conservative
enough, focusing on the collective systemic risk posed by all smaller
counterparties in the aggregate. Other commenters representing CSEs and
financial end users expressed concerns about the additional initial
margin they would be required to exchange compared to foreign firms,
and the associated competitive impacts.
Commenters also commented on the method for calculating material
swaps exposure. A few commenters suggested that a daily aggregate
notional measure was burdensome and the Commission should use a month-
end notional amount like the EU proposal and consistent with the
international framework.\69\ Commenters urged the Commission to make
clear that inter-affiliate swaps would not be included for purposes of
determining the material swaps exposure.\70\ Certain of these
commenters also argued that the proposal could require an entity to
double-count inter-affiliate swaps in assessing material swaps
exposure.
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\69\ See JBA; Sifma.
\70\ See ABA; CEWG; CDEU; FSR; GPC; ICI; ISDA: Sifma AMG; Sifma;
Shell TRM; Vanguard.
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Commenters also argued that certain other swaps should not be
counted for purposes of the material swaps exposure calculation. A few
commenters argued that foreign exchange swaps and foreign exchange
forwards that are exempt from the definition of swap by Treasury
determination should not be included for purposes of determining
material swaps exposure.\71\ Other commenters argued that hedging
positions should not be counted toward material swaps exposure.\72\ A
commenter argued that the material swaps exposure calculation should
not include swaps of all affiliates of a financial end user.\73\
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\71\ See ICI; ABA; ISDA; GPC; Sifma; Sifma AMG; Vanguard. The
final rule defines ``foreign exchange forward and foreign exchange
swap'' to mean any foreign exchange forward, as that term is defined
in section 1a(24) of the Commodity Exchange Act (7 U.S.C. 1a(24)),
and foreign exchange swap, as that term is defined in section 1a(25)
of the Commodity Exchange Act (7 U.S.C. 1a(25)). See Regulation
23.151.
\72\ See GPC; CFC.
\73\ See CDEU (many non-financial end users have financial end
users as affiliates, and certain of their swaps should be excluded).
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A few commenters urged the Commission to make clear that a CSE may
rely on representations of its counterparties in assessing whether it
is transacting with a financial end user with material swaps
exposure.\74\ One commenter urged the Commission to clarify what
happens when a financial end user counterparty that had a material
swaps exposure falls below the threshold.\75\
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\74\ See ABA; FHLB: IFM; ISDA; BP; Shell TRM; CEWG; see also
GPC; SIFMA.
\75\ See FHLB.
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The final rule increases the level of the aggregate notional amount
of transactions that gives rise to material swaps exposure to $8
billion. The material swaps exposure threshold of $8 billion in the
final rule is broadly consistent with the [euro]8 billion established
by the 2013 international framework and the EU and Japanese proposals.
In the proposal, the Commission had calibrated the proposed $3 billion
threshold to the size of a potential swap portfolio between a CSE and a
financial end user for which the initial margin amount would often
exceed the proposed initial margin threshold amount of $65 million,
reducing the burden of calculating initial margin amounts for smaller
portfolios.
The material swaps exposure threshold of $8 billion in the final
rule has been calibrated relative to the [euro]8 billion established by
the 2013 international framework in the manner described below. At this
time, the Commission believes the better course is to calibrate the
final rule's material swaps exposure threshold to the higher 2013
international framework amount, in recognition of each financial end
user's overall potential future swaps exposure to the market rather
than its potential future exposure to one dealer. In this regard, the
Commission notes that variation margin will still be exchanged without
any threshold, and further that the $8 billion threshold may warrant
further discussion among international regulators in future years, if
implementation of the threshold proves to create concerns about market
coverage for initial margin.
In the final rule, ``material swaps exposure'' for an entity means
that an
[[Page 645]]
entity and its affiliates have an average daily aggregate notional
amount of uncleared swaps, uncleared 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
$8 billion, where such amount is calculated only for business days.\76\
The final rule's definition also provides that an entity shall count
the average daily aggregate notional amount of an uncleared swap, an
uncleared security-based swap, a foreign exchange forward or a foreign
exchange swap between the entity and an affiliate only one time. In
addition, as discussed below, the calculation does not include a swap
or security-based swap that is exempt pursuant to TRIPRA.
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\76\ The final rule also includes a new definition of ``business
day'' that means any day other than a Saturday, Sunday, or legal
holiday. This definition is described further below.
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The time period for measuring material swaps exposure is June, July
and August of the previous calendar year under the final rule, the same
period as under the proposal. The Commission believes that using the
average daily aggregate notional amount \77\ during June, July, and
August of the previous year, instead of a single as-of date, is
appropriate to gather a more comprehensive assessment of the financial
end user's participation in the swaps market, and to address the
possibility that a market participant might ``window dress'' its
exposure on an as-of date such as year-end, in order to avoid the
Commissions' margin requirements. Material swaps exposure would be
calculated based on the previous year. For example, for the period
January 1, 2017 through December 31, 2017, an entity would determine
whether it had a material swaps exposure with reference to June, July,
and August of 2016.\78\
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\77\ A few commenters suggested that a daily aggregate notional
measure was burdensome and that the Commission should use a month-
end notional amount like the EU proposal and consistent with the
international framework. JBA; SIFMA. The Commission has maintained
the daily aggregate notional amount.
\78\ As a specific example of the calculation for material swaps
exposure, consider a financial end user (together with its
affiliates) with a portfolio consisting of two uncleared swaps
(e.g., an equity swap, an interest rate swap) and one uncleared
security-based credit swap. Suppose that the notional value of each
swap is exactly $10 billion on each business day of June, July, and
August of 2016. Furthermore, suppose that a foreign exchange forward
is added to the entity's portfolio at the end of the day on July 31,
2016, and that its notional value is $10 billion on every business
day of August 2016. On each business day of June and July 2016, the
aggregate notional amount of uncleared swaps, security-based swaps
and foreign exchange forwards and swaps is $30 billion. Beginning on
June 1, 2016, the aggregate notional amount of uncleared swaps,
security-based swaps and foreign exchange forwards and swaps is $40
billion. The daily average aggregate notional value for June, July,
August 2016 is then (22 x $30 billion + 23 x $30 billion + 21 x $40
billion)/(22 + 20 + 23) = $33.5 billion, in which case this entity
would be considered to have a material swaps exposure for every date
in 2017.
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The definition of material swaps exposure also contains a number of
other changes from the proposed definition. Commenters urged the
Commission to make clear that inter-affiliate swaps would not be
included for purposes of determining the material swaps exposure.\79\
Certain of these commenters also argued that the proposal could require
an entity to double-count inter-affiliate swaps in assessing material
swaps exposure.
---------------------------------------------------------------------------
\79\ See ABA; WGCEF; FSR; GPC; ICI; ISDA: SIFMA AMG; SIFMA;
Vanguard.
---------------------------------------------------------------------------
In order to address concerns about double counting affiliate swaps,
the final rule provides that an entity shall count the average daily
aggregate notional amount of an uncleared swap, an uncleared security-
based swap, a foreign exchange forward or a foreign exchange swap
between the entity and an affiliate only one time.\80\ The Commission
also believes that the revised definition of affiliate in the final
rule (described below) should help mitigate some of the concerns raised
by commenters about the inclusion of an affiliate's swaps in
determining material swaps exposure.\81\
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\80\ The Commission made a similar change to the definition of
``initial margin threshold amount'' as described in Regulation
23.151.
\81\ For example, the revised definition of ``affiliate''
generally would not treat investment funds that share an investment
adviser or investment manager as affiliates.
---------------------------------------------------------------------------
The final rule's definition of material swaps exposure also states
that for purposes of this calculation, an entity shall not count a swap
that is exempt pursuant to Sec. 23.150(b).\82\ This change is
consistent with the statutory exemptions provided by Congress in TRIPRA
2015 and ensures that exempt swaps do not count toward determining
whether an entity has material swaps exposure.
---------------------------------------------------------------------------
\82\ The Commission made a similar change to the definition of
``initial margin threshold amount'' as described in Regulation
23.151.
---------------------------------------------------------------------------
As the material swaps exposure is designed to measure the overall
derivatives exposure of an entity, the final rule's calculation of
material swaps exposure continues to include foreign exchange swaps and
foreign exchange forwards as well as swaps used to hedge. The final
rule also does not make a distinction between uncleared swaps entered
into prior to and after the effective dates for mandatory clearing. The
Commission believes that the increase in the level of the material
swaps exposure to $8 billion in the final rule should address many of
the concerns raised by commenters about the inclusion of particular
categories of swaps. Moreover, the material swaps exposure threshold is
intended to identify entities that engage in significant derivatives
activity in order to determine whether their swaps activity should be
subject to initial margin requirements under the final rule.
The Commission believes the final rule's approach is appropriate in
assessing a swap counterparty's overall size and risk exposure and
providing for a simple and transparent measurement of exposure that
presents only a modest operational burden. This approach also is
intended to achieve consistency with other jurisdictions based on the
2013 international framework which sets a threshold based on overall
gross notional non-centrally cleared derivatives activity.\83\
Moreover, given that the Commission is viewing the final rule's
material swaps exposure as an indicator of a financial end user's
overall exposure in the market and revising the threshold upward to $8
billion, the Commission believes the inclusiveness of the calculation
adopted in the final rule is appropriate.
---------------------------------------------------------------------------
\83\ One commenter urged the Commission to conform with the 2013
international framework where material swaps exposure is based on
derivatives (not swaps). See ICI. Another commenter urged the
Commission to exclude registered swap dealers from the material
swaps exposure calculation as this could cause affiliates of the
swap dealer to exceed the material swaps exposure threshold. See
FSR. The final rule does not exclude registered swap dealers from
the material swaps exposure threshold. The Commission believes that
financial affiliates of a registered swap dealer should be treated
as having a material swaps exposure based on their level of risk.
---------------------------------------------------------------------------
Although the final rule does not explicitly provide how a CSE
should determine if a financial end user counterparty has material
swaps exposure, the Commission believes that it would be reasonable for
a CSE to rely on good-faith representations of its counterparty in
making such assessments.
One commenter urged the Commission to clarify what happens when a
financial end user counterparty that had a material swaps exposure
falls below the threshold. Because the material swaps exposure
determination applies to a financial end user for an entire calendar
year, depending on whether the financial end user exceeded the
threshold during the third calendar quarter of the previous year, it is
possible for a CSE to have a portfolio of swaps with a financial end
user whose
[[Page 646]]
status under the material swaps exposure test changes from time to
time. New Sec. 23.161(c) of the final rule addresses this concern and
explains what happens upon a change in counterparty status.
For example, if a financial end user is moving below the threshold
for the upcoming calendar year, the CSE is not obligated under the
final rule to exchange initial margin with that end user during that
calendar year, either for new swaps entered into that year or existing
swaps from a prior year. Any margin that had been previously collected
while the counterparty had a material swaps exposure would not be
required under the final rule for as long as the counterparty did not
have a material swaps exposure. In addition, a CSE's swaps with a
financial end user without material swaps exposure would continue to be
subject to the variation margin requirements of the final rule.
If a financial end user is moving above the threshold for the
upcoming calendar year, the treatment of the existing swaps and the new
swaps is the same as described for swaps before and after the rule's
compliance implementation date. As described in more detail below, the
parties have the option to document the old and new swaps as separate
portfolios for netting purposes under an eligible master netting
agreement, and exchange initial margin only for the new portfolio of
swaps entered into during the new calendar year after the financial end
user triggered the material swaps exposure threshold determination.
(v) Margin Affiliates and Margin Subsidiaries
The proposal defined an ``affiliate'' as any company that controls,
is controlled by, or is under common control with another company.\84\
The proposal defined the control of another company generally as the
ownership or power to vote 25% or more of any class of voting
securities of another entity; or the ownership of 25% or more of the
total equity in any entity; or the power to elect a majority of the
directors or trustees of an entity. An entity would be a subsidiary of
another entity if it were controlled by that other entity.
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\84\ The Commission notes that under the proposal the Commission
used the terms affiliate and subsidiary; however in its final rule,
it is using the term ``margin affiliate'' and ``margin subsidiary''.
---------------------------------------------------------------------------
Commenters raised a number of concerns with the proposal's
definitions of ``affiliate,'' ``subsidiary'' and ``control.'' While one
commenter expressed support for the proposal's definition of
control,\85\ the vast majority of commenters argued for a modified
definition of control that did not use the 25 percent threshold.\86\
One commenter suggested that these terms should be defined by reference
to whether an affiliate or subsidiary is consolidated under accounting
standards.\87\ A number of these commenters urged the Commission to use
a majority ownership test (51 percent or more) for determining
control.\88\ Certain commenters expressed concern about the cross-
border application of these definitions.\89\
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\85\ See Better Markets.
\86\ See ACLI; FSR; CEWG; the GPC; IIB; ISDA; JBA; MFA; Sifma
AMG; Sifma; Vanguard. (One commenter argued that the definitions of
affiliate and control should not include relationships with or
through the U.S. government and its representatives. See Freddie.)
\87\ See ISDA.
\88\ See ACLI; Commercial Energy Working Group; IIB; JBA; IFM;
SIFMA AMG; SIFMA; TIAA-CREF; Vanguard. For example, one commenter
argued that applying the initial margin threshold would be difficult
with a 25 percent control test and it would be hard to agree on
allocation of the threshold among the parties. ACLI.
\89\ See CCMR; IIB; SIFMA AMG. For example, one commenter argued
that a 50 percent ownership threshold would conform to the EU
Proposal. See IIB.
---------------------------------------------------------------------------
Commenters also expressed particular concerns about the application
of these definitions in the proposal to investment funds, including
during the seeding period. A number of commenters urged the Commission
to use the same criteria as the 2013 international framework as the
basis for determining whether or not an investment fund is an affiliate
of a fund sponsor.\90\ Commenters also argued that seed capital
contributed by a fund sponsor should not be viewed as control even if
the ownership by the fund sponsor exceeds 25 percent.\91\ One
commenter, for example, suggested that passive investors should be
excluded even where they own more than 51 percent of the ownership
interests.\92\ A few commenters also suggested that registered funds
may treat each separately managed ``sleeve'' of the fund as a separate
registered fund.\93\
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\90\ See AIMA; CCMR; ICI; SIFMA AMG; Vanguard; MFA. The 2013
international framework states that investment funds that are
managed by an investment adviser are considered distinct entities
that are treated separately when applying the threshold as long as
the funds are distinct legal entities that are not collateralized by
or otherwise guaranteed or supported by other investment funds or
the investment adviser in the event of fund insolvency or
bankruptcy. One commenter suggested an investment fund separateness
to determine whether an investment fund is a separate legal entity.
This commenter also urged the Commission to incorporate the concept
of ``effective control'' as developed by the Financial Accounting
Standards Board (``FASB'') to cover variable interest entities and
special purpose entities. See Better Markets.
\91\ See ACLI; Sifma; Sifma AMG. One commenter also urged the
Commission to clarify that independently controlled accounts are
separate counterparties. See Sifma.
\92\ See Sifma AMG.
\93\ See ICI; Sifma AMG.
---------------------------------------------------------------------------
Commenters also expressed particular concerns about how the
definitions applied to pension funds. One commenter argued that the
sponsor of a pension should not be an affiliate of the pension fund by
virtue of appointing trustees or directors of the pension fund.\94\
This commenter urged that pension plans should not be deemed to have
any affiliates other than those entities to whom a CSE counterparty has
recourse for relevant pension trades. Other commenters argued that
pension plans should be exempted from the definition of affiliate which
could conflict with fiduciary obligations under ERISA.\95\
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\94\ See GPC (arguing this could foreclose pension plans from
using third-party custodians).
\95\ See FSR (arguing that how a swap entity allocates its
initial margin threshold to the ERISA plan must be done in a way not
to violate the fiduciary duty to the pension plan and that would
requirement input from the Department of Labor).
---------------------------------------------------------------------------
The term affiliate is used in the definition of initial margin
threshold amount which means a credit exposure of $50 million that is
applicable to uncleared swaps between a CSE and its affiliates with a
counterparty and its affiliates. The inclusion of affiliates in this
definition is meant to make clear that the initial margin threshold
amount applies to an entity and its affiliates.
Similarly, the term ``affiliate'' is also used in the definition of
``material swaps exposure,'' as material swaps exposure takes into
account the exposures of an entity and its affiliates. The term
``affiliate'' is also used for determining the compliance date for a
CSE and its counterparty in Sec. 23.161.
Using financial accounting as the trigger for affiliation, rather
than a legal control test, should address many of the concerns raised
by commenters. In addition, the Commission believes that this approach
reflects a more accurate method for discerning whether an entity has
control over another entity. Although consolidation tests under any
other accounting standard that the entity may use must also be applied
on a case-by-case basis, like the proposed rule's ``control'' test, the
analysis has already been performed for companies that prepare their
financial statements in accordance with relevant standards. For
companies that do not prepare these statements, the Commission believes
that industry participants are more familiar with the relevant
accounting
[[Page 647]]
standards and tests, and they will be less burdensome to apply.\96\
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\96\ The Commission is deleting the definition of the term
``subsidiary.'' This term is no longer used in this set of rules.
---------------------------------------------------------------------------
Additionally, the accounting consolidation analysis typically
results in a positive outcome (consolidation) at a higher level of an
affiliation relationship than the 25 percent voting interest standard
of the legal control test. This is responsive to commenters' concerns
that the proposed definitions were over-inclusive.
Because there are circumstances where an entity holds a majority
ownership interest and would not consolidate, the Prudential Regulators
have reserved the right to include any other entity as an affiliate or
subsidiary based on a conclusion that either company provides
significant support to, or is materially subject to the risks or losses
of, the other company. This provision is meant to leave discretion to
the Prudential Regulators in order to avoid evasion. The Commission has
determined not to include this provision at this time.
The Commission believes that the modifications to the definition of
affiliate will address many of the concerns raised by commenters,
including with respect to investment and pension funds. Investment
funds generally are not consolidated with the asset manager other than
during the seeding period or other periods in which the manager holds
an outsized portion of the fund's interests although this may depend on
the facts and circumstances. The Commission believes that during these
periods, when an entity may own up to 100 percent of the ownership
interest of an investment fund, the investment fund should be treated
as an affiliate.
This approach to investment funds is similar to that in the 2013
international framework. The Commission acknowledges that some
accounting standards, such as the GAAP and IFRS variable interest
standards, sometimes require consolidation between a sponsor or manager
and a special purpose entity created for asset management,
securitization, or similar purposes, under circumstances in which the
manager does not hold interests comparable to a majority equity or
voting control share. On balance, the Commission believes it is
appropriate to treat these consolidated entities as affiliates of their
sponsors or managers. They are structured with legal separation to
address the concerns of passive investors, but the manager retains such
levels of influence and exposure as to indicate its status is beyond
that of another minority or passive investor.
In the case of pension funds that are associated with a non-
financial end user, the Commission believes that consolidation of the
pension fund with its parent would be the exception to the rule under
applicable accounting standards. Even if consolidation is applicable
for some pension funds, the parent would, as a general matter, be
exempt from the rule under TRIPRA and would not be included in the
threshold amount calculations.
(vi) Treasury Affiliates Acting as Principal
The Commission has issued no-action letters providing relief with
respect to certain Treasury affiliates acting as principal from the
clearing requirement provided that certain conditions are met.\97\ Some
commenters urged the Commission to provide similar treatment here.\98\
The Commission has determined that similar treatment is appropriate.
The Commission has included in the definition of financial end user a
provision stating that the term shall not include an eligible treasury
affiliate that the Commission has exempted by rule. The Commission will
act to implement this approach by rule in a separate procedure.
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\97\ See CFTC No-Action Letter No. 13-22 (June 4, 2013); CFTC
No-Action Letter No. 14-144 (Nov. 26, 2014).
\98\ See W&C (initial and variation margin should not apply to
an eligible treasury affiliate as defined in Commission No-Action
Letter No. 13-22).
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The Prudential Regulators final rules do not include this
provision. The Prudential Regulators have stated, however, that if the
CFTC acted to exclude these entities by rule, the entities would be
excluded from the Prudential Regulators' rule.\99\
---------------------------------------------------------------------------
\99\ 80 FR 74840 at 74856.
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c. Non-Financial End Users
(i) Proposal
Non-financial end users under the proposal included any entity that
was not an SD, an MSP, or a financial end user. The proposal did not
require CSEs to exchange margin with non-financial end users. The
Commission believes that such entities, which generally are using swaps
to hedge commercial risk, pose less risk to CSEs than financial
entities.
To ensure the safety and soundness of CSEs, the proposal required a
CSE (i) to enter into certain documentation with all counterparties to
provide clarity about the parties' respective rights and obligations
and (ii) to calculate hypothetical initial and variation margin amounts
each day for positions held by non-financial entities that have
material swaps exposure to the covered counterparty.\100\ That is, the
CSE would be required to calculate what the margin amounts would be if
the counterparty were another SD or MSP and compare them to any actual
margin requirements for the positions.\101\ These calculations would
serve as risk management tools to assist the CSE in measuring its
exposure and to assist the Commission in conducting oversight of the
CSE.
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\100\ Proposed Regulations 23.154(a)(6) and 23.155(a)(3).
\101\ This is consistent with the requirement set forth in
section 4s(h)(3)(B)(iii)(II) of the CEA that SDs and MSPs must
disclose to counterparties who are not SDs or MSPs a daily mark for
uncleared swaps.
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(ii) Comments
Many commenters supported the Commission's decision not to impose
margin requirements on non-financial end users.\102\ One commenter
raised concerns about certain uncleared matched commodity swaps that
economically offset each other and that are used to hedge municipal
prepayment transactions for the supply of long-term natural gas or
electricity (municipal prepayment transactions as described
earlier).\103\ However, two commenters expressed concerns with this
decision.\104\ These concerns ranged from fears that large market
players (such as the type of entities that once included Enron, among
others) would be able to participate in the markets on an unmargined
basis to disappointment that the Commission did not at least include a
requirement for a specific internal exposure limit for commercial
counterparties.
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\102\ See ABA; ETA; CDEU (asking the Commission to make explicit
in the rule text the exclusion for non-financial end users from the
margin requirements); COPE.
\103\ This commenter contended that each side of this matched
pair of swaps could be subject to different margin treatment that
could make these transactions prohibitively expensive. In
particular, according to this commenter, the first or ``front-end''
swap in this matched pair would be between a non-financial end user
(typically a government gas supply agency) and a swap entity, while
the second swap or ``back-end'' swap generally would be between a
swap entity and a prepaid gas supplier that is a swap entity or
other financial entity.
\104\ See Public Citizen (opposed the exemption, citing that
non-financial end users are not exempt by statute); AFR (suggesting
that the Commission should separate clearing and margin exemptions
while expressing concerns regarding the scope of this exemption).
AFR further argued that margin should be required where the volume
of swaps could present risks to the financial system or to
affiliated entities deemed to be systemically important.
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Many commenters opposed the documentation requirement in the
proposal, citing administrative burdens on the parties and noting that
non-
[[Page 648]]
financial end users currently use other forms of documentation.\105\
Other commenters asked the Commission for clarification with respect to
aspects of the documentation requirement.\106\
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\105\ See ISDA; Joint Associations; CDEU; Freddie; COPE; ABA;
ETA; BP; Shell TRM.
\106\ See Sifma (seeking assurance that (i) a CSE would not
violate its obligations to maintain sufficient margin if it releases
margin to a counterparty at the conclusion of a dispute resolution
mechanism consistent with the U.S. implementation of Basel and the
Commission is not requiring the parties to lock in dispositive
valuation methods; and (ii) if a non-bank swap entity and a non-
financial end user have not agreed to exchange margin, the parties
will not need to modify their trading documentation to address
matters specified in the proposal such as valuation methodologies
and data sources); JBA (seeks clarification on the level of
documentation required to ``allow the counterparty and regulators to
calculate a reasonable approximation of the margin requirement
independently); FHLB (arguing that documentation requirement with
respect to dispute resolution are inadequate).
---------------------------------------------------------------------------
The majority of commenters opposed the hypothetical margin
calculation requirement for non-financial end users.\107\ Commenters
generally noted the extra burdens this requirement may place on CSEs
and the non-financial end user, who must monitor their swaps exposures
to determine if they exceed the material swaps exposure threshold. Only
one commenter expressed support for this requirement.\108\
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\107\ See ISDA; Sifma; Joint Associations; JBA; FSR; ETA; NGCA/
NCSA; CDEU; COPE; BP; Shell TRM; CEWG.
\108\ See AFR.
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(iii) Discussion
In response to the comments, the Commission has removed the
hypothetical margin calculation and documentation requirements
concerning non-financial end users. Although the Commission continues
to believe that its documentation and hypothetical margin calculation
requirements would promote the financial soundness of CSEs, the
Commission recognizes the additional administrative burdens that its
proposed requirements could impose on CSEs and on non-financial end
users. The Commission has other requirements that should address the
monitoring of risk exposures for these entities.\109\
---------------------------------------------------------------------------
\109\ See e.g., Sec. 23.600 of the CFTC's regulations.
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Moreover, under the interim final rule discussed below, certain
transactions with certain financial counterparties are exempt from the
Commission's margin requirements. Section 23.150 of the final rule
implements the exemptions enacted in Title III of TRIPRA, which
excludes these swaps from the statutory directive issued to the
Commission by section 4s of the CEA to impose margin requirements for
all uncleared swaps.
The Commission is implementing the transaction based (as opposed to
counterparty based) TRIPRA exemptions in Sec. 23.150(b) of the final
rule. With respect to municipal prepayment transactions, the Commission
notes that CSEs that are parties to these and other types of matched or
offsetting swap transactions would need to evaluate each swap to
determine whether the requirements of the final rule apply. Under the
final rule, it is possible that one swap may be exempt from the
requirements of the rule while an offsetting swap is subject to the
final rule's requirements as these requirements are set on a risk basis
as required under the statute.
A commenter also contended that the rule would cause counterparties
to matched commodity swaps to face increased costs to the extent that
the rules apply a capital charge to a CSE in connection with these
matched swaps. The Commission notes that capital requirements of CSEs
are outside the scope of this rulemaking and therefore is not
addressing the capital implications of Municipal Prepayment
Transactions at this time.
D. Nature and Timing of Margin Requirements
1. Initial Margin
a. Proposal
Subject to thresholds discussed below, the proposal required each
CSE to collect initial margin from, and to post initial margin with,
each covered counterparty on or before the business day after execution
\110\ for every swap with that counterparty.\111\ The proposal required
the CSEs to continue to post and to collect initial margin until the
swap is terminated or expires.\112\
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\110\ Commission Regulation 23.200(e) defines execution to mean,
``an agreement by the counterparties (whether orally, in writing,
electronically, or otherwise) to the terms of the swap transaction
that legally binds the counterparties to such terms under applicable
law.'' 17 CFR 23.200(e).
\111\ Proposed Sec. Sec. 23.152(a) and 23.153(d).
\112\ Proposed Sec. 23.152(b).
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Recognizing the greater risk that SDs, MSPs, and financial end
users pose to the financial system, the Commission proposed to require
SDs and MSPs to collect initial margin from, and to post initial margin
with, one another. SDs and MSPs also would be required to collect
initial margin from, and post initial margin to, financial end user
counterparties that have exceeded the material swaps exposure
threshold. SDs and MSPs would be required to collect variation margin
from, and post variation margin to, each other and all financial end
user counterparties.
The proposal contains a provision stating that a CSE would not be
deemed to have violated its obligation to collect initial or variation
margin if it took certain steps to collect margin from its counterparty
in the event the counterparty failed to post.\113\ Specifically, if a
counterparty failed to pay the required initial margin to the CSE, the
CSE would be required to make the necessary efforts to attempt to
collect the initial margin, including the timely initiation and
continued pursuit of formal dispute resolution mechanisms,\114\ or
otherwise demonstrate upon request to the satisfaction of the
Commission that it has made appropriate efforts to collect the required
initial margin or commenced termination of the swap.
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\113\ Proposed Sec. 23.152(c).
\114\ See Sec. 23.504(b)(4) of the CFTC's regulations.
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b. Comments
Commenters generally expressed support for two-way initial and
variation margin.\115\ One commenter suggested that CSEs should not be
required to post margin but only to collect margin.\116\ Another
commenter further supported allowing more time to raise the required
initial margin if an increase is mandated as a result of model
recalibration.\117\
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\115\ See Barnard; ICI; MFA; Public Citizen; AFR; CME; GPC.
\116\ See JBA.
\117\ See CCMR.
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All commenters that addressed the Commission's proposed timing
requirement for initial margin collection opposed it.\118\ The basis
for these objections included the fact that the settlement and delivery
periods for many types of eligible margin securities are longer than
the time allowed for margin collection under the proposed rule; the
potential inability of financial end users to arrange for collateral
transfers under the proposed rule's timeframes; and the difficulties
encountered where the parties are in distant time zones.\119\
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\118\ See JFMC; Joint Associations; JBA; Sifma; Sifma-AMG; ISDA;
ETA; Shell TRM; BP; GPC; and NGSA/NGCA.
\119\ See ISDA; Sifma; JFMC; and JBA.
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Other concerns included the fact that valuations are typically
determined after market close and that the proposed rule did not
include time for portfolio reconciliation and dispute resolution. A
commenter suggested that, since financial end users would be required
to exchange margin with a CSE in amounts determined by the CSE's
models, the final rule should allow for a dispute resolution process
acceptable to both the CSE and its counterparty. Commenters proposed a
number of alternatives, including moving to a T+2
[[Page 649]]
basis; \120\ requiring prompt margin calls no later than a T+1 or T+2
basis with margin transfer occurring one or two days thereafter or
according to the standard settlement cycle for the type of collateral;
requiring margin collection and settlement weekly; or simply requiring
margin collection on a prompt or reasonable basis.
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\120\ See ISDA.
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One commenter asked for clarification that the Commission would not
require the calculation and collection of margin more than once a
day.\121\
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\121\ See MFA.
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c. Discussion
(i) Two-Way Margin
Consistent with the proposal, the final rule requires a CSE to
collect initial margin when it engages in an uncleared swap with
another swap entity. Because all swap entities will be subject to a
Prudential Regulator or Commission margin rule that requires them to
collect initial margin on their uncleared swaps, the final rule will
result in a collect-and-post system for all uncleared swaps between
swap entities.
When a CSE engages in an uncleared swap with a financial end user
with material swaps exposure,\122\ the final rule will require the CSE
to collect and post initial margin with respect to the uncleared swap.
Under the final rule, a CSE transacting with a financial end user with
material swaps exposure must (i) calculate its initial margin
collection amount using an approved internal model or the standardized
look-up table, (ii) collect an amount of initial margin that is at
least as large as the initial margin collection amount less any
permitted initial margin threshold amount (which is discussed in more
detail below), and (iii) post at least as much initial margin to the
financial end user with material swaps exposure as the CSE would be
required to collect if it were in the place of the financial end user
with material swaps exposure.
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\122\ The calculation of ``material swaps exposure'' is
addressed in more detail in the discussion of the definitions above.
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The Commission is not adopting a ``collect only'' approach for
financial end user counterparties recommended by a number of financial
industry commenters. The posting requirement under the final rule is
one way in which the Commission seeks to reduce overall risk to the
financial system, by providing initial margin to non-dealer swap market
counterparties that are interconnected participants in the financial
markets (i.e., financial end users that have material swap
exposure).\123\ Commenters representing public interest groups and
asset managers supported this aspect of the Commission's approach,
stating that it not only would better protect financial end users from
concerns about failure of a CSE, but also would act as a discipline on
CSEs by requiring them to post margin reflecting the risk of their
swaps business.
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\123\ Some of these commenters contrasted the Commission's 2014
proposed approach with those of European and Japanese regulators. In
the United States, many financial end users operate outside of the
jurisdiction of the Commission to impose margin requirements. Thus,
unlike the proposed Japanese and European requirements, which would
cover a broader array of financial entities, a collect-only regime
in the United States would be applicable only to CSEs and thus could
leave a large number of financial entities with significant
unmargined potential future exposures to their swap dealers.
---------------------------------------------------------------------------
The final rule permits a CSE to select from two methods (the
standardized look-up table or the internal margin model) for
calculating its initial margin requirements as described in more detail
in the paragraphs that follow. In all cases, the initial margin amount
required under the final rule is a minimum requirement; CSEs are not
precluded from collecting additional initial margin (whether by
contract or subsequent agreement with the counterparty) in such forms
and amounts as the CSE believes is appropriate.
The provisions of the final rule requiring a CSE to collect initial
margin amounts calculated under the standardized approach or an
internal model apply only with respect to counterparties that are
financial end users with material swaps exposure or swap entities.\124\
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\124\ The same is true with respect to the final rule's
requirements for eligible collateral and custody of initial margin
collected by a CSE.
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(ii) Timing
The final rule establishes the timing under which a CSE must comply
with the initial margin requirements set out in Sec. Sec. 23.154 and
155. Under Sec. 23.152 of the final rule, a CSE, on each business day,
must comply with the initial margin requirements for a period beginning
on or before the business day following the day of execution of the
swap and ending on the date the uncleared swap is terminated or
expires. ``Business day'' is defined in Sec. 23.151 to mean any day
other than a Saturday, Sunday, or legal holiday. \125\
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\125\ A ``business day'' under the final rule is not limited by
or tied to typical business hours. A swap dealer seeking to post or
collect margin may make the transfer during a ``business day'' but
at a time which is before or after typical business hours.
---------------------------------------------------------------------------
In practice, each CSE typically will have a portfolio of swaps with
a specific counterparty, and the CSE will collect and post initial
margin for that portfolio with that counterparty on a rolling basis.
The final rule requires the CSE to collect and post initial margin each
business day for its portfolio of swaps with that counterparty, based
on the initial margin amount calculated for that portfolio by the CSE
on the previous business day.\126\
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\126\ Of course, if the initial margin amounts have not changed,
or the change to the posting or collecting amount (combined with
changes in the variation margin amount, as applicable) is less than
the minimum transfer amount specified in Sec. 23.151, no posting or
collection will be required.
---------------------------------------------------------------------------
As the CSE and its counterparty enter into new swaps, adding them
to the portfolio, these new swaps need to be incorporated into the
CSE's calculation of initial margin amounts to be posted and collected
on this daily cycle. When a CSE and its counterparty are located in the
same or adjacent time zones, this is a straightforward process.
However, when the CSE is located in a distant time zone from the
counterparty, or the two parties observe different sets of legal
holidays, this can be less straightforward.
The Commission added new provisions to the final rule to
accommodate practical considerations that arise in these
circumstances.\127\ The final rule requires the CSE to post and collect
initial margin on or before the end of the business day after the ``day
of execution,'' as defined in Sec. 23.151 of the rule. The ``day of
execution'' is determined with reference to the point in time at which
the parties enter into the uncleared swap.
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\127\ The approach is patterned on principles incorporated in
the Commission's rulemaking on clearing execution, with differences
the Commission believes are appropriate in consideration of the
bilateral nature of uncleared swap margin and the non-standardized
terms of uncleared swaps. See Clearing Requirement Determination
Under Section 2(h) of the CEA, 77 FR 74,284 (Dec. 13, 2012),
available at: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-29211a.pdf.
---------------------------------------------------------------------------
When the location of the CSE is in a different time zone than the
location of the counterparty, the ``day of execution'' definition
provides three special accommodations for the difference. These
accommodations are made in recognition of the fact that each of the two
parties to the swap will, as a practical necessity, observe its own
``business day'' in transmitting instructions to the third-party
custodian.
First, if at the time the parties enter into the swap, it is a
different calendar day at the location of each party, the day of
execution is deemed to be the later of the two calendar days. For
example, if a CSE located in New York enters into
[[Page 650]]
a swap at 3:30 p.m. on Monday with a counterparty located in Japan, in
the Japanese counterparty's location, it is 4:30 a.m. on Tuesday, and
the day of execution (for both parties) will be deemed to be Tuesday.
Second, if an uncleared swap is entered into between 4:00 p.m. and
midnight in the location of a party, then such uncleared swap shall be
deemed to have been entered into on the immediately succeeding day that
is a business day for both parties, and both parties shall determine
the day of execution with reference to that business day. For example,
if a CSE located in New York enters into a swap at noon on Friday with
a counterparty located in the U.K., and in the U.K. counterparty's
location, it is 5:00 p.m. on Friday, then the U.K. counterparty will be
deemed to enter into the swap the following Monday. Or, if a CSE
located in New York enters into a swap at noon on Friday with a
counterparty located in Japan, and in the Japanese counterparty's
location, it is 1:00 a.m. on Saturday, then the Japanese counterparty
will be deemed to enter into the swap the following Monday. In both
examples, the day of execution (for both parties) will be Monday.
Third, if the day of execution determined under the foregoing rules
is not a business day for both parties, the day of execution shall be
deemed to be the immediately succeeding day that is a business day for
both parties. For example, this addresses the outcome arising from an
uncleared swap entered into by a CSE in New York at noon on Friday with
a counterparty in Japan, where it would be 1:00 a.m. on Saturday. Under
the first provision, the later calendar day would be deemed the day of
execution, which would be Saturday. Accordingly, this third provision
would operate to move the deemed day of execution to the next business
day for both parties, i.e. Monday. As a further example under the same
circumstances, except that the Monday was a legal holiday in New York,
the day of execution would then be deemed to be Tuesday for both
parties.
Section 23.152 consistently requires the CSE to begin posting and
collecting initial margin reflecting that swap no later than the end of
the business day following that day of execution and thereafter collect
and post on a daily basis. The Commission believes the final rule
should provide adequate time for the CSE to include the new swap in the
regular initial margin cycle, under which the CSE calculates the
initial margin posting and collection requirements each business day
for a portfolio of swaps with a counterparty, and under which the
independent custodian(s) for both parties must hold segregated eligible
margin collateral in those amounts by the end of the next business day,
pursuant to the respective instruction of the parties. The CSE is
required to continue including the swap in its determination of the
initial margin posting and collection requirements for that portfolio
until the date the swap expires or is terminated.
The Commission has made limited adjustments to the final rule to
accommodate operational concerns created by differences in time zones
and legal holidays between the counterparties, but otherwise has
retained the proposed approach. The Commission recognizes that the
final rule requires initial margin to be posted and collected so
quickly that CSE and their counterparties may be required to take
precautionary steps. These could include (i) pre-positioning eligible
margin collateral at the custodian, (ii) using readily-transferrable
forms of eligible collateral, such as cash, or (iii) initially
supplying readily-transferrable forms of eligible collateral and
subsequently arranging to substitute other eligible margin collateral
after the initial margin collateral has been delivered to the custodian
and the minimum margin requirements have been satisfied.
The Commission also recognizes that the final rule will require
portfolio reconciliation and dispute resolution to be performed after
initial margin has been collected, as adjustments to the original
margin call, rather than before. While the Commission recognizes the
incremental regulatory burden created by the final rule's timing
requirement, the Commission believes the additional delay that would be
introduced by the commenters' alternatives would reduce the overall
effectiveness of the margin requirements, as any further timing delay
will result in an increased margin period of risk, which is not
accounted for in calculating the initial margin amount.\128\
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\128\ For example, if the Commission provided T+3 as the
required timing for the posting of margin, the initial margin
model's margin period of risk of 10 days, would only end up being 7
days, as the initial margin amount would not be available for
another 3 days after its calculation (i.e., 10 days (margin period
of risk)--3 days (T+3 posting requirement) = 7 days).
---------------------------------------------------------------------------
Under Sec. 23.152 of the final rule, a CSE shall not be deemed to
have violated its obligation to collect or post initial or variation
margin from or to a counterparty if: (1) The counterparty has refused
or otherwise failed to provide or accept the required margin to or from
the CSE; and (2) the CSE has (i) made the necessary efforts to collect
or to post the required margin, or has otherwise demonstrated upon
request to the satisfaction of the Commission that it has made
appropriate efforts to collect the required margin, or (ii) commenced
termination of the uncleared swap with the counterparty promptly
following the applicable cure period and notification requirements.
Under the final rule, disputes that may arise between a CSE and its
counterparty should be handled pursuant to the terms of the relevant
contract or agreement and in the normal course of business. A CSE would
not be deemed to have violated its obligation to collect or post
initial or variation margin from or to a counterparty if the
counterparty is acting in accordance with agreed-upon practices to
settle a disputed trade.
2. Netting Arrangements
a. Proposal
The proposal would permit netting of initial margin across swaps
and variation margin across swaps, but would not permit the netting of
initial and variation margin.\129\ Any netting would have to be done
pursuant to an eligible master netting agreement (``ENMA'').\130\ The
agreement would create a single legal obligation for all individual
transactions covered by the agreement upon an event of default. It
would specify the rights and obligations of the parties under various
circumstances.\131\
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\129\ Proposed Sec. Sec. 23.152(c) and 23.153(c).
\130\ Proposed Sec. 23.151, definition of ``eligible master
netting agreement.''
\131\ Id.
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The proposed rule provided that if uncleared swaps entered into
prior to the applicable compliance date were included in the EMNA,
those swaps would be subject to the margin requirements.\132\ Under the
proposal, a CSE would need to establish a new EMNA to cover swaps
entered into after the compliance date in order to exclude pre-
compliance date swaps.
---------------------------------------------------------------------------
\132\ The netting provisions in the proposal were in Sec.
23.153(c).
---------------------------------------------------------------------------
b. Comments
A number of commenters argued that, in order to allow close-out
netting and contain costs, the final rule should not require new master
agreements to separate pre- and post-compliance date swaps, and that
parties should be permitted to use credit support annexes that are part
of the EMNA instead of new master agreements to distinguish
[[Page 651]]
pre-and post-compliance date swaps.\133\ One party also asked the
Commission for confirmation that the requirement to separately margin
pre- and post-effective date swaps applies only to initial and not
variation margin.\134\ Another party argued that ISDA should publish
and standardize a credit support annex that would conform to the
requirements of the margin regulations and parties should be allowed to
use such credit support annex alongside other existing credit support
annexes among the parties.\135\
---------------------------------------------------------------------------
\133\ See TIAA-CREF; CPFM; ICI; Sifma; ISDA; Sifma-AMG; ABA;
JBA; CS; AIMA; MFA; FSR; Freddie; ACLI; and FHLB. One commenter also
requested clarification that the use of an EMNA does not prevent use
of a master-master netting agreement. The final rule requires that
any uncleared swaps that are netted for purposes of calculating the
margin requirements under the final rule are subject to an EMNA that
meets the definition in Sec. 23.151 of the final rule regardless of
whether or not there is a master-master agreement.
\134\ See ICI.
\135\ See Freddie.
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c. Discussion
The final rule permits a CSE to calculate initial margin (using an
initial margin model) or variation margin on an aggregate net basis
across uncleared swap transactions that are executed under an
EMNA.\136\ Although the proposal provided that the margin requirements
would not apply to uncleared swaps entered into before the rule's
compliance dates, as a general rule, the proposal provided that if an
EMNA covered uncleared swaps that were entered into before the
applicable compliance date, those uncleared swaps would be subject to
the requirements of the rule and must be included in the aggregate
netting portfolio for purposes of calculating the required margin.
---------------------------------------------------------------------------
\136\ Initial margin and variation margin amounts may not be
netted against each other under the final rule. In addition, initial
margin netting is only for the purposes of calculating the
collection amount or post amount under an approved initial margin
model, which may not be netted against each other.
---------------------------------------------------------------------------
As discussed by several commenters, the Commission recognizes that
CSEs and their counterparties may wish to separate netting portfolios
under a single EMNA. Accordingly, the final rule provides that an EMNA
may identify one or more separate netting portfolios that independently
meet the requirement for close-out netting \137\ and to which, under
the terms of the EMNA, the collection and posting of margin applies on
an aggregate net basis separate from and exclusive of any other
uncleared swaps covered by the agreement. (These separate netting
portfolios are commonly covered by separate credit support annexes to
the EMNA.)
---------------------------------------------------------------------------
\137\ See Sec. 23.151 (paragraph 1 of the EMNA definition).
---------------------------------------------------------------------------
This rule facilitates the ability of the parties to document two
separate netting sets, one for uncleared swaps that are subject to the
final rule and one for swaps that are not subject to the margin
requirements. A netting portfolio that contains only uncleared swaps
entered into before the applicable compliance date is not subject to
the requirements of the final rule. The rule does not prohibit the
parties from including one or more pre-compliance-date swaps in the
netting portfolio of uncleared swaps subject to the margin rule, but
they will thereby become subject to the final rule's margin
requirement, as part of the netting portfolio. Similarly, any netting
portfolio that contains any uncleared swap entered into after the
applicable compliance date will subject the entire netting portfolio to
the requirements of the final rule.
The netting provisions of the final rule also address the
implications of status changes for counterparties. As discussed above,
the final rule imposes a requirement to exchange initial margin only
with respect to financial end users whose swap portfolios exceed the
material swap exposure threshold. This means that a CSE may accumulate
a portfolio of swaps with a financial end user below the threshold,
subject to a variation margin requirement, and later if the financial
end user crosses the threshold, only new swaps entered into after the
change in the financial end user's status will be subject to both
initial and variation margin requirements. To address this possibility,
the final rule extends the treatment of separate netting portfolios
under a single ENMA beyond pre-compliance-date swaps to include
separate netting portfolios for swaps entered into before and after a
financial end user's change into a higher risk status.\138\
---------------------------------------------------------------------------
\138\ As discussed earlier, the change in status might also
occur as a counterparty moves in or out of financial end user status
entirely. The final rule extends the separate netting portfolio
treatment to all status changes equally.
---------------------------------------------------------------------------
The netting provisions in the final rule are modified from the
proposal in order to provide clarifications to address implementation
concerns raised by commenters. The proposed rule provided that if
uncleared swaps entered into prior to the applicable compliance date
were included in the EMNA, those swaps would be subject to the margin
requirements.\139\ Under the proposal, a CSE would need to establish a
new EMNA to cover swaps entered into after the compliance date in order
to exclude pre-compliance date swaps.
---------------------------------------------------------------------------
\139\ The netting provisions in the proposal were in Sec.
23.153.
---------------------------------------------------------------------------
The final rule addresses the commenters' concerns regarding close-
out netting and preserves close-out netting by allowing an EMNA to
identify one or more separate netting portfolios to which the
requirements of the final rule apply on an aggregate net basis. Thus,
under the final rule, pre-compliance date swaps in the same EMNA as
post-compliance date swaps would be subject to the requirements of the
final rule unless they are treated under the EMNA as separately
identified netting portfolio.
The Commission believes it would be inconsistent with the purposes
and objectives of the rule to permit a CSE to net a counterparty's
uncleared swap obligations to the CSE in determining margin collection
amounts, unless the CSE can conclude on a well-founded basis that the
netting provisions of the agreement can be enforced against the
counterparty (as required in accordance with the final rule's
definition of the EMNA).
The Commission will address commenters' concerns regarding the lack
of availability of netting in foreign jurisdictions in its application
of the margin rule on cross-border transaction final rule.
The Commission does not believe that it would be appropriate for
margin requirements for uncleared swaps to be offset by netting other
products or exposures across markets against other products that may
present different concerns about safety and soundness or financial
stability, or that are not subject to similar associated margin
requirements. Such treatment appears inconsistent with the purposes of
the Dodd-Frank Act.
E. Calculation of Initial Margin
1. Overview
a. Proposal
Under the proposed rules, a CSE could calculate initial margin
using either a model-based method or a standardized table-based
method.\140\ The required amount of initial margin would be the amount
computed pursuant to either an internal model or the table minus an
initial margin threshold amount of $65 million.\141\ In the proposal,
the initial margin threshold was calculated on a consolidated basis
(i.e. including all of the entity's affiliates). This amount
[[Page 652]]
could not be less than zero.\142\ The initial margin specified under
the proposal would be a minimum requirement, and the parties would have
been free to require more initial margin. To ease the transaction costs
associated with the exchange of margin, the Commission also proposed a
minimum transfer amount of $650,000.\143\
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\140\ Proposed Sec. 23.154.
\141\ Proposed Sec. 23.151, definition of ``initial margin
threshold amount.''
\142\ Proposed Sec. 23.154(a)(4).
\143\ Proposed Sec. 23.151.
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b. Comments
A few commenters urged that the threshold should be set for
individual legal entities within a group instead of at the group
level,\144\ while at least one commenter expressed support for applying
the threshold to the larger consolidated group.\145\ One commenter
argued that firms should be required to disclose their aggregate
uncollateralized exposures from use of the initial margin threshold as
well as allocation of the threshold across counterparties, including
affiliated counterparties.\146\ The same commenter also argued that the
full amount of gross initial margin should be exchanged, and asked for
increased disclosure requirements regarding uncollateralized exposures
(e.g., exposures that fall below the initial margin threshold).
---------------------------------------------------------------------------
\144\ CEWG; BP; Shell TRM; ISDA; Sifma AMG.
\145\ Public Citizen.
\146\ CME.
---------------------------------------------------------------------------
Commenters also suggested that the minimum transfer amount should
apply separately to initial and variation margin.\147\ A commenter also
urged the Commission to revisit the amounts periodically to ensure
international consistency.\148\ Another commenter suggested that
entities for which the U.S. Dollar is not the common or transacting
currency or whose payment obligations are in another currency should be
allowed to use an average exchange rate between the U.S. Dollar and the
foreign currency for calculating thresholds.\149\ One commenter also
suggested that the Commission allow the counterparties to set a minimum
transfer amount below $650,000.\150\ Another commenter requested
confirmation that the rule allows a minimum transfer amount but does
not require it.
---------------------------------------------------------------------------
\147\ See ISDA; JBA; Sifma.
\148\ See Sifma.
\149\ See ICI.
\150\ See Shell TRM.
---------------------------------------------------------------------------
Commenters also asked for separate treatment of various
arrangements under which the assets of a single investment fund or
pension plan are treated as separate portfolios or accounts, each
assigned some portion of the fund's or plan's total assets for purposes
of managing them pursuant to different investment strategies or by
different investment managers as agent for the fund or plan.\151\
Commenters said these ``separate accounts'' are generally managed under
documentation that caps the asset manager's ability to incur
liabilities on behalf of the fund or plan at the amount of the assets
allocated to the account.
---------------------------------------------------------------------------
\151\ One industry group commenter also cited as an example a
securitization vehicle that creates separate issuances of asset-
backed securities through use of a series trust.
---------------------------------------------------------------------------
c. Discussion
As an initial matter, the final rules allow CSEs to choose between
model-based and table-based initial margin calculations. The Commission
expects that some CSEs may choose to adopt a mix of internal models and
standardized approaches to calculating initial margin requirements. For
example, it may be the case that a CSE engages in some swap
transactions on an infrequent basis to meet client demands but the
level of activity does not warrant all of the costs associated with
building, maintaining, and overseeing a quantitative initial margin
model. Further, some CSE clients may value the transparency and
simplicity of the standardized approach. In such cases, the Commission
expects that it would be acceptable to use the standardized approach to
margin such swaps.
Under certain circumstances it may be appropriate to employ both a
model based and standardized approach to calculating initial margins.
At the same time, the Commission is aware that differences between the
standardized approach and internal model based margins across different
types of swaps could be used to ``cherry pick'' the method that results
in the lowest margin requirement. Rather, the choice to use one method
over the other should be based on fundamental considerations apart from
which method produces the most favorable margin results. Similarly, the
Commission does not anticipate there should be a need for CSEs to
switch between the standardized or model-based margin methods for a
particular counterparty, absent a significant change in the nature of
the entity's swap activities. The Commission expects CSEs to provide a
rationale for changing methodologies if requested. The Commission will
monitor for evasion of the swap margin requirements through selective
application of the model and standardized approach as a means of
lowering the margin requirements.
The final rule does not require a CSE to collect or to post initial
margin collateral to the extent that the aggregate un-margined exposure
either to or from its counterparty remains below $50 million.\152\ In
this regard, the final rule is generally consistent with the 2013
international framework and the 2014 proposal. The initial margin
threshold amount of $50 million has been adjusted relative to the $65
million threshold in the proposed rule in the manner described below.
---------------------------------------------------------------------------
\152\ Sec. 23.151, definition of ``initial margin threshold
amount.''
---------------------------------------------------------------------------
The Commission believes that allowing CSEs to apply initial margin
thresholds of up to $50 million is consistent with the rule's risk-
based approach, as it will provide relief to counterparties, while
ensuring that initial margin is collected from those counterparties
with exposure over the threshold, which could pose greater systemic
risk to the financial system. The initial margin threshold also should
serve to reduce the aggregate amount of initial margin collateral
required by the final rule.
Under the final rule, the initial margin threshold applies on a
consolidated entity level. It will be calculated across all non-
exempted \153\ uncleared swaps between a CSE and its affiliates and the
counterparty and the counterparty's affiliates.\154\ The requirement to
apply the threshold on a fully consolidated basis applies to both the
counterparty to which the threshold is being extended and the
counterparty that is extending the threshold. Applying this threshold
on a consolidated entity level precludes the possibility that CSEs and
their counterparties could create legal entities and netting sets that
have no economic basis and are constructed solely for the purpose of
applying additional thresholds to evade margin requirements.
---------------------------------------------------------------------------
\153\ To the extent that an uncleared swap transaction is exempt
from the margin requirements pursuant to Sec. 23.150(b), consistent
with TRIPRA, the interim final rule excludes the exempted swap
transaction from the calculation of the initial margin threshold
amount.
\154\ The threshold may be allocated among entities within the
consolidated group, at the agreement of the CSE and the
counterparties, but the total must remain below $50 million on a
combined basis. For an example illustrating allocations, see the
2014 proposal.
---------------------------------------------------------------------------
Although some commenters suggested the Commission should not
implement the threshold across the CSE and counterparties on a
consolidated basis, and instead rely on general anti-evasion authority
to address efforts to exploit the threshold, the Commission has not
done so. The revisions to the affiliate and subsidiary definitions in
the final
[[Page 653]]
rule, described above, simplify implementation of the consolidated
approach and should help address some of the concerns raised by
commenters in this respect.
The Commission notes that the threshold represents a minimum
requirement and should not be viewed as preventing parties from
contracting with each other to require the collection of initial margin
at a lower threshold, using the same method as set forth in the final
rule. For such transactions, the Commission expects CSEs to make their
own internal credit assessments when making determinations as to the
credit and other risks presented by their specific counterparties.
Therefore, a CSE dealing with a counterparty it judges to be of high
credit quality may determine that a counterparty-specific threshold of
up to $50 million is appropriate.
In response to commenters, and to clarify the Commission's intent,
the Commission notes that the $50 million threshold is measured as the
amount of initial margin for the relevant portfolio of uncleared swaps
pursuant to either the internal model or standardized initial margin
table used by the CSE.\155\ The Commission has not incorporated
suggestions by a commenter that the Commission permit the threshold to
be calculated in foreign currencies. Conversion to USD can be readily
accomplished and provides a measure of relative consistency in
application from counterparty to counterparty within and across CSEs.
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\155\ Although one commenter urged the Commission to require
CSEs to make granular disclosures about the use of the $65 million
threshold to their investors, credit providers, and the central
counterparties of which the CSE is a member, the suggestion is
beyond the scope of this margin rulemaking. The Commission notes the
final rule does not prohibit a CSE from providing this information,
should it wish to negotiate that arrangement with an interested
party.
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In addition, the Commission has not incorporated suggestions by
commenters for separate treatment of various arrangements under which
the assets of a single investment fund vehicle or pension plan are
treated as separate portfolios or accounts, each assigned some portion
of the fund's or plan's total assets for purposes of managing them
pursuant to different investment strategies or by different investment
managers as agent for the fund or plan.\156\ Commenters said these
``separate accounts'' are generally managed under documentation that
caps the asset manager's ability to incur liabilities on behalf of the
fund or plan at the amount of the assets allocated to the account.
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\156\ One industry group commenter also cited as an example a
securitization vehicle that creates separate issuances of asset-
backed securities through use of a series trust.
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While the Commission recognizes these types of asset management
approaches are well-established industry practice, and that separate
managers acting for the same fund or plan do not currently take steps
to inform the fund or plan of their uncleared swap exposures on behalf
of their principal on a frequent basis, the Commission is not persuaded
that it would be appropriate to extend each separate account its own
initial margin threshold. Based on the comments, it appears the
liability cap on each account manager often will be reflected in the
fund's or plan's contract with the manager. If one manager breaches its
limit, there could be cross-default implications for other managed
accounts, and in periods of market stress, the cumulative effect of
multiple managers' uncleared swaps could, in turn, strain the fund or
plan's resources. Because all the swaps are transacted on behalf of a
single legal principal, the Commission does not believe that the
subdivision of these separately managed accounts is sufficient to merit
the extension of separate thresholds.\157\ Nevertheless, the Commission
expects that in most cases, two separate investment funds of a single
asset manager would not be consolidated under the relevant accounting
standards and thus would not be affiliates under this rule.
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\157\ Some commenters expressing this concern made the same
point with respect to application of the material swaps exposure
threshold, which is also calculated on a legal entity basis. The
Commission has the same reservations about subdividing the material
swaps exposure test at the managed account level, and these
reservations are even somewhat compounded given that the Commission
has revised the threshold to $8 billion in reflection of the
financial end user's overall market exposure, instead of a CSE-
specific exposure.
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The final rule provides for a minimum transfer amount for the
collection and posting of margin by CSEs. The final rule does not
require a CSE to collect or post margin from or to any individual
counterparty unless and until the combined amount of initial and
variation margin that must be collected or posted under the final rule,
but has not yet been exchanged with the counterparty, is greater than
$500,000.\158\ This minimum transfer amount is consistent with the 2013
international framework and has been adjusted relative to the amount
that appeared in the proposal in the manner described below.
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\158\ See Sec. 23.151 of the final rule. The minimum transfer
amount only affects the timing of margin collection; it does not
change the amount of margin that must be collected once the $500,000
threshold is crossed. For example, if the margin amount due from (or
to) the counterparty were to increase from $500,000 to $800,000, the
CSE would be required to collect the entire $800,000 (subject to
application of any applicable initial margin threshold amount).
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The final rule has been modified from the proposal to make clear
that the minimum transfer amount applies to the combined amount of
initial and variation margin. The Commission believes that the
proposal's minimum transfer amount of $500,000 is appropriately sized
to generally alleviate the operational burdens associated with making
de minimis margin transfers and that the amount applies to both initial
and variation margin transfers on a combined basis. The Commission also
confirms that the minimum transfer amount is allowed but not required
under the final rule, and parties are free to collect and post margin
below that amount.
2. Models
As in the proposed rule, the final rule adopts an approach whereby
CSEs may calculate initial margin requirements using an approved
initial margin model. As in the case of the proposal, the final rule
also requires that the initial margin amount be set equal to a model's
calculation of the potential future exposure of the uncleared swap
consistent with a one-tailed 99 percent confidence level over a 10-day
close-out period. More specifically, under the final rule, initial
margin models must capture all of the material risks that affect the
uncleared swap including material non-linear price characteristics of
the swap.\159\
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\159\ See Sec. 23.154(b)(2) of the final rule. An exception to
this requirement has been made in the specific case of cross-
currency swaps. In a cross-currency swap, one party exchanges with
another party principal and interest rate payments in one currency
for principal and interest rate payments in another currency, and
the exchange of principal occurs upon the inception of the swap,
with a reversal of the exchange of principal at a later date that is
agreed upon at the inception of the swap.
Under the final rule, an initial margin model need not recognize
any risks or risk factors associated with the foreign exchange
transactions associated with the fixed exchange of principal
embedded in a cross-currency swap as defined in Sec. 23.151 of the
final rule. The initial margin model must recognize all risks and
risk factors associated with all other payments and cash flows that
occur during the life of the cross-currency swap. In the context of
the standardized margin approach, described further below, the gross
initial margin rates have been set equal to those for interest rate
swaps. This treatment recognizes that cross-currency swaps are
subject to risks arising from fluctuations in interest rates but
does not recognize any risks associated with the fixed exchange of
principal since principal is typically not exchanged on interest
rate swaps.
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For example, the initial margin calculation for a swap that is an
option on an underlying asset, such as an option on a credit default
swap contract, would be required to capture material
[[Page 654]]
non-linearities arising from changes in the price of the underlying
asset or changes in its volatility. Moreover, the margin calculations
for derivatives in distinct product-based asset classes, such as equity
and credit, must be performed separately without regard to derivatives
contracts in other asset classes. Each derivative contract must be
assigned to a single asset class in accordance with the classifications
presented in the final rule (i.e., foreign exchange or interest rate,
commodity, credit, and equity). The presence of any common risks or
risk factors across asset classes cannot be recognized for initial
margin purposes.
The Commission's belief is that these modeling standards should
ensure a strong initial margin regime for uncleared swaps that
sufficiently limits systemic risk and reduces potential counterparty
exposures.
a. Commission Approval
The proposal required CSEs to obtain the written approval of the
Commission before using a model to calculate initial margin.\160\ The
CSE would have to demonstrate that the model satisfied all of the
requirements of this section on an ongoing basis.\161\ In addition, a
CSE would have to notify the Commission in writing before extending the
use of a model that has been approved for one or more types of products
to any additional product types, making any change to any initial
margin model that has been approved that would result in a material
change in the CSE's assessment of initial margin requirements, or
making any material change to assumptions used in an approved
model.\162\ The Commission could rescind its approval of a model if the
Commission determined that the model no longer complied with this
section.\163\
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\160\ Proposed Sec. 23.154(b)(1). See BCBS/IOSCO Report at 12:
``any quantitative model that is used for initial margin purposes
must be approved by the relevant supervisory authority.''
\161\ Id.
\162\ Proposed Sec. 23.154(b)(1).
\163\ Id.
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(i) Comments
While one commenter disapproved of the use of proprietary initial
margin models,\164\ several commenters supported the use of either a
proprietary \165\ or a standardized (developed by the industry) initial
margin model.\166\ One commenter urged the Commission to recognize a
model that has been approved by other regulators, including foreign
authorities in jurisdictions with margin requirements consistent with
the 2013 international standards.\167\ Another commenter suggested that
the Commission provide more information regarding the process for model
approval.\168\
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\164\ See AFR (supporting instead the adoption of a unified
modeling capacity within the regulatory community).
\165\ See Barnard; SIFMA; GPC (cautioning that initial margin
models must be consistent with commonly accepted market practice and
should be open for review by market participants).
\166\ See CPFM; Sifma; MetLife; Freddie; AFR.
\167\ See IFM.
\168\ See JBA (asking the Commission to provide information
regarding the data and documents necessary to the process, and also
the timeline for the submissions); see also Shell TRM (urging the
Commission to adopt a process for provisional approval of models).
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(ii) Discussion
Under the final regulations, all initial margin models must be
approved before being used for margin calculation purposes. In the
event that a model is not approved, initial margin calculations would
have to be performed according to the standardized initial margin
approach that is detailed in Regulation 23.154(c) and discussed below.
Given the number of SDs and the likely complexity of the models,
the Commission is concerned that, with its limited resources, it might
not be able to review models as thoroughly and expeditiously as it
would like. Accordingly, the Commission has determined to amend the
final rules to provide that a CSE may use a model approved by a
registered futures association (``RFA'') or the Commission. Currently,
the National Futures Association (``NFA'') is the only RFA.
As an RFA, NFA is required to establish minimum capital and other
financial requirements applicable to its members that are at least as
stringent as the capital and financial requirements imposed by the
Commission. This requirement to establish financial requirements
extends to SD and MSP margin requirements for uncleared swap
transactions.
The Commission anticipates that NFA margin rules will recognize the
use of models, and that the minimum requirements for such models,
including the quantitative and qualitative requirements of the models,
are the same as, or more stringent than, the requirements set forth in
final Sec. 23.154. Accordingly, final Sec. 23.154 provides that an SD
or MSP may use models to compute initial margin requirements if such
models have been approved by NFA.
Given that CSEs may engage in highly specialized and complex swap
dealing activity, it is expected that specific initial margin models
may vary across CSEs. Accordingly, the specific analyses that will be
undertaken in the context of any single model review may have to be
tailored to the specific swap dealing activity of the CSE. Initial
margin models will also undergo periodic reviews to ensure that they
remain compliant with the requirements of the rule and are consistent
with existing best practices over time.
Given the complexity and diverse nature of uncleared swaps, it is
expected that CSEs may choose to make use of vendor-supplied products
and services in developing their own initial margin models. The final
rule does not place any limitations or restrictions on the use of
vendor-supplied model components such as specific data feeds, computing
environments, or calculation engines beyond those requirements that
must be satisfied by any initial margin model. In particular, the
Commission will conduct a holistic review of the entire initial margin
model and assess whether the entire model and related inputs and
processes meet the requirements of the final rule.\169\
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\169\ The Commission expects that NFA will conduct a similar
process for the models it reviews.
---------------------------------------------------------------------------
To the extent that a CSE uses vendor-supplied inputs in conjunction
with its own internal inputs and processes, the model approval decision
will apply to the specific initial margin model used by a CSE and not
to a generally available vendor-supplied model. To the extent that one
or more vendors provide models or model-related inputs (e.g.,
calculation engines) that, in conjunction with the CSEs' own internal
methods and processes, are part of an approved initial margin model,
the Commission may also approve those vendor models and model-related
inputs for use by other CSEs though that determination will be made on
a case-by-case basis depending on the entirety of the processes that
are employed in the application of the vendor-supplied inputs and
models by a CSE.
In many instances, CSEs whose margin models would be subject to
Commission or RFA review would be affiliates of entities whose margin
models would be subject to review by one of the Prudential Regulators.
In such situations, the Commission or the RFA would coordinate with the
Prudential Regulators in order to avoid duplicative efforts and to
provide expedited approval of Prudential Regulator approved
models.\170\ For
[[Page 655]]
example, if a Prudential Regulator had approved a model of an insured
depository institution registered as an SD, Commission or RFA review of
a comparable model used by its non-bank affiliate would be greatly
facilitated. Similarly, the Commission or the RFA would coordinate with
the SEC for CSEs that are dually registered and would coordinate with
foreign regulators that had approved margin models for foreign CSEs.
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\170\ Whether an initial margin model has obtained a Prudential
Regulators approval will be given a significant weight in
determining whether the model meets the Commission's standards.
---------------------------------------------------------------------------
The provision permitting a CSE to use a model approved by an RFA is
a point of distinction between the Commission's rules and those of the
Prudential Regulators. The Prudential Regulators do not have a
comparable rule.
b. Applicability to Multiple Swaps
(i) Proposal
The proposal provided that to the extent more than one uncleared
swap is executed pursuant to an EMNA \171\ between a CSE and a covered
counterparty, the CSE would be permitted to calculate initial margin on
an aggregate basis with respect to all uncleared swaps governed by such
agreement.\172\ However, only exposures in certain asset classes could
be offset. If the agreement covered uncleared swaps entered into before
the applicable compliance date, those swaps would have to be included
in the calculation.\173\
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\171\ This term is defined in proposed Sec. 23.151.
\172\ Proposed Sec. 23.154(b)(2).
\173\ Id.
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The proposal defined EMNA as any written, legally enforceable
netting agreement that creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default (including receivership, insolvency, liquidation, or similar
proceeding) provided that certain conditions are met. These conditions
include requirements with respect to the CSE's right to terminate the
contract and to liquidate collateral and certain standards with respect
to legal review of the agreement to ensure that it meets the criteria
in the definition.
(ii) Comments
A number of commenters requested that the Commission remove the
``suspends or conditions payment'' language.\174\ These commenters
argued that this provision would be inconsistent with the ISDA Master
Agreement which allows a non-defaulting counterparty to suspend payment
to a defaulting counterparty.\175\
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\174\ ACLI; FSR; Freddie; ISDA; MetLife; Sifma AMG; Sifma; and
Vanguard.
\175\ One commenter urged the Commission not to ``outsource''
the EMNA definition to ISDA, noting that the vast majority of
existing master netting agreements are governed by the ISDA Master
Agreement. The commenter argued that the ISDA Master Agreement
contains provisions that may be contrary to the interests of
counterparties other than ISDA's large swap entity members, such as
mandatory arbitration covenants. See Better Markets. So long as an
agreement meets the requirements of the EMNA definition, however,
the Commission is not endorsing, requiring. or prohibiting use of a
particular master netting agreement in the final rule.
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A few commenters urged the Commission to align its definition with
that of the Prudential Regulators,\176\ while others argued that ISDA
master agreements should qualify as ENMAs.\177\ One commenter supported
the use of netting agreements,\178\ while others cautioned that
entities operating in jurisdictions where netting is not enforceable
may be penalized by having to put up a greater amount of
collateral.\179\
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\176\ See Sifma; FHLB.
\177\ See ETA; Joint Associations; NGSA/NGCA.
\178\ See Barnard.
\179\ See JFMC. See also ISDA (suggesting netting restrictions
on posting variation margin (where restricted by law for example) to
non-netting counterparties).
---------------------------------------------------------------------------
Commenters generally expressed support for the recognition of
foreign stays in the proposal's definition of ENMA.\180\ A few
commenters argued that a limited stay under State insolvency and
receivership laws applicable to insurance companies also should be
recognized under this provision.\181\ Some commenters also argued for
permitting appropriate contractual stays.\182\
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\180\ AIMA; ICI; SIFMA. However, at least one commenter
expressed concern that allowing for foreign jurisdiction and
contractual stays could limit important bankruptcy protections for
commercial end users and argued that the rule should recognize and
clearly state that market participants' rights to avoid stays and
other limitations of their close-out rights should be protected.
CEWG.
\181\ See ACLI; MetLife.
\182\ See ISDA; Sifma AMG (a party should be allowed to suspend
ongoing performance where an event of default or potential event of
default has occurred and is continuing); AFR (upon the default of a
party, the non-defaulting party should be allowed to enter into a
limited contractual stay and suspend payment obligation to the
defaulting party according to the process set forth in the ISDA 2014
Resolution Stay Protocol).
---------------------------------------------------------------------------
A number of commenters expressed various concerns with the
provision of the EMNA that requires a CSE to conduct sufficient legal
review to conclude with a well-founded basis (and maintains sufficient
written documentation of that legal review) that the agreement meets
the requirements with respect to the CSE's right to terminate the
contract and liquidate collateral and that in the event of a legal
challenge (including one resulting from default or from receivership,
insolvency, liquidation, or similar proceeding), the relevant court and
administrative authorities would find the agreement to be legal, valid,
binding, and enforceable under the law of the relevant
jurisdictions.\183\ These commenters urged that requiring a legal
opinion would be expensive and may not be able to be given without
qualification, meaning parties can never be certain that a contract is
enforceable.\184\ Some of these commenters recommended removing the
requirement that the ENMA be enforceable in multiple jurisdictions
since it would be legally impractical.\185\
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\183\ One commenter, for example, urged ``would'' should be
changed to ``should'' as ``would'' is difficult to satisfy in
bankruptcy courts making it difficult to state with certainty. CEWG.
\184\ ACLI; GPC; ICI; JBA; Sifma AMG; see also CEWG.
\185\ See GPC; Sifma AMG.
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(iii) Discussion
The final rule defines an EMNA to be any written, legally
enforceable netting agreement that creates a single legal obligation
for all individual transactions covered by the agreement upon an event
of default (including receivership, insolvency, liquidation, or similar
proceeding) provided that certain conditions are met.\186\ These
conditions include requirements with respect to the CSE's right to
terminate the contract and liquidate collateral and certain standards
with respect to legal review of the agreement to ensure it meets the
criteria in the definition. The legal review must be sufficient so that
the CSE may conclude with a well-founded basis that, among other
things, the contract would be found legal, binding, and enforceable
under the law of the relevant jurisdiction and that the contract meets
the other requirements of the definition.
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\186\ This definition of ENMA aligns with the recently adopted
definition of a ``qualifying master netting agreement'' for bank
regulatory capital purposes and the Prudential Regulators' margin
requirements. See Regulatory Capital Rules, Liquidity Coverage
Ratio: Interim Final Revisions to the Definition of Qualifying
Master Netting Agreement and Related Definitions, 79 FR 78287 (Dec.
30, 2014).
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The EMNA definition includes a requirement that the agreement not
include a walkaway clause, which is defined as a provision that permits
a non-defaulting counterparty to make a lower payment than it otherwise
would make under the agreement, or no payment at all, to a defaulter or
the estate of a defaulter, even if the defaulter or the estate of the
defaulter is a net creditor under the agreement.
[[Page 656]]
The proposed EMNA definition included additional language in the
definition of walkaway clause that would expressly preclude an EMNA
from including a clause that permits a non-defaulting counterparty to
``suspend or condition payment'' to a defaulter or the estate of a
defaulter, even if the defaulter or the estate of the defaulter is or
otherwise would be, a net creditor under the agreement. This additional
language is not being included in the final rule's definition of EMNA.
Therefore, the commenters' concerns regarding the impact of the
additional proposed language on current provisions of the ISDA Master
Agreement are moot.
Like the proposal, the final rule's definition of EMNA contains a
stay condition regarding certain insolvency regimes where rights can be
stayed. In particular, the second clause of this condition has been
modified to provide that any exercise of rights under the agreement
will not be stayed or avoided under applicable law in the relevant
jurisdictions, other than (i) in receivership, conservatorship, or
resolution by a Prudential Regulator exercising its statutory
authority, or substantially similar laws in foreign jurisdictions that
provide for limited stays to facilitate the orderly resolution of
financial institutions, or (ii) in an agreement subject by its terms to
any of the foregoing laws.\187\
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\187\ See Sec. 23.151.
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The Commission did not modify the final rule's definition of EMNA
to recognize stays under State insolvency and receivership laws for
insurance companies. The Commission believes that other changes to the
rule should help address these concerns as explained further below.
The Commission did not modify the provision relating to the legal
enforceability of the EMNA definition in the final rule. The Commission
believes that the legal review must be sufficient so that the CSE may
conclude with a well-founded basis that, among other things, the
contract would be found legal, binding, and enforceable under the law
of the relevant jurisdiction and that the contract meets the other
requirements of the definition. In some cases, the legal review
requirement could be met by reasoned reliance on a commissioned legal
opinion or an in-house counsel analysis. In other cases, for example,
those involving certain new derivative transactions or derivative
counterparties in jurisdictions where a CSE has little experience, the
CSE would be expected to obtain an explicit, written legal opinion from
external or internal legal counsel addressing the particular situation.
The rules set an outcome-based standard for a review that is sufficient
so that an institution may conclude with a well-founded basis that,
among other things, the contract would be found legal, binding, and
enforceable under the law of the relevant jurisdiction and that the
contract meets the other requirements of the definition.
The Commission recognizes that there may be certain jurisdictions
where a netting arrangement may not be enforceable; the Commission will
address this issue in its final rule on the application of margin rule
to cross-border transactions.
c. Elements of a Model
The final rule specifies a number of conditions that a model would
have to meet to receive Commission approval.\188\ These conditions
relate to the technical aspects of the model as well as broader
oversight and governance standards. They include, among others, the
following.
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\188\ Proposed Sec. 23.154(b)(3).
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(i) Ten-Day Close-Out Period
Under the proposal, the model must calculate potential future
exposure using a one-tailed 99 percent confidence interval for an
increase in the value of the uncleared swap or netting set of uncleared
swaps due to an instantaneous price shock that is equivalent to a
movement in all material underlying risk factors, including prices,
rates, and spreads, over a holding period equal to the shorter of ten
business days or the maturity of the swap.
The Commission received a number of comments concerning the length
of the assumed close-out period used in the initial margin
calculations. Commenters suggested that ten days was too long and
suggested that a close-out period of three to five days was adequate to
ensure sufficient time to close out or hedge a defaulting
counterparty's swap contract.\189\ Another commenter suggested that a
ten day close out period was too short and that the resulting initial
margins would not always be larger and more conservative than initial
margins charged on cleared swaps.\190\ The same commenter also argued
that the Commission should require an ex-post 99% initial margin
coverage and not simply a 99% confidence level sampling to better
reflect the liquidity and risk profile of the uncleared markets and to
retain incentives to promote central clearing. One commenter argued
that mandating a 10 day close out period for all swaps is not
sufficiently risk-sensitive as the approach fails to take into account
the liquidity of any particular swap.\191\ Another commenter argued for
allowing market participants to determine appropriate market-based
liquidation periods.\192\ Two commenters supported the 10-day holding
period.\193\
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\189\ Pension Coalition. See also CCMR (10 day horizon is not
risk-adjusted and the horizon should be set according to the type of
swap); ISDA (liquidity horizon should be consistent with
requirements in other jurisdictions); Sifma AMG (the horizon should
be closer to 5 days).
\190\ CME.
\191\ See CCMR.
\192\ See NERA.
\193\ See Public Citizen; AFR.
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Since uncleared swaps are expected to be less liquid than cleared
swaps, the final rule specifies a minimum close-out period for the
initial margin model of 10 business days, compared with a typical
requirement of 3 to 5 business days used by central counterparties
(CCPs).\194\ Accordingly, to the extent that uncleared swaps are
expected to be less liquid than cleared swaps and to the extent that
related capital rules which also mitigate counterparty credit risk
similarly require a 10-day close-out period assumption, the
Commission's view is that a 10-day close-out period assumption for
margin purposes is appropriate.\195\
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\194\ See Sec. 23.154(b)(2)(i) of the final rule.
\195\ In cases where a swap has a remaining maturity of less
than 10 days, the remaining maturity of the swap, rather than 10
days, may be used as the close-out period in the margin model
calculation.
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At the same time, the Commission is aware that it may not be the
case that the regulatory minimum required initial margin on an
uncleared swap will always be larger than the initial margin required
on any related cleared swap as margining practices vary among DCOs. In
some cases, they may exceed minimum required margin levels due to the
specific risk of the swap in question and the margining practices of
the DCO. Moreover, given the complexity and diversity of the uncleared
swap market, the Commission believes that it is not possible and
unnecessary to prescribe a specific and different close-out horizon for
each type of uncleared swap that may exist in the marketplace. The
Commission does believe that it is appropriate for a CSE to use a
close-out period longer than ten-days in those circumstances in which
the specific risk of the swap indicates that doing so is prudent. In
terms of specifying a regulatory minimum requirement, however, the
Commission believes that a ten-day close-out period is sufficiently
[[Page 657]]
long to generally guard against the heightened risk of less liquid,
uncleared swaps.
Under the final rule, the initial margin model calculation must be
performed directly over a 10-day period. In the context of bank
regulatory capital rules, a long horizon calculation (such as 10 days),
under certain circumstances, may be indirectly computed by making a
calculation over a shorter horizon (such as 1 day) and then scaling the
result of the shorter horizon calculation to be consistent with the
longer horizon. The rule does not provide this option to CSEs using an
approved initial margin model. The Commission's view is that the
rationale for allowing such indirect calculations that rely on scaling
shorter horizon calculations has largely been based on computational
and cost considerations that were material in the past but are much
less so in light of advances in computational speeds and reduced
computing costs. Moreover, the Commission believes that the more
accurate approach would be to use the 10 day period rather than the
scaling approach. Therefore, as a result of the less burdensome
calculations, the Commission is retaining this requirement.
(ii) Portfolio Offsets
Under the proposal, an initial margin model may reflect offsetting
exposures, diversification, and other hedging benefits for uncleared
swaps that are governed by the same EMNA by incorporating empirical
correlations within the broad risk categories, provided the CSE
validates and demonstrates the reasonableness of its process for
modeling and measuring hedging benefits. Under the proposal, the
categories were agriculture, credit, energy, equity, foreign exchange/
interest rate, metals, and other. Empirical correlations under an
eligible master netting agreement could be recognized by the model
within each broad risk category, but not across broad risk categories.
In the proposal, the sum of the initial margins calculated for each
broad risk category would be used to determine the aggregate initial
margin due from the counterparty.
The Commission received comments on a range of issues that broadly
relate to the recognition of portfolio risk offsets.
One commenter requested that the rule specify only a single
commodity asset class rather than the four separate asset classes that
were set forth in the proposal (agricultural commodities, energy
commodities, metal commodities and other commodities).\196\ Another
commenter suggested that the margin requirements should be more
reflective of risk offsets that exist between disparate asset classes
such as equity and commodities.\197\
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\196\ See Sifma (Bentsen) (suggesting that there are significant
and relatively stable correlations across related commodity
categories that should not be ignored for hedging and margining
purposes; commodity index swaps are a significant source of
uncleared commodity swap activity and these swaps are a significant
source of uncleared commodity swap activity and comprise exposures
to each of the four commodity sub-asset classes that were
identified; implementing the proposal's four separate sub-asset
classes would not be appropriately risk sensitive and would be
difficult and burdensome to implement for a significant class of
commodity swaps); see also ISDA (all commodities should be one asset
class as would be consistent with the 2013 international framework).
\197\ Sifma AMG
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Many commenters generally argued for allowing a broader set of
offsets. Some commenters suggested that for the purposes of calculating
model-based initial margin amounts portfolio offsets should be
recognized between uncleared swaps, cleared swaps, and other products
such as positions in securities or futures.\198\ Some commenters
promoted a ``risk factor based'' approach and suggested that initial
margin models should allow for offsets across risk factors even if
these risk factors are present in uncleared swaps across multiple asset
classes such as equity and credit.\199\
---------------------------------------------------------------------------
\198\ CCMR; GPC; CEWG; Sifma; MFA; Sifma AMG (offsets should be
allowed for risk across all instruments and asset classes subject to
the same master netting agreement so long as there is sound
theoretical basis and significant empirical support); IECA and BP
(netting should be allowed across swaps and physical commodity
forward transactions entered pursuant to an ISDA master agreement
with physical annexes).
\199\ See ISDA (some assets may be classified as swaps in one
jurisdiction but as some other type of financial instrument in
another jurisdiction); Sifma; JBA.
---------------------------------------------------------------------------
For example, the commenters stated that both an equity swap and a
credit swap may be exposed to some amount of interest rate risk. The
commenters suggested that the interest rate risk inherent in the equity
and credit swaps should be recognized on a portfolio basis so that any
offsetting interest rate exposure across the two swaps could be
recognized in the initial margin model. This approach would effectively
require that all uncleared swaps be described in terms of a number of
``risk factors'' and the initial margin model would consider the
exposure to each risk factor separately. The initial margin amount
required on a portfolio of uncleared swaps would then be computed as
the sum of the amounts required for each risk factor.
This ``risk factor'' based approach described above is different
from the Commission's proposal. Under the proposal, initial margin on a
portfolio of uncleared swaps was calculated on a product-level basis.
In terms of the above example, initial margin would have been
calculated separately for the equity swap and calculated separately for
the credit swap. In the case of both the equity and credit swap,
interest rate risk in the swap would have been modeled and measured
without regard to the interest rate exposure of the other swap. The
total initial margin requirement would have been the sum of the initial
margin requirement for the equity swap and the credit swap.
Accordingly, no offset would have been recognized between any
potentially offsetting interest rate exposure in the equity and credit
swap.
The final rule permits a CSE to use an internal initial margin
model that reflects offsetting exposures, diversification, and other
hedging benefits within four broad risk categories: Credit, equity,
foreign exchange and interest rates (considered together as a single
asset class), and commodities when calculating initial margin for a
particular counterparty if the uncleared swaps are executed under the
same EMNA.\200\
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\200\ See final rule Sec. 23.154(b)(2)(v).
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The rule no longer divides commodities into smaller asset classes.
The Commission has decided to group all uncleared commodity swaps into
a single asset class for initial margin calculation purposes. The
Commission believes that there is enough commonality across different
commodity categories to warrant recognition of conceptually sound and
empirically justified risk offsets. Moreover, the Commission notes that
both the proposal and the final rule take a relatively broad view of
the other asset classes: Equity, credit, interest rates and foreign
exchange. In prescribing the granularity of the asset classes there is
a clear trade-off between simplicity and certainty around the stability
of hedging relationships in narrowly defined asset classes and the
greater flexibility and risk sensitivity that is provided by broader
asset class distinctions. Therefore, the Commission has decided to
adopt a commodity asset class definition that is consistent with the
other three asset classes and is appropriate in light of current market
practices and conventions.
The final rule does not permit an initial margin model to reflect
offsetting exposures, diversification, or other hedging benefits across
broad risk
[[Page 658]]
categories.\201\ Hence, the margin calculations for derivatives in
distinct product-based asset classes, such as equity and credit, must
be performed separately without regard to derivatives contracts in
other asset classes. Each derivative contract must be assigned to a
single asset class in accordance with the asset class classification
presented in the standardized minimum gross initial margin requirements
for uncleared swaps. The presence of any common risks or risk factors
across asset classes cannot be recognized for initial margin purposes.
---------------------------------------------------------------------------
\201\ Id.
---------------------------------------------------------------------------
As a specific example, if a CSE entered into two uncleared credit
swaps and two uncleared commodity swaps with a single counterparty
under an EMNA, the CSE could use an approved initial margin model to
perform two separate initial margin calculations: The initial margin
collection amount calculation for the uncleared credit swaps and the
initial margin collection amount calculation for the uncleared
commodity swaps. Each calculation could recognize offsetting and
diversification within the uncleared credit swaps and within the
uncleared commodity swaps. The result of the two separate calculations
would then be summed together to arrive at the total initial margin
collection amount for the four uncleared swaps (two uncleared credit
swaps and two uncleared commodity swaps).
The Commission believes that the qualitative and quantitative basis
for allowing for risk offsets among uncleared swaps within a given, and
relatively broad, asset class such as equities is conceptually stronger
and better supported by historical data and experience than is the
basis for recognizing such offsets across disparate asset classes such
as foreign exchange and commodities. Uncleared swaps that trade within
a given asset class, such as equities, are likely to be subject to
similar market fundamentals and dynamics as the underlying instruments
themselves trade in related markets and represent claims on related
financial assets. In such cases, it is more likely that a stable and
systematic relationship exists that can form the conceptual and
empirical basis for applying risk offsets.
By contrast, uncleared swaps in disparate asset classes such as
foreign exchange and commodities are generally unlikely to be
influenced by similar market fundamentals and dynamics that would
suggest a stable relationship upon which reasonable risk offsets could
be based. Rather, to the extent that empirical data and analysis
suggest some degree of risk offset exists between swaps in disparate
asset classes, this relationship may change unexpectedly over time in
ways that could demonstrably weaken the assumed risk offset.
Accordingly, the Commission has decided to allow for risk offsets that
have a sound conceptual and empirical basis across uncleared swaps
within the broad asset classes as listed in the final rule but not to
allow risk offsets across swaps in differing asset classes.
Moreover, the Commission notes that the final asset class described
above is interest rates and foreign exchange taken as a group.
Accordingly, the final rule will allow conceptually sound and
empirically supported risk offsets between an interest rate swap on a
foreign interest rate and a currency swap in a foreign currency.
The Commission has considered the risk factor based approach
described above and has decided not to adopt that approach, but to
adopt the proposed approach in the final rule for a number of reasons.
First, a product-based approach to calculating initial margin is
clear and transparent. In many market segments it is quite common to
report and measure swap exposures on a product-level basis.\202\ As an
example, the Bank for International Settlements regularly publishes
data on the outstanding notional amounts of OTC derivatives on a
product-level basis. In addition, existing trade repositories, such as
the DTCC global trade repositories for interest rate and credit swaps,
report credit and interest rate derivatives on a product-level basis.
Moreover, a risk factor based approach has the potential to be opaque
and unwieldy. Modern derivative pricing models that are used by banks
and other market participants may employ hundreds of risk factors that
are not standardized across products or models.
---------------------------------------------------------------------------
\202\ http://www.bis.org/statistics/dt1920a.pdf.
---------------------------------------------------------------------------
While it is the case that some swaps may have hybrid features that
make it challenging to assign them to one specific asset class, the
Commission believes that the incidence of this occurrence will be
relatively uncommon and can be dealt with under the final rule. In
particular, as of December 2014, the Bank for International Settlements
reports that of the roughly $630 trillion in gross notional
outstanding, roughly 3.6 percent of these contracts cannot be allocated
to one of the following broad asset categories: Foreign exchange,
interest rate, equity, commodity and credit. The Commission also notes
that this fraction has declined from roughly 6.6 percent in June 2012
which suggests that the challenges associated with such hybrid swaps
are declining over time. In such cases where the allocation of a
particular uncleared swap to a specific asset class is not certain, the
Commission expects an allocation to be made based on whichever broad
asset class represents the preponderance of the uncleared swap's
overall risk profile.
Second, a product-level initial margin model is well aligned with
current practice for cleared swaps. Some clearinghouses that offer
multiple swaps for clearing, such as the CME, do allow for risk offsets
within an asset class but do not generally allow for any risk offsets
across asset classes. Again, as a specific example, the CME offers both
cleared interest rate and credit default swaps. The CME's initial
margin model is a highly sophisticated risk management model that does
allow for offsetting among different credit swaps and among different
interest rate swaps but does not allow for risk offsets between
interest rate and credit swaps. This approach to calculating initial
margin also provides a significant amount of transparency as market
participants, regulators and the public can assess the extent to which
trading activity in specific asset classes generates counterparty
exposures that require initial margin.
To the extent that some risk factors may cut across more than one
asset class, the use of a risk factor-based margining approach would
make evaluating the quantum of risk posed by the trading activity in
any one set of products difficult to measure and manage on a systematic
basis. This would also pose significant challenges to users of
uncleared swaps as well as regulators and the broader public who have
an interest in monitoring and evaluating the risks of different
uncleared swap activities.
Third, the Commission notes that the final rule's product-level
approach to initial margin explicitly allows for risk offsets though
the precise form of these offsets differs from a ``risk factor'' based
approach. The Commission believes that conceptually sound and
empirically justified risk offsets for initial margin are appropriate
and have included such offsets in the final rule. In general, there are
a large number of possible approaches that could be taken to allow for
such offsets. The Commission considered the alternatives raised by the
commenters and adopted in the final rule an approach recognizing risk
offsets that provides for a significant amount of hedging and
diversification benefits while promoting transparency and simplicity in
the margining framework.
[[Page 659]]
Finally, the Commission notes that it may not have the authority to
prescribe margin requirements for all the types of products that may be
included in an ENMA. For example, the Commission's authority to set
margin requirements relates to certain types of swaps and does not
extend to other products such as equity-linked swaps or similar
financial instruments. Accordingly, the Commission believes that the
margin requirements should be reflective of the risks in a CSE's
portfolio of uncleared swaps but may not recognize risks--either as
offsets or sources of additional risk from other products that are
themselves not uncleared swaps and not subject to the margin
requirements of the final rule.
(iii) Stress Calibration and Non-Linear Price Characteristics
The proposed rule required the initial margin model to be
calibrated to a period of financial stress. In addition, the proposal
requires the model to use risk factors sufficient to measure all
material price risks inherent in the transactions for which initial
margin is being calculated. Under the proposal, the initial margin
model would have been required to include all material risks arising
from the nonlinear price characteristics of option positions or
positions with embedded optionality and the sensitivity of the market
value of the positions to changes in the volatility of the underlying
rates, prices, or other material risk factors.
One commenter suggested that the overall level of the proposed
initial margin requirements were too high and that the proposed
requirement to calibrate the initial margin model to a period of
financial stress was too conservative.\203\ Another commenter supported
the stress period calibration requirement.\204\ A third commenter asked
for clarification on the term ``period of financial stress.'' \205\
---------------------------------------------------------------------------
\203\ MetLife
\204\ See AFR.
\205\ See Barnard.
---------------------------------------------------------------------------
Some commenters suggested that the proposal's requirement that the
initial margin model include all material nonlinear price
characteristics in the underlying uncleared swap was too stringent and
should be relaxed,\206\ while one commenter applauded the requirement
to include risk from nonlinearities.\207\ One commenter argued that the
initial margin model should incorporate the cost of liquidating large
portfolios during periods of stress as well as volatility floors to
guarantee a minimum level of volatility assumed.\208\
---------------------------------------------------------------------------
\206\ JBA, ISDA.
\207\ See AFR.
\208\ See CME.
---------------------------------------------------------------------------
As noted, the final rule requires the initial margin model to be
calibrated to a period of financial stress.\209\ In particular, the
initial margin model must employ a stress period calibration for each
broad asset class (commodity, credit, equity, and interest rate and
foreign exchange). The stress period calibration employed for each
broad asset class must be appropriate to the specific asset class in
question. While a common stress period calibration may be appropriate
for some asset classes, a common stress period calibration for all
asset classes would be considered appropriate only if it is appropriate
for each specific underlying asset class. Also, the time period used to
inform the stress period calibration must include at least one year,
but no more than five years of equally-weighted historical data.
---------------------------------------------------------------------------
\209\ See final rule Sec. 23.154(b)(2)(ii).
---------------------------------------------------------------------------
The final rule's requirement is intended to balance the tradeoff
between shorter and longer data spans. Shorter data spans are sensitive
to evolving market conditions but may also overreact to short-term and
idiosyncratic spikes in volatility. Longer data spans are less
sensitive to short-term market developments but may also place too
little emphasis on periods of financial stress, resulting in
insufficient initial margins. The requirement that the data be equally
weighted will establish a degree of consistency in initial margin model
calibration while also ensuring that particular weighting schemes do
not result in excessive initial margin requirements during short-term
bouts of heightened volatility.
Calibration to a stress period helps to ensure that the resulting
initial margin requirement is sufficient in a period of financial
stress during which swap entities and financial end user counterparties
are more likely to default, and counterparties handling a default are
more likely to be under pressure. The stress calibration requirement
also reduces the systemic risk associated with any increase in initial
margin requirements that might occur in response to an abrupt increase
in volatility during a period of financial stress, as initial margin
requirements will already reflect a historical stress event.
The Commission continues to believe that the overall level of the
initial margin requirements is consistent with the goals of prescribing
margin requirements that are appropriate for the risk of uncleared
swaps and the safety and soundness of the CSE. Moreover, the
requirement to calibrate the initial margin model to a period of
financial stress has two important benefits. First, initial margin
requirements that are consistent with a period of financial stress will
help to ensure that counterparties are sufficiently protected against
the type of severe financial stresses that are most likely to have
systemic consequences. Second, calibrating initial margins to a period
of financial stress should have the effect of reducing the extent to
which margin changes increase stress.
Specifically, because initial margin levels will be consistent with
a period of above average market volatility and risk, a moderate rise
in risk levels should not require any increase or re-evaluation of
initial margin levels. In this sense, initial margin requirements will
be less likely to increase abruptly following a market shock. There may
be circumstances in which the financial system experiences a
significant financial stress that is even greater than the stress to
which initial margins have been calibrated. In these cases, initial
margin requirements will rise as margin levels are re-calibrated to be
consistent with the new and greater stress level. The Commission
expects such occurrences to be relatively infrequent and, ultimately,
any risk sensitive and empirically based method for calibrating a risk
model must exhibit some sensitivity to changing financial market risks
and conditions.
The Commission has decided to retain in the final rule the
requirement that initial margin models must include all material
nonlinear risks. The Commission is concerned that the uncleared swap
market will be comprised of a large number of complex and customized
swaps that will display significant nonlinear price characteristics
that will have a direct effect on their risk exposure. If the models
did not take these into account the initial margin amount collected
would be inadequate to cover the swap's or swap portfolio's potential
future exposure. Accordingly, the final rule requires that all material
nonlinear price characteristics of an uncleared swap be considered in
assessing the risk of the swap.
There may be nonlinear price characteristics of a particular
uncleared swap that are not material in assessing its risk profile. In
such cases, these nonlinear price characteristics need not be
explicitly included in the initial margin model. The Commission expects
that in determining whether or not a given nonlinear price
characteristic is
[[Page 660]]
material, CSEs will engage in a holistic review of the uncleared swap's
risk profile and make determinations based on the totality of the
uncleared swap's risks.
(iv) Frequency of Margin Calculation
The proposed rule required daily calculation of initial margin. The
use of an approved initial margin model may result in changes to the
initial margin amount on a daily basis.
One commenter argued that the Commission should follow the approach
of the European Union and require parties to establish procedures for
adjusting initial margin requirements in response to changing market
conditions.\210\ Another commenter sought clarification that the
initial margin calculation under a model would occur once daily based
on the prior day's prices.\211\
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\210\ See Sifma (these procedures allow the counterparties to
post increased margin requirements resulting from the recalibration
of a model over a period longer than one day).
\211\ See MFA (suggesting also that the Commission should modify
the timing of recalculation to focus on the time at which a
collateral taker makes a demand for transfer of collateral and
provide that such transfer must be made promptly following the
demand).
---------------------------------------------------------------------------
The final rule retains the requirement that an approved initial
margin model be used to calculate the required initial margin
collection amount on a daily basis. As discussed below, the Commission
believes that swap portfolios and the variables that are used to
calculate the amount of initial margin on those swaps are constantly
changing. Therefore, to ensure the adequacy of the amount of initial
margin the Commission is requiring daily calculation. In cases where
the initial margin collection amount increases, this new amount must be
used as the basis for determining the amount of initial margin that
must be collected from a financial end user with material swaps
exposure or a swap entity counterparty.
In addition, when a CSE faces a financial end user with material
swaps exposure, the CSE must also calculate the initial margin
collection amount from the perspective of its counterparty on a daily
basis. In the event that this amount increases, the CSE must use this
new amount as the basis for determining the amount of initial margin
that it must post to its counterparty. In cases where this amount
decreases, the new amount would represent the new minimum required
amount of initial margin. Accordingly, any previously collected or
posted collateral in excess of this amount would represent additional
initial margin collateral that, subject to bilateral agreement, could
be returned.
The use of an approved initial margin model may result in changes
to the initial margin collection amount on a daily basis for a number
of reasons. First, the characteristics of the swaps that have a
material effect on their risk may change over time. As an example, the
credit quality of a corporate reference entity upon which a credit
default swap contract is written may undergo a measurable decline. A
decline in the credit quality of the reference entity would be expected
to have a material impact on the initial margin model's risk assessment
and the resulting initial margin collection amount.
More generally, as the swaps' relevant risk characteristics change,
so will the initial margin collection amount. In addition, any change
to the composition of the swap portfolio that results in the addition
or deletion of swaps from the portfolio will result in a change in the
initial margin collection amount.
Second, the underlying parameters and data that are used in the
model may change over time as underlying conditions change. As an
example, in the event that a new period of financial stress is
encountered in one or more asset classes, the initial margin model's
risk assessment of a swap's overall risk may also change. While the
stress period calibration is intended to reduce the extent to which
small or moderate changes in the risk environment influence the initial
margin model's risk assessment, a significant change in the risk
environment that affects the required stress period calibration could
influence the margin model's overall assessment of the risk of a swap.
Third, quantitative initial margin models are expected to be
maintained and refined on a continuous basis to reflect the most
accurate risk assessment possible with available best practices and
methods.\212\ As best practice risk management models and methods
change, so too may the risk assessments of initial margin models.
---------------------------------------------------------------------------
\212\ Section 23.154(b)(iii) of the final rule would require any
material change to the model be communicated to the Commission
before taking effect. The Commission, however, anticipates that some
changes will be made to initial margin models on an ongoing basis
consistent with regular and ongoing maintenance and oversight that
will not require Commission notification.
---------------------------------------------------------------------------
(v) Benchmarking
The proposed rule required a model used for calculating initial
margin requirements to be benchmarked periodically against observable
margin standards to ensure that the initial margin required is not less
than what a CCP would require for similar transactions.\213\
---------------------------------------------------------------------------
\213\ Proposed Sec. 23.154(b)(5).
---------------------------------------------------------------------------
While one commenter supported the benchmarking requirement,\214\
other commenters urged the Commission to remove the benchmarking
requirement, noting the differences between model parameters and the
availability of other risk-mitigating factors at a CSE, such as capital
requirements that are not applicable to DCOs.\215\ Another commenter
suggested that any differences in initial margin requirements for
cleared and uncleared swaps should be limited to the amount necessary
to reflect counterparty credit risk.\216\
---------------------------------------------------------------------------
\214\ See CME.
\215\ See ISDA; Sifma.
\216\ See MetLife.
---------------------------------------------------------------------------
The Commission is retaining the benchmarking requirements. This
benchmarking requirement is intended to ensure that any initial margin
amount produced by a model is subject to a readily observable minimum.
It will also have the effect of limiting the extent to which the use of
models might disadvantage the movement of certain types of swaps to
DCOs by setting lower initial margin amounts for uncleared transactions
than for similar cleared transactions.
d. Control Mechanisms
(i) Proposal
The proposal would have required CSEs to implement certain control
mechanisms.\217\ They include, among others, the following.
---------------------------------------------------------------------------
\217\ Proposed Sec. 23.154(b)(5).
---------------------------------------------------------------------------
The CSE must maintain a risk management unit in accordance with
existing Commission Regulation 23.600(c)(4)(i) that reports directly to
senior management and is independent from the business trading
units.\218\ The unit must validate its model before implementation and
on an ongoing basis. The validation process must include an evaluation
of the conceptual soundness of the model, an ongoing monitoring process
to ensure that the initial margin is not less than what a DCO would
require for similar cleared products, and back testing.
---------------------------------------------------------------------------
\218\ Commission Regulation 23.600 requires each registered SD/
MSP to establish a risk management program that identifies the risks
implicated by the SD/MSP's activities along with the risk tolerance
limits set by the SD/MSP. The SD/MSP should take into account a
variety of risks, including market, credit, liquidity, foreign
currency, legal, operational, settlement, and other applicable
risks. The risks would also include risks posed by affiliates. See
17 CFR 23.600.
---------------------------------------------------------------------------
If the validation process revealed any material problems with the
model, the
[[Page 661]]
CSE would be required to notify the Commission of the problems,
describe to the Commission any remedial actions being taken, and adjust
the model to insure an appropriate amount of initial margin is being
calculated.
The CSE must have an internal audit function independent of the
business trading unit that at least annually assesses the effectiveness
of the controls supporting the model. The internal audit function must
report its findings to the CSE's governing body, senior management, and
chief compliance officer at least annually.
(ii) Comments
Some commenters suggested that the model governance, control and
oversight standards of the proposed rule were too strict and should not
be so closely aligned with the model governance requirements for bank
capital models.\219\ One commenter suggested that since initial margin
amounts must be agreed to between counterparties, it is not practical
to require strict model governance standards.\220\ Another commenter
suggested that the initial margin model not be required to be back
tested against the initial margin requirements for similar cleared
swaps.\221\ One commenter suggested that the frequency with which data
must be reviewed and revised as necessary should be annual rather than
monthly to better align with other aspects of the proposal that require
certain governance processes to be conducted on an annual rather than
monthly basis.\222\ One commenter also cautioned against creating
duplicative requirement for internal auditing since the effectiveness
of initial and variation margin calculations are routinely and
regularly evaluated as required in other Commission regulations.\223\
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\219\ See JBA and SIFMA and IIB
\220\ JBA.
\221\ See SIFMA.
\222\ See ISDA.; see also NERA.
\223\ See BP (noting Commission Regulation 23.600).
---------------------------------------------------------------------------
The Commission believes that strong model governance, oversight and
control standards are crucial to ensuring the integrity of the initial
margin model so as to provide for margin requirements that are
commensurate with the risk of uncleared swaps. Moreover, the Commission
is aware that there will be incentives to minimize the amount of
initial margin and that strong governance standards that are intended
to result in strong and risk appropriate initial margin amounts is of
critical importance.
In light of the clear competitive forces that will exist between
cleared and uncleared swaps, the Commission believes that it is
appropriate to compare the initial margin requirements of uncleared
swaps to those of similar cleared swaps. Further, the Commission
understands that comparable cleared swaps with observable initial
margin standard may not always be available given the complexity and
variety of uncleared swaps. Nevertheless, the Commission believes that
where similar swaps trade on a cleared and uncleared basis such
comparisons are useful and informative.
More specifically, under the final rule a CSE must periodically,
and no less than annually, review its initial margin model in light of
developments in financial markets and modeling technologies and make
appropriate adjustments to the model. The Commission believes that
harmonizing the frequency with which certain model governance processes
must be performed will reduce the costs associated with the regular
oversight and maintenance of the initial margin model without
meaningfully altering the overall standards for model governance.
Accordingly, the final rule requires that data used in the initial
margin model be reviewed and revised as necessary, but at least
annually rather than monthly to ensure that the data is appropriate for
the products for which initial margin is being calculated. The
Commission notes that different, additional or more granular data
series may, at certain times, become available that would provide more
accurate measurements of the risks that the initial margin model is
intended to capture.
In addition to this regular review process, the final rule also
requires that strong oversight, control and validation mechanisms be in
place to ensure the integrity and validity of the initial margin model
and related processes. More specifically, the final rule requires that
the model be independently validated prior to implementation and on an
ongoing basis which would also include a monitoring process that
includes back-tests of the model and related analyses to ensure that
the level of initial margin being calculated is consistent with the
underlying risk of the swap being margined. Initial margin models must
also be subject to explicit escalation procedures that would make any
significant changes to the model subject to internal review and
approval before taking effect. Under the final rule, any such review
and approval must be based on demonstrable analysis that the change to
the model results in a model that is consistent with the requirements
of the final rule. Furthermore, under the final rule, any such changes
or extensions of the initial margin model must be communicated to the
Commission 60 days prior to taking effect to give the Commission the
opportunity to rescind its prior approval or subject it to additional
conditions.
The Commission also acknowledges that a CSE's internal audit
department is required to routinely and regularly audit the
effectiveness of initial and variation margin calculations. The
Commission believes that this requirement is necessary to ensure
compliance with a minimum standard.
e. Input From Counterparties
The Commission received comments regarding counterparty inputs on a
CSE's initial margin model. One commenter urged the Commission to allow
financial end users to have a role in determining the margin
methodology used and suggested that CSEs should not be able to switch
methodologies without the consent of the counterparty.\224\ Other
commenters suggested that the Commission require CSEs to disclose their
initial margin models to non-CSE counterparties so that counterparties
may validate the margin amount calculated \225\ or otherwise allow
financial end users access to the initial margin model and the inputs
used by the CSE to allow them to challenge margin calls or demand the
return of excess collateral during the life of a swap.\226\
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\224\ See GPC.
\225\ See ICI; GPC; MFA.
\226\ See FHLB.
---------------------------------------------------------------------------
The Commission notes that counterparties to a swap with a CSE have
other mechanisms through which they could address their concerns
without requiring a CSE to disclose its initial margin model
methodologies. In particular, the Commission points to Commission
Regulation 23.504(b)(4)(i) prescribing trade documentation requirements
on counterparties. Specifically, Regulation 23.504(b)(4)(i) requires
``written documentation in which the parties [to a swap] agree on the
process, which may include any agreed upon methods, procedures, rules,
and inputs, for determining the value of each swap at any time from
execution to the termination, maturity, or expiration of such swap for
purposes of complying with the margin requirements . . . and
regulations . . . .'' \227\ The Commission believes that the
requirements on trade documentation specified in Regulation
23.504(b)(4)(i) should adequately address the concerns of commenters
and is not prescribing more specific
[[Page 662]]
disclosure requirements with respect to internal initial margin models
used by a CSE to its counterparties in the final rule.
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\227\ 17 CFR 23.504(b)(4)(i).
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3. Table-Based Method
a. Method of Calculation
Some CSEs might not have the internal technical resources to
develop initial margin models or have simple portfolios for which they
want to avoid the complexity of modeling. The table-based method would
allow a CSE to calculate its initial margin requirements using a
standardized table.\228\ The table specifies the minimum initial margin
amount that must be collected as a percentage of a swap's notional
amount. This percentage varies depending on the asset class of the
swap. Except as modified by the net-to-gross ratio adjustment,\229\ a
CSE would be required to calculate a minimum initial margin amount for
each swap and sum up all the minimum initial margin amounts calculated
under this section to arrive at the total amount of initial margin. The
table is consistent with international standards.\230\
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\228\ Proposed Sec. 23.154(c).
\229\ See 79 FR 59898, at 59911 (Oct. 3, 2014).
\230\ BCBS/IOSCO Report at Appendix A.
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b. Comments
Two commenters suggested that the Commission adopt an altogether
different approach to computing standardized initial margins in a
manner consistent with the standardized approach for measuring
counterparty credit risk exposures that was finalized and published by
the Basel Committee on Banking Supervision in March 2014.\231\ This
approach is intended to be used in bank regulatory capital requirements
for the purposes of computing capital requirements for counterparty
credit risk resulting from OTC derivative exposures. A third commenter
remarked that the table-based method should be modified to reflect
greater granularity, including increasing the number of asset
categories recognized by the standardized initial margin table.\232\
Among other things, this commenter suggested increasing the number of
asset categories recognized by the standardized initial margin table.
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\231\ See JBA; CS.
\232\ See MFA.
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c. Discussion
In the final rule, the Commission has adopted the proposed approach
to standardized initial margin. The Commission has decided not to adopt
a different approach advocated by the commenters in the final rule for
several reasons. First, the standardized approach for counterparty
credit risk has been developed for counterparty capital requirement
purposes and, while clearly related to the issue of initial margin for
uncleared swaps, it is not entirely clear that this framework can be
transferred to a simple and transparent standardized initial margin
framework without modification.
Second, the standardized approach that has been published by the
Basel Committee on Banking Supervision is not intended to become
effective until January 2017 which follows the initial compliance date
of the final rule. Accordingly, the Commission expects that some form
of the standardized approach will be proposed by U.S. banking
regulators prior to January 2017. Following the notice and comment
period, a final rule for capitalizing counterparty credit risk
exposures will be finalized in the United States. Once these rules are
in place and effective it may be appropriate to consider adjusting the
approach in this rule to standardized initial margins. Prior to the new
capital rules being effective in the United States for the purpose for
which they were intended, the Commission does not believe it would be
appropriate to incorporate the standardized approach to counterparty
credit risk that has been published by the Basel Committee on Banking
Supervision into the final margin requirements for uncleared swaps.
The Commission acknowledges the desire to reflect greater
granularity in the standardized approach but also notes that the
approach in the final rule distinguishes among four separate asset
classes and various maturities. The Commission also notes that no
commenter provided a specific and fully articulated suggestion on how
to modify the standardized approach to achieve greater flexibility
without becoming overly burdensome. The Commission also notes that the
standardized initial margins are a minimum margin requirement. CSEs and
their counterparties are free to develop standardized margin schedules
that reflect greater granularity than the final rule's standardized
approach so long as the resulting amounts would in all circumstances be
at least as large as those required by the final rule's standardized
approach to initial margin. Accordingly, the final rule affords CSEs
and their counterparties the opportunity to develop simple and
transparent margin schedules that reflect the granular and specific
nature of the swap activity being margined.
Under the final rule, standardized initial margins depend on the
asset class (commodity, equity, credit, foreign exchange and interest
rate) and, in the case of credit and interest rate asset classes,
further depend on the duration of the underlying uncleared swap. In
addition, the standardized initial margin requirement allows for the
recognition of risk offsets through the use of a net-to-gross ratio in
cases where a portfolio of uncleared swaps is executed under an EMNA.
The net-to-gross ratio compares the net current replacement cost of
the non-cleared portfolio (in the numerator) with the gross current
replacement cost of the non-cleared portfolio (in the denominator). The
net current replacement cost is the cost of replacing the entire
portfolio of swaps that are covered under the EMNA. The gross current
replacement cost is the cost of replacing those swaps that have a
strictly positive replacement cost under the EMNA.
As an example, consider a portfolio that consists of two uncleared
swaps under an EMNA in which the mark-to-market value of the first swap
is $10 (i.e., the CSE is owed $10 from its counterparty) and the mark-
to-market value of the second swap is -$5 (i.e., the CSE owes $5 to its
counterparty). Then the net current replacement cost is $5 ($10-$5),
the gross current replacement cost is $10, and the net-to-gross ratio
would be 5/10 or 0.5.\233\
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\233\ Note that in this example, whether or not the
counterparties have agreed to exchange variation margin has no
effect on the net-to-gross ratio calculation, i.e., the calculation
is performed without considering any variation margin payments. This
is intended to ensure that the net-to-gross ratio calculation
reflects the extent to which the uncleared swaps generally offset
each other and not whether the counterparties have agreed to
exchange variation margin. As an example, if a swap dealer engaged
in a single sold credit derivative with a counterparty, then the
net-to-gross calculation would be 1.0 whether or not the dealer
received variation margin from its counterparty.
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The net-to-gross ratio and gross standardized initial margin
amounts (provided in Sec. 23.154(c)) are used in conjunction with the
notional amount of the transactions in the underlying swap portfolio to
arrive at the total initial margin requirement as follows:
Standardized Initial Margin = 0.4 x Gross Initial Margin + 0.6 x NGR x
Gross Initial Margin
where:
Gross Initial Margin = the sum of the notional value multiplied by
the appropriate initial margin requirement percentage from Appendix
A of each uncleared swap under the EMNA; and
NGR = net-to-gross ratio
[[Page 663]]
As a specific example, consider the two-swap portfolio discussed
above. Suppose further that the swap with the mark-to-market value
of $10 is a sold 5-year credit default swap with a notional value of
$100 and the swap with the mark-to-market value of -$5 is an equity
swap with a notional value of $100. The standardized initial margin
requirement would then be:
[0.4 x (100 x 0.05 + 100 x 0.15) + 0.6 x 0.5 x (100 x 0.05 + 100 x
0.15)] = 8 + 6 = 14.
The Commission further notes that the calculation of the net-to-
gross ratio for margin purposes must be applied only to swaps subject
to the same EMNA and that the calculation is performed across
transactions in disparate asset classes within a single EMNA such as
credit and equity in the above example. That is, all uncleared swaps
subject to the same EMNA and subject to the final rule's requirements
can net against each other in the calculation of the net-to-gross
ratio, as opposed to the modeling approach that allows netting only
within each asset class.
This approach is consistent with the standardized counterparty
credit risk capital requirements. Also, the equations are designed such
that benefits provided by the net-to-gross ratio calculation are
limited by the standardized initial margin term that is independent of
the net-to-gross ratio, i.e., the first term of the standardized
initial margin equation which is 0.4 x Gross Initial Margin.
Finally, if a counterparty maintains multiple uncleared swap
portfolios under one or multiple EMNAs, the standardized initial margin
amounts would be calculated separately for each portfolio with each
calculation using the gross initial margin and net-to-gross ratio that
is relevant to each portfolio. The total standardized initial margin
would be the sum of the standardized initial margin amounts for each
portfolio.
The final rule's standardized approach to initial margin depends on
the calculation of a net-to-gross ratio. In the context of performing
margin calculations, it must be recognized that at the time uncleared
swaps are entered into it is often the case that both the net and gross
current replacement cost is zero. This precludes the calculation of the
net-to-gross ratio. In cases where a new swap is being added to an
existing portfolio that is being executed under an existing EMNA, the
net-to-gross ratio may be calculated with respect to the existing
portfolio of swaps. In cases where an entirely new swap portfolio is
being established, the initial value of the net-to-gross ratio should
be set to 1.0. After the first day's mark-to-market valuation has been
recorded for the portfolio, the net-to-gross ratio may be re-calculated
and the initial margin amount may be adjusted based on the revised net-
to-gross ratio.
The final rule requires that the standardized initial margin
collection amount be calculated on a daily basis. In cases where the
initial margin collection amount increases, this new amount must be
used as the basis for determining the amount of initial margin that
must be collected from a financial end user with material swaps
exposure or a swap entity. In addition, when a CSE faces a financial
end user with material swaps exposure, the CSE must also calculate the
initial margin collection amount from the perspective of its
counterparty on a daily basis. In the event that this amount increases,
the CSE must use this new amount as the basis for determining the
amount of initial margin that it must post to its counterparty. In the
event that this amount decreases, this new amount would also serve as
the basis for the minimum required amount of initial margin.
Accordingly, any previously collected or posted initial margin over and
above the new requirement could, subject to bilateral agreement, be
returned.
As in the case of internal-model-generated initial margins, the
margin calculation under the standardized approach must also be
performed on a daily basis. Because the standardized initial margin
calculation depends on a standardized look-up table (in Regulation
23.154(c)), there are fewer reasons for the initial margin collection
amounts to vary on a daily basis. However, there are some factors that
may result in daily changes in the initial margin collection amount
under the standardized margin calculations.
First, any changes to the notional size of the swap portfolio that
arise from any addition or deletion of swaps from the portfolio would
result in a change in the standardized margin amount. As an example, if
the notional amount of the swap portfolio increased as a result of
adding a new swap to the portfolio then the standardized initial margin
collection amount would increase.
Second, changes in the net-to-gross ratio that result from changes
in the mark-to-market valuation of the underlying swaps would result in
a change in the standardized initial margin collection amount.
Third, changes to characteristics of the swap that determine the
gross initial margin would result in a change in the standardized
initial margin collection amount. As an example, the gross initial
margin applied to interest rate swaps depends on the duration of the
swap. An interest rate swap with a duration between zero and two years
has a gross initial margin of one percent while an interest rate swap
with duration of greater than two years and less than five years has a
gross initial margin of two percent. Accordingly, if an interest rate
swap's duration declines from above two years to below two years, the
gross initial margin applied to it would decline from two to one
percent. Accordingly, the standardized initial margin collection amount
will need to be computed on a daily basis to reflect all of the factors
described above.
F. Calculation of Variation Margin
1. Proposal
Under the proposal, each CSE would be required to calculate
variation margin for itself and for each covered counterparty using a
methodology and inputs that to the maximum extent practicable, and in
accordance with existing Regulation 23.504(b)(4) rely on recently-
executed transactions, valuations provided by independent third
parties, or other objective criteria.\234\ In addition, each CSE would
need to have in place alternative methods for determining the value of
an uncleared swap in the event of the unavailability or other failure
of any input required to value a swap.\235\
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\234\ Proposed Sec. 23.155(a)(1) and current Sec.
23.504(b)(4).
\235\ Proposed Sec. 23.155(a)(2).
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Similar to the requirement for initial margin, the proposal would
require each CSE to collect variation margin from, and to pay variation
margin to, each counterparty that is a swap entity or a financial end
user, on or before the end of the business day after execution for each
swap with that counterparty.\236\ The proposed rule required the CSEs
to continue to pay or collect variation margin each business day until
the swap is terminated or expires.\237\
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\236\ Proposed Sec. 23.153(a).
\237\ Proposed Sec. 23.153(b).
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The proposal would also set forth several control mechanisms.\238\
Each CSE would be required to create and maintain documentation setting
forth the variation margin methodology with sufficient specificity to
allow the counterparty, the Commission, and any applicable Prudential
Regulator to calculate a reasonable approximation of the margin
requirement independently. Each CSE would be required to evaluate the
reliability of its data sources at least annually, and to make
adjustments, as appropriate. The proposal would permit
[[Page 664]]
the Commission to require a CSE to provide further data or analysis
concerning the methodology or a data source.
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\238\ Proposed Sec. 23.155(b).
---------------------------------------------------------------------------
2. Comments
Several commenters suggested that the Commission consider alternate
methods for calculating variation margin.\239\ Commenters stated that
the proposal appeared to require a CSE to determine minimum variation
margin requirements based on the market value of a swap calculated only
from the CSE's own perspective, rather than at a mid-market price
consistent with current market practice. These commenters urged that
using mid-market swap values to determine variation margin would align
more closely with industry practice and would not skew in favor of a
CSE.\240\ They also remarked that all calculations and methodologies
should be available to counterparties.
---------------------------------------------------------------------------
\239\ See MetLife; Sifma-AMG; Freddie; FHLB (parties should seek
prices based on recently-executed transactions, valuations provided
by independent third-parties or other objective criteria).
\240\ These commenters argued that this approach would result in
dealer exposures being over-collateralized and their counterparties'
exposures being under-collateralized.
---------------------------------------------------------------------------
Further, one commenter remarked that the requirements on the method
for calculating variation margin is redundant because other Commission
regulations already address variation margin calculation
methodology.\241\ Additionally, commenters also questioned the
Commission's view of variation margin as a settlement or payment,
noting for example concerns with the tax and accounting
consequences.\242\
---------------------------------------------------------------------------
\241\ See ISDA.
\242\ See e.g., ACLI.
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Many commenters urged the Commission to provide more time for the
delivery of variation margin.\243\ One commenter asked for
clarification that the collection and calculation of variation margin
would occur only once a day based on the closing price of the previous
day.\244\ Another commenter argued that the frequency of posting
variation margin (i.e., daily) could possibly create liquidity
pressures and have pro-cyclicality effects.\245\
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\243\ See JFMC; GPC; and ISDA.
\244\ See MFA.
\245\ See NERA.
---------------------------------------------------------------------------
One commenter also suggested that CSEs should not be required to
exchange variation margin with financial end users whose exposures to
the CSE fall below the material swaps exposure threshold.\246\
---------------------------------------------------------------------------
\246\ See ISDA.
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3. Discussion
After carefully reviewing the comments, the Commission is adopting
the variation margin requirement largely as proposed, but with a
limited number of changes to address concerns raised by commenters with
respect to the calculation and exchange of variation margin.
When a CSE engages in an uncleared swap transaction with a
financial end user, regardless of whether or not the financial end user
has a material swaps exposure, the final rule will require the CSE to
collect and post variation margin with respect to the uncleared swap.
The final rule requires a CSE to collect or to post (as applicable)
variation margin on uncleared swaps in an amount that is at least equal
to the increase or decrease (as applicable) in the value of such swaps
since the previous exchange of variation margin.
Consistent with the proposal, a CSE may not establish a threshold
amount below which it need not exchange variation margin on swaps with
a swap entity or financial end user counterparty (although transfers
below the minimum transfer amount would not be required).
The Commission believes the bilateral exchange of variation margin
will support CSE safety and soundness as well as effectively reduce
systemic risk by protecting both the CSE and its counterparty from the
effects of a counterparty default.
Unlike the proposal, which used the terms ``pay'' and ``paid'' to
refer to the transfer of variation margin, the final rule refers to
variation margin in terms of ``post'' and ``collect.'' After carefully
reviewing the comments on the proposal that addressed the appropriate
characterization of the transfer of variation margin, the Commission
has determined that it is more appropriate to refer to variation margin
collateral as having been ``posted,'' rather than ``paid,'' consistent
with the treatment of initial margin.
Among the reasons underlying the Commission's proposal to refer to
variation margin in terms of payment, was the existing market practice
of swap dealers to exchange variation margin with other swap dealers in
the form of cash. As is discussed below in the final rule's provisions
on eligible collateral, the Commission has concluded that it is
appropriate to permit financial end users to use other, non-cash forms
of collateral for variation margin. This revision to the nomenclature
of the final rule is consistent with the Commission's inclusion of
eligible non-cash collateral for variation margin.
In the context of cash variation margin, commenters also expressed
concerns that the Commission's choice of the ``pay'' nomenclature
reflected an underlying premise of current settlement that may be
inconsistent with various operational, accounting, tax, legal, and
market practices. The Commission's use of the ``post'' and ``collect''
nomenclature for the final rule is not intended to reflect upon or
alter the characterization of variation margin exchanges--either as a
transfer and settlement or a provisional form of collateral--for other
purposes in the market.
Under the final rule, ``variation margin'' means the collateral
provided by one party to its counterparty to meet the performance of
its obligations under one or more uncleared swaps between the parties
as a result of a change in value of such obligations since the last
time such collateral was provided.\247\ The amount of variation margin
to be collected or posted (as appropriate) is the amount equal to the
cumulative mark-to-market change in value to a CSE of an uncleared
swap, as measured from the date it is entered into (or, in the case of
an uncleared swap that has a positive or negative value to a CSE on the
date it is entered into, such positive or negative value plus any
cumulative mark-to-market change in value to the CSE of a uncleared
swap after such date), less the value of all variation margin
previously collected, plus the value of all variation margin previously
posted with respect to such uncleared swap.\248\ The CSE must collect
this amount if the amount is positive, and post this amount if the
amount is negative.
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\247\ Sec. 23.155.
\248\ Sec. 23.151.
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The Commission wishes to clarify that the reference in the rule
text to the ``cumulative mark-to-market change in value to a CSE of an
uncleared swap'' is not designed or intended to have the effect
suggested by commenters. The market value used to determine the
cumulative mark-to-market change will be mid-market prices, if that is
consistent with the agreement of the parties.\249\ The final rule is
consistent with market practice in this respect. The rule text's
reference to ``change in value to a covered swap entity'' refers to
whether the value change is positive or negative from the CSE's
standpoint. This ties to the final rule's requirement
[[Page 665]]
for the CSE to post variation margin when the variation margin amount
is positive, or to collect variation margin when the variation margin
amount is negative.
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\249\ Additionally, the Commission notes that the final margin
requirements should be viewed as minimums. To the extent that two
counterparties agree to transfer collateral in addition to the
minimum amount required by the final rule, the final rule will not
impede them.
---------------------------------------------------------------------------
In calculating variation margin amounts, the final rule permits
netting across a portfolio of uncleared swaps between the CSE and a
particular counterparty, subject to a number of conditions. These
provisions are discussed in more detail above.
Consistent with the proposal, the final rule requires a CSE to
exchange variation margin for uncleared swaps with swap entities and
financial end users (regardless of whether the financial end user has a
material swaps exposure). However, as discussed earlier, the enactment
of TRIPRA exempts certain nonfinancial counterparties from the scope of
this rulemaking for uncleared swaps that hedge or mitigate commercial
risk.\250\ The Commission is not requiring that CSEs exchange variation
margin with respect to the swaps that are exempted from the margin
final rule by TRIPRA.
---------------------------------------------------------------------------
\250\ The Commission is not requiring that CSEs collect initial
or variation margin from these so-called ``commercial end user''
counterparties.
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Overall, this aspect of the variation margin provisions of the
final rule is consistent with the approach for initial margin. The
final rule largely retains the proposed rule's requirement for
variation margin to be posted or collected on a T+1 timeframe. The
final rule requires variation margin to be posted or collected no less
than once per business day, beginning on the business day following the
day of execution. These provisions of the final rule operate in the
same way as those discussed earlier in the description of the final
rule's initial margin requirements.
The one difference is that all transactions with financial end user
counterparties are subject to the variation margin requirements, while
only financial end user counterparties with material swaps exposure are
subject to initial margin requirements. The Commission believes it is
appropriate to apply the minimum variation margin requirements to non-
exempted transactions with all financial entity counterparties, not
just those with a material swaps exposure, because the daily exchange
of variation margin is an important risk mitigant that (i) reduces the
build-up of risk that may ultimately pose systemic risk; (ii) does not,
in aggregate, reduce the amount of liquid assets readily available to
posting and collecting entities because it simply transfers resources
from one entity to another; and (iii) reflects both current market
practice and a risk management best practice.
The final rule in this area is consistent with that of the
Prudential Regulators but is more detailed in one respect. The
Commission's rule requires that variation margin calculations use
methods, procedures, rules, and inputs that, to the maximum extent
practicable rely on recently-executed transactions, valuations provided
by independent third parties, or other objective criteria.
The Commission believes that the accurate valuation of positions is
a critical element in assuring the safety and soundness of CSEs and in
preserving the integrity of the financial system. The standard set
forth in the Commission's rule is consistent with recently-issued
international standards.\251\
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\251\ Risk Mitigation Standards for Non-centrally Cleared OTC
Derivatives, International Organization of Securities Commissions
(January 28, 2015).
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G. Forms of Margin
1. Initial Margin
a. Proposal
In general, the Commission believes that margin assets should share
the following fundamental characteristics. The assets should be liquid
and, with haircuts, hold their value in times of financial stress. The
value of the assets should not exhibit a significant correlation with
the creditworthiness of the counterparty or the value of the swap
portfolio.\252\
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\252\ See BCBS/IOSCO Report at 16.
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Guided by these principles, the Commission proposed that CSEs may
only post or accept certain assets to meet initial margin requirements
to or from covered counterparties.\253\ These are assets for which
there are deep and liquid markets and, therefore, assets that can be
readily valued and easily liquidated.
---------------------------------------------------------------------------
\253\ Proposed Sec. 23.156(a)(1).
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Certain assets would be prohibited from use as initial margin
because the Commission was concerned that the use of those assets could
compound risk.\254\ These included any asset that is an obligation of
the party providing such asset or an affiliate of that party. These
also include instruments issued by bank holding companies, depository
institutions, and market intermediaries. These restrictions reflected
the Commission's view that the price and liquidity of securities issued
by the foregoing entities are very likely to come under significant
pressure during a period of financial stress when a CSE may be
resolving a counterparty's defaulted swap position and, therefore,
present an additional source of risk.
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\254\ Proposed Sec. 23.156(a)(2).
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b. Comments
Commenters generally supported the Commission's proposed asset
categories or sought limited modifications. Several commenters argued
in support of including other assets (such as interests in money market
funds and high quality liquid debt securities) in the list of eligible
collateral or allowing parties to negotiate acceptable forms of
collateral.\255\ Commenters who asked the Commission to consider GSE
securities as eligible collateral for variation margin joined many
others who opposed limiting variation margin collateral to cash only.
---------------------------------------------------------------------------
\255\ See ICI; ISDA; CPFM; GPC; Sifma-AMG; IECA (letters of
credit); Freddie; and CDEU.
---------------------------------------------------------------------------
Commenters representing the interests of asset managers, mutual
funds, and other institutional asset managers asked the Commission to
expand the list of eligible collateral to include money market mutual
funds and bank certificates of deposit, in the interests of providing
financial end users with a higher yield than cash held by the margin
custodian and more liquidity than direct holdings of government or
corporate bonds. Some commenters requested that bank certificates of
deposit be considered eligible collateral for margin purposes.
Commenters stated that GSE debt securities already are widely used
as collateral for uncleared swaps and should continue to be eligible
under the final rule given their historically low levels of volatility.
A smaller number of the commenters argued that GSE mortgage-backed
securities (``MBS'') also should be eligible collateral given that
markets have accepted GSE MBS as liquid, high-quality securities along
with other GSE debt. A number of commenters suggested that GSE debt
securities and MBS should qualify as eligible collateral, regardless of
whether or not the GSE is operating with capital support or another
form of financial assistance from the United States.
Some commenters also questioned why the minimum haircut for debt
securities of GSEs (operating without capital support or other
financial assistance from the U.S.) is not lower than the minimum
haircuts applicable to corporate debt. Another concern that some
commenters raised is that the capital and margin rule for uncleared
swaps is inconsistent in its treatment of GSE securities with the
liquidity
[[Page 666]]
coverage ratio rule that the Board, OCC, and FDIC issued in 2014.\256\
---------------------------------------------------------------------------
\256\ See 79 FR 61439 (October 10, 2014) (Liquidity Coverage
Ratio: Liquidity Risk Measurement Standards).
---------------------------------------------------------------------------
One commenter cautioned against classifying the debt securities of
federal home loan banks as eligible collateral and stated that asset-
backed securities issued by a U.S. Government-sponsored enterprises
(``GSE'') should not be precluded from the list of eligible collateral
solely because those securities are not unconditionally guaranteed by a
GSE whose obligations are fully guaranteed by the U.S. government.\257\
Another commenter cautioned against including equities in the list of
eligible collateral because of their inherent risky nature.\258\
Commenters also suggested that the Commission allow parties to model
haircuts for eligible collateral.\259\
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\257\ See FHLB.
\258\ See Barnard.
\259\ See ISDA; Sifma.
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Commenters also requested that the Commission provide guidance
about the rule's application to current market practice incorporating
contractual provisions specifying an agreed-upon currency of
settlement, transport, transit currencies and termination currencies.
Additionally, commenters urged the Commission to permit any cross-
currency sensitivity between the swap portfolio credit exposure and the
margin collateral provided against that exposure to be measured as a
component of the margin required to be exchanged under the rule.
Finally, some commenters urged the Commission to perform annual
reviews of the eligible collateral categories and the haircuts.\260\
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\260\ As with all of its rules, the Commission will make
appropriate changes if it believes it is necessary.
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c. Discussion
With respect to initial margin, the final rule includes an
expansive list of the types of collateral that is largely consistent
with the list set forth in the proposal. Eligible collateral for
initial margin includes immediately available cash funds denominated in
any major currency or the currency of settlement, debt securities that
are issued or guaranteed by the U.S. Department of Treasury or by
another U.S. government agency, the Bank for International Settlements,
the International Monetary Fund, the European Central Bank,
multilateral development banks, certain GSEs' debt securities, certain
foreign government debt securities, certain corporate debt securities,
certain listed equities, shares in certain investment funds, and gold.
The Commission is including equities as eligible collateral in the
final rule, with the requirement for a minimum 15 percent haircut on
equities in the S&P 500 Index and a minimum 25 percent haircut for
those in the S&P 1500 Composite Index but not in the S&P 500
Index.\261\ The Commission notes that, even with these restrictions
designed to address liquidity and volatility, CSEs should also take
concentrations into account, and prudently manage their acceptance of
initial margin collateral, with the idiosyncratic risk of equity--and
publicly traded debt--issuers in mind. The Commission notes that it is
important to consider longer time periods incorporating periods of
market stress, and the minimum haircuts are calibrated accordingly.
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\261\ Although equities included in the S&P 500 Index are also
included in the S&P 1500 Composite Index, equities in the S&P 500
Index are subject to the 15 percent minimum haircut, not the 25
percent minimum haircut.
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To accommodate the concern of certain commenters that argued for an
inclusion of money market mutual funds and bank certificates of deposit
in the list of eligible collateral for initial margin and to provide
flexibility while maintaining a level of safety, the final rule adds
redeemable securities in a pooled investment fund that holds only
securities that are issued by, or unconditionally guaranteed as to the
timely payment of principal and interest by, the U.S. Department of the
Treasury, and cash funds denominated in U.S. dollars. To provide a
parallel collateral option for uncleared swap portfolios in
denominations other than U.S. dollars, the pooled investment fund may
be structured to invest in pool of securities that are denominated in a
common currency and issued by, or fully guaranteed as to the timely
payment of principal and interest by, the European Central Bank or a
sovereign entity that is assigned no higher than a 20 percent risk
weight under applicable regulatory capital rules, and cash denominated
in the same currency.
The final rule requires these pooled investment vehicles to issue
redeemable securities representing the holder's proportional interest
in the fund's net assets, issued and redeemed only on the basis of the
fund's net assets prepared each business day after the holder makes its
investment commitment or redemption request to the fund. These criteria
are similar to those used for bank trust department common trust funds
and common investment funds, to facilitate liquidity of the redeemable
securities while still protecting holders of the fund's securities from
dilution. The final rule also provides that assets of the fund may not
be transferred through securities lending, securities borrowing,
reverse repurchase agreements, or similar arrangements. This is to
ensure consistency with the prohibition under the final rule against
custodian rehypothecation of initial margin collateral.
Consistent with the proposal, the final rule generally does not
include asset-backed securities (``ABS''), including MBS, within the
permissible category of publicly-traded debt securities. However, ABS
are included as eligible collateral if they are issued by, or
unconditionally guaranteed as to the timely payment of principal and
interest by, the U.S. Department of the Treasury or another U.S.
government agency whose obligations are fully guaranteed by the full
faith and credit of the United States government; or if they are fully
guaranteed by a U.S. GSE that is operating with capital support or
another form of direct financial assistance received from the U.S.
government that enables repayment of the securities.
Publicly traded debt securities (that are not ABS) issued by GSEs
are included in eligible collateral as long as the issuing GSE is
either operating with capital support or another form of direct
financial assistance received from the U.S. government that enables
full repayment of principal and interest on these securities, or the
CSE determines the securities are ``investment grade'' (as defined by
the appropriate prudential regulator).
Although the Commission received several comments concerning the
proposal's treatment of GSE securities, only modest changes have been
made in the final rule. In the final rule, the Commission recognizes
the unique nature of GSE securities by placing them in a category
separate from both securities issued directly by U.S. government
agencies and those from non-GSE, private sector issuers. However, the
Commission continues to believe the final rule should treat GSE
securities differently depending on whether or not the GSE enjoys
explicit government support, in the interests of both the safety and
soundness of CSE and the stability of the financial system.
GSE debt obligations are not explicitly guaranteed by the full
faith and credit of the U.S. government. Existing law, however,
authorizes the United States Treasury to provide lines of credit, up to
a specified amount, to certain GSEs in the event they face specific
financial difficulties. An act of Congress would be required to provide
adequate support if, for example, a GSE were to experience severe
difficulty in selling its securities
[[Page 667]]
in financial markets because investors doubted its ability to meet its
financial obligations.\262\ The treatment of GSE securities by market
participants as if those securities were nearly equivalent to Treasury
securities in the absence of explicit Treasury support creates a
potential threat to financial market stability, especially if
vulnerabilities arise in markets where one or more GSEs are dominant
participants, as occurred during the summer of 2008.
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\262\ Congress provided such support with the passage of the
Agricultural Credit Act of 1987 and with the Housing and Economic
Recovery Act of 2008.
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The final rule's differing treatment of GSE collateral based on
whether or not the GSE has explicit support of the U.S. government
helps address this source of potential financial instability and
recognizes that securities issued by an entity explicitly supported by
the U.S. government might well perform better during a crisis than
those issued by an entity operating without such support. The final
rule adopts the approach that was used in the proposed rule and assigns
the same minimum haircut to both corporate obligations and the debt
securities of GSEs that are operating without capital support or
another form of financial assistance from the U.S. From the
Commission's perspective, this approach facilitates appropriate due
diligence when a party considers the creditworthiness of a GSE security
that it may accept as collateral.
The final rule retains the 2014 proposal's provision excluding any
securities issued by the counterparty or any of its affiliates. To
avoid the compounding of risk, the final rule continues to exclude
securities issued by a bank holding company, a savings and loan holding
company, a foreign bank, a depository institution, a market
intermediary, or any company that would be one of the foregoing if it
were organized under the laws of the United States or any State, or an
affiliate of one of the foregoing institutions. For the same reason,
the Commission has expanded this restriction in the final rule also to
exclude securities issued by a non-bank systemically important
financial institution designated by the Financial Stability Oversight
Council. These entities are financial in nature and, like banks or
market intermediaries, would be expected to come under significant
financial stress in the event of a period of financial stress.
Accordingly, the Commission believes that it is also appropriate to
restrict securities issued by these entities as eligible margin
collateral to ensure that collected collateral is free from significant
sources of this type of risk.
The final rule does not allow a CSE to fulfill the rule's minimum
margin requirements with any assets not included in the eligible
collateral list, which is comprised of assets that should remain liquid
and readily marketable during times of financial stress. The use of
alternative types of collateral to fulfill regulatory margin
requirements would introduce concerns that the changes in the
liquidity, price volatility, or other risks of collateral during a
period of financial stress could exacerbate that stress) and could
undermine efforts to ensure that collateral is subject to low credit,
market, and liquidity risk. Therefore, the final rule limits the
recognition of margin collateral to the aforementioned list of assets.
Counterparties that wished to rely on assets that do not qualify as
eligible collateral under the proposed rule still would be able to
pledge those assets with a lender in a separate arrangement, such as
collateral transformation arrangements, using the cash or other
eligible collateral received from that separate arrangement to meet the
minimum margin requirements.
The Commission wishes to note here that because the value of
noncash collateral and foreign currency may change over time, the
proposal would require a CSE to monitor the value of such collateral
previously collected to satisfy initial margin requirements and, to the
extent the value of such collateral has decreased, to collect
additional collateral with a sufficient value to ensure that all
applicable initial margin requirements remain satisfied on a daily
basis.\263\
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\263\ Proposed Sec. 23.156(a)(4).
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Moreover, the Commission notes that the proposal would not restrict
the types of collateral that could be collected or posted to satisfy
margin terms that are bilaterally negotiated above required amounts.
For example, if, notwithstanding the $50 million threshold, a CSE
decided to collect initial margin to protect itself against the credit
risk of a particular counterparty, the CSE could accept any form of
collateral.
2. Variation Margin
a. Proposal
The proposal would require that variation margin be paid in U.S.
dollars, or a currency in which payment obligations under the swap are
required to be settled.\264\ When determining the currency in which
payment obligations under the swap are required to be settled, a CSE
would be required to consider the entirety of the contractual
obligation. For example, in cases where a number of swaps, each
potentially denominated in a different currency, are subject to a
single master agreement that requires all swap cash flows to be settled
in a single currency, such as the Euro, then that currency (Euro) may
be considered the currency in which payment obligations are required to
be settled.
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\264\ Proposed Sec. 23.156(b).
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Under this proposed rule, the value of cash paid to satisfy
variation margin requirements is not subject to a haircut.
b. Comments
The Commission received a large number of comments arguing for the
broadening of the list of eligible collateral for variation margin to
include noncash assets.\265\ These commenters generally argued that
limiting variation margin to cash is inconsistent with current market
practice for financial end users, is incompatible with the 2013
international framework agreement, and would drain the liquidity of
these financial end users by forcing them to hold more cash. The same
commenters suggested including securities such as U.S. Treasuries or
other government bonds.
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\265\ See ICI; JFMC; ISDA; CCRM; CPFM; Sifma; MetLife; GPC;
Sifma-AMG; ABA; JBA; AIMA; MFA; FSR; Freddie; CDEU; FHLB; ACLI;
NERA; and TIAA-CREF. However, commenters representing public
interest groups generally favored the proposed approach.
---------------------------------------------------------------------------
While some commenters representing public interest groups favored
limiting variation margin exchanged between CSEs to cash, some
commenters representing the financial sector expressed concern that
regulators in other key market jurisdictions have not proposed
comparable variation margin restrictions. Commenters also asked the
Commission to consider GSE securities as eligible collateral for
variation margin.
One commenter asked for clarification on whether a haircut applies
if variation margin is paid in the currency in which the swap is
denominated.\266\ Another commenter asked for confirmation that a cash
payment of variation margin would not be subject to any haircuts.\267\
One commenter also proposed that the Commission grant the
counterparties the flexibility to specify a base currency in their
counterparty agreements on a case-by-case basis.\268\
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\266\ See JBA.
\267\ See ISDA.
\268\ See CPFM.
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[[Page 668]]
c. Discussion
With respect to variation margin, the proposal would have limited
eligible collateral to immediately available cash funds, denominated
either in U.S. dollars or in the currency in which payment obligations
under the uncleared swap are required to be settled. However, after
reviewing comments from financial end users of derivatives, such as
insurance companies, mutual funds, and pension funds, the Commission
has expanded the list of eligible variation margin for uncleared swaps
between a CSE and financial end users. These commenters generally
argued that limiting variation margin to cash is inconsistent with
current market practice for financial end users; is incompatible with
the 2013 international framework agreement; and would drain the
liquidity of these financial end users by forcing them to hold more
cash. In response to these comments, the final rule permits assets that
are eligible as initial margin to also be eligible as variation margin
for swap transactions between a CSE and financial end user, subject to
the applicable haircuts for each type of eligible collateral.
This change aligns the rule more closely with current market
practice. Commenters indicated many types of financial end users
exchange variation margin with their swap dealers in the form of non-
cash collateral that consists of their investment assets. This practice
permits them to maximize their investment income and minimize margin
costs, even though these assets are subject to valuation haircuts when
posted as variation margin.
The Commission notes however (as described in the 2014 proposal)
that most of the variation margin by total volume continues to be in
the form of cash exchanged between SDs. Therefore, consistent with the
proposal, variation margin exchanged by a CSE with another swap entity
must be in the form of immediately available cash. The Commission
continues to believe that limiting variation margin exchanged between a
CSE and a swap entity to cash is consistent with regulatory and
industry initiatives to improve standardization and efficiency in the
OTC swaps market. Swap entities have access to cash, and its continued
use as variation margin between swap entities will reduce the potential
for disputes over the value of variation margin collateral, due to the
absence of associated market and credit risks. Also, in periods of
severe market stress, the ultimate liquidity of cash variation margin
exchanged between CSEs--which occupy a key position to provide and
maintain trading liquidity in the market for uncleared swaps--should
assist in preserving the financial integrity of that market and the
stability of the U.S. financial system.
However, for reasons discussed below, the Commission is revising
the final rule to expand the denominations of immediately available
cash funds that are eligible. Whereas the proposal only recognized U.S.
dollars or the currency of settlement, the final rule expands the
category to include any major currency.\269\
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\269\ The final rule defines the following as a ``major
currency'': United States Dollar (USD); Canadian Dollar (CAD); Euro
(EUR); United Kingdom Pound (GBP); Japanese Yen (JPY); Swiss Franc
(CHF); New Zealand Dollar (NZD); Australian Dollar (AUD); Swedish
Kronor (SEK); Danish Kroner (DKK); Norwegian Krone (NOK); and any
other currency as determined by a Prudential Regulator or the
Commission.
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3. Currency of Settlement, Collateral Valuation, and Haircuts
For those assets whose values may show volatility during times of
stress, the final rule imposes an 8 percent cross-currency haircut, and
standardized prudential supervisory haircuts that vary by asset class.
When determining how much collateral will be necessary to satisfy the
minimum initial margin requirement for a particular transaction, a CSE
must apply the relevant standardized prudential supervisory haircut to
the value of the eligible collateral. The final rule's haircuts guard
against the possibility that the value of non-cash eligible margin
collateral could decline during the period between when a counterparty
defaults and when the CSE closes out that counterparty's swap
positions.
The Commission has revised the cross-currency haircut applicable to
eligible collateral under the final rule. The cross-currency haircut
will apply whenever the eligible collateral posted (as either variation
or initial margin) is denominated in a currency other than the currency
of settlement, except that variation margin in immediately available
cash funds in any major currency is never subject to the haircut. The
amount of the cross-currency haircut remains 8 percent, as it was in
the proposal.
The Commission has decided to eliminate the haircut on variation
margin provided in immediately available cash funds denominated in all
major currencies because the cash funds are liquid at the point of
counterparty default, and there are deep and liquid markets in the
major currencies that allow conversion or hedging to the currency of
settlement or termination at relatively low cost. The Commission is
including in the final rule the cross-currency haircut for all eligible
noncash variation and initial margin collateral, in consideration of
the limitations on market liquidity that can frequently arise on those
assets in periods of market stress.
In response to commenters' request for clarification, the
Commission has revised the final rule text for the cross-currency
haircut to refer to the ``currency of settlement,'' and have eliminated
the corresponding formulation offered for comment in the proposal.\270\
Commenters requested that the Commission provide guidance about the
rule's application to current market practice incorporating contractual
provisions specifying an agreed-upon currency of settlement, transport
currencies and transit, and termination currencies.\271\
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\270\ The 2014 proposal was formulated as ``the currency in
which payment obligations under the swap are required to be
settled.'' Proposed Rule, Sec. 23.156(a)(1)(iii).
\271\ The guidance the Commission is providing about currencies
of settlement is specific to the application of this final rule on
margin collecting and posting requirements for uncleared swaps.
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In identifying the ``currency of settlement'' for purposes of this
final rule, the Commission will look to the contractual and operational
practice of the parties in liquidating their periodic settlement
obligations for an uncleared swap in the ordinary course, absent a
default by either party. To provide greater clarity, the Commission has
added a new definition of ``currency of settlement'' to the rule. The
Commission has defined ``currency of settlement'' to mean a currency in
which a party has agreed to discharge payment obligations related to an
uncleared swap or a group of uncleared swaps subject to a master
agreement at the regularly occurring dates on which such payments are
due in the ordinary course.
For eligible non-cash initial margin collateral, the final rule
expressly carves out of the cross-currency haircut assets denominated
in a single termination currency designated as payable to the non-
posting counterparty as part of the eligible master netting agreement.
The final rule accommodates agreements under which each party has a
different termination currency. If the non-posting counterparty has the
option to select among more than one termination currency as part of
the agreed-upon termination and close-out process, the agreement does
not meet the final rule's single termination currency condition.
However, the single termination currency condition does not rule out an
[[Page 669]]
eligible master netting agreement establishing more than one discrete
netting set and establishing separate margining and early termination
provisions for such a select netting set with its own single
termination currency.\272\
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\272\ As discussed above, the final rule permits discrete
netting sets under a single eligible master netting agreement,
subject to conditions specified in Sec. Sec. 23.152(c) and
23.153(c).
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As an alternative to the 8 percent cross-currency haircut,
commenters urged the Commission to permit any cross-currency
sensitivity between the swap portfolio credit exposure and the margin
collateral provided against that exposure to be measured as a component
of the margin required to be exchanged under the rule. The Commission
is concerned this alternative presupposes the CSE's certain knowledge,
at the time margin amounts must be determined, of the collateral
denomination to be posted by the counterparty in response to the margin
call and the denomination of future settlement payments. The likelihood
of such information being predictably available to the CSE does not
square with commenters' depiction of the amount of optionality
exercised with respect to these factors by swap market participants in
current market practice.
The 8 percent foreign currency haircut--to the extent it arises in
application of the final rule--is additive to the final rule's
standardized prudential supervisory haircuts that vary by asset class.
These haircuts are unchanged from the proposal. They have been
calibrated to be broadly consistent with valuation changes observed
during periods of financial stress, as noted above.
Although commenters suggested that the Commission permit CSEs to
determine haircuts through the firm's internal models, the Commission
believes the simpler and more transparent approach of the standardized
haircuts is adequate to establish appropriately conservative discounts
on eligible collateral. The final rule permits initial margin
calculations to be performed using an initial margin model in
recognition of the fact that swaps and swap portfolios are
characterized by a number of complex and inter-related risks that
depend on the specifics of the swap and swap portfolio composition and
are difficult to quantify in a simple, transparent and cost-effective
manner. The exercise of establishing appropriate haircuts based on
asset class of eligible collateral across long exposure periods is much
simpler as the risk associated with a position in any particular margin
eligible asset can be reasonably and transparently determined with
readily available data and risk measurement methods that are widely
accepted.
Finally, because the value of collateral may change, a CSE must
monitor the value and quality of collateral previously collected or
posted to satisfy minimum initial margin requirements. If the value of
such collateral has decreased, or if the quality of the collateral has
deteriorated so that it no longer qualifies as eligible collateral, the
CSE must collect or post additional collateral of sufficient value and
quality to ensure that all applicable minimum margin requirements
remain satisfied on a daily basis.
4. Other Collateral
Consistent with the proposal, Sec. 23.156(a)(5) of the final rule
states that CSE may collect or post initial margin that is not required
pursuant to the rule in any form of collateral.
The Dodd-Frank Act provides that in prescribing margin
requirements, the Commission shall permit the use of noncash
collateral, as the Commission determines to be consistent with (1)
preserving the financial integrity of markets trading swaps; and (2)
preserving the stability of the United States financial system. The
Commission believes that the eligibility of certain non-cash
collateral, subject to the conditions and restrictions contained in the
final rule, is consistent with the Dodd-Frank Act, because the use of
such non-cash collateral is consistent with preserving the financial
integrity of markets by trading swaps and preserving the stability of
the United States financial system. The non-cash collateral permitted
is highly liquid and resilient in times of stress and the rule does not
permit collateral exhibiting other significant risk. The use of
different types of eligible collateral pursuant to the requirements of
the final rule should also incrementally increase liquidity in the
financial system.
H. Custodial Arrangements
1. Proposal
Under the proposal, each CSE that posts initial margin with respect
to an uncleared swap would be mandated to require that all funds or
other property that it provided as initial margin be held by one or
more custodians that are not the CSE or the counterparty or are not
affiliates of the CSE or the counterparty. Each CSE that collects
initial margin with respect to an uncleared swap would be mandated to
require that required initial margin be held at one or more custodians
that are not the CSE or the counterparty or are not affiliates of the
CSE or the counterparty.
Each CSE would be required to enter into custodial agreements
containing specified terms. These would include a prohibition on
rehypothecating the margin assets and standards for the substitution of
assets.
The Commission previously adopted rules implementing section 4s(l)
of the Act.\273\ The Commission proposed to amend those rules to
reflect the approach set out in the proposal where segregation of
initial margin would be mandatory under certain circumstances.
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\273\ Protection of Collateral of Counterparties to Uncleared
Swaps; Treatment of Securities in a Portfolio Margining Account in a
Commodity Broker Bankruptcy, 78 FR 66621 (Nov. 6, 2013).
---------------------------------------------------------------------------
2. Comments
The Commission received several comments regarding custody of
margin collateral.
Several commenters that operate as custodian banks requested
clarification whether the final rule's prohibition against the
custodian rehypothecating, repledging, reusing or otherwise
transferring initial margin funds or property means that a custodian
bank is not permitted to accept cash funds that it holds pursuant to
Sec. 23.157 as a general deposit, and use such funds as it would any
other funds placed on deposit with it.\274\
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\274\ State Street; SIFMA; ABA, Sifma-AMG.
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Under Sec. 23.156, eligible collateral for initial margin includes
``immediately available cash funds'' that are denominated in a major
currency or the currency of settlement for the uncleared swap. It is
not practical for cash funds to be held by a custodian as currency that
remains the property of the posting party with a security interest
being granted to its counterparty, e.g., by placing such currency in a
safety deposit box or in the custodian's vault. Rather, the custodian
banks explained in their joint comment letter that, under their current
business practices, when a customer provides them with cash funds to
hold as a custodian, the custodian bank accepts the funds as a general
deposit, with the cash becoming property of the custodian bank and the
customer holding a contractual debt obligation, i.e., a general deposit
account, of the custodian bank.\275\
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\275\ State Street.
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When holding cash under the arrangement described by the custodian
bank commenters, a custodian is not a custodian of a discrete asset but
rather a recipient of cash under a contractual arrangement that
establishes a debt
[[Page 670]]
obligation to be paid on demand, i.e., the custodian is acting as a
bank. When such a customer has pledged cash funds as collateral under
the arrangements described by the commenters, the commenter's property
interest is the deposit account liability that the custodian bank owes
to the customer.
Several commenters supported the requirement that initial margin be
held at a third party custodian that was not affiliated with either the
CSE or its counterparty.\276\ Other commenters contended that the
independent third-party custodian requirement is unnecessary and the
Commission should allow for more flexibility in how initial margin is
kept, including permitting the counterparties to negotiate acceptable
custodians, including affiliated custodians.\277\ These commenters
expressed concern about complexities that additional parties bring to
the relationship, as well as reservations about the capacity and
availability of established custodians in the marketplace. One
commenter argued against independent third-party custodians, citing
increased costs arising from the negotiation of custodial contracts and
the cost of developing operational infrastructure, as it is not the
current practice for certain financial entities.\278\
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\276\ See State Street; ICI (in addition to urging the
Commission to require mandatory segregation for excess margin
amounts); AFR; and Public Citizen.
\277\ See ISDA; Sifma; GPC; Sifma-AMG; ABA; JBA; MFA; JFMC.
\278\ See GPC.
---------------------------------------------------------------------------
Commenters also expressed concerns with meeting the proposal's
requirement that the custodial agreement be legal, valid, binding, and
enforceable under the laws of all relevant jurisdictions, including
asking the Commission to specify that the only relevant jurisdiction is
that of the custodian.\279\ The same commenters urged more flexibility
in custodial agreements to be consistent with current market practice.
Another commenter noted that custodians should not be excluded solely
because they are affiliates of either the CSE or the counterparty since
the number of custodians is limited and many of the largest custodians
are affiliates of CSEs.\280\ The same commenter also argued that CSEs
should not be required to segregate initial margin that is not subject
to mandatory posting or collection.
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\279\ See BP; Shell; TRM; GPC; ISDA (asking for clarification of
the enforceability requirements, including whether the
enforceability in bankruptcy provisions refer to the bankruptcy of
the CSE or the counterparty); Sifma-AMG (contending that the
Commission instead adopt disclosure instead of enforceability
requirements).
\280\ See ISDA.
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Several commenters recommended lifting the restriction on
rehypothecation and reuse of initial margin collateral, either
generally or on a conditional basis.\281\ One commenter recommended
that the final rule allow limited rehypothecation that would meet the
requirements of the 2013 international framework if a model for such
rehypothecation could be developed for use by counterparties. The
commenter also noted that other regulators may permit rehypothecation
and, if so, a prohibition would create a competitive disadvantage for
market participants subject to the Commission's rule. Other commenters
supported the restriction on rehypothecation and reuse.\282\ Two
commenters argued that the prohibition on rehypothecation and reuse of
initial margin should not restrict the custodian's ability to accept
cash collateral, as cash collateral would be reinvested in the
custodian's account.\283\
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\281\ See CPFM; CCMR; IFM; ISDA; Sifma; ABA; CS; and FSR.
\282\ See ICI; Sifma-AMG; GPC; PublicCitizen; and AFR.
\283\ See Sifma-AMG and MetLife.
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Several commenters requested that the final rule allow greater
flexibility in segregation arrangements. These commenters requested
that the final rule permit arrangements such as title transfer and
charge-back of margin, segregation of margin on the books of the CSE or
within an affiliate if such collateral is insulated from the CSE's
insolvency.
One commenter requested that the final rule clarify that the
required custodian arrangements be tri-party, i.e., entered into
pursuant to an agreement between the CSE, its counterparty, and the
custodian.\284\ The commenter wrote that if a CSE's counterparty is not
a party to the custodial agreement, it would not be in contractual
privity with the unaffiliated custodian, and the CSE essentially would
exercise exclusive control over its counterparty' initial margin.
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\284\ MFA.
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3. Discussion
a. Initial Margin
The final rule establishes minimum standards for the safekeeping of
collateral. Section 23.157(a) addresses requirements for when a CSE
posts any collateral other than variation margin. Posting collateral to
a counterparty exposes a CSE to risks in recovering such collateral in
the event of its counterparty's insolvency. To address these risk and
to protect the safety and soundness of the CSE, Sec. 23.157(a)
requires a CSE that posts any collateral required under the final rule
other than variation margin with respect to a uncleared swap to require
that such collateral be held by one or more custodians that are neither
the CSE, its counterparty, or an affiliates of either counterparty.
This requirement applies to initial margin posted by a CSE pursuant to
Sec. 23.152.
Section 23.157(b) addresses requirements for when a CSE collects
initial margin required by Sec. 23.152. Under Sec. 23.157(b), the CSE
shall require that initial margin collateral collected pursuant to
Sec. 23.152 be held at one or more custodians that are neither the
CSE, its counterparty, or an affiliate of either counterparty. As is
the case with initial margin that a CSE posts, the Sec. 23.157(b)
applies only to initial margin that a CSE collects as required by Sec.
23.154, rather than all collateral collected.
For collateral subject to Sec. 23.157(a) or Sec. 23.157(b), Sec.
23.157(c) requires the custodian to act pursuant to a custodial
agreement that is legal, valid, binding, and enforceable under the laws
of all relevant jurisdictions, including in the event of bankruptcy,
insolvency, or similar proceedings. Such a custodial agreement must
prohibit the custodian from rehypothecating, repledging, reusing or
otherwise transferring (through securities lending, repurchase
agreement, reverse repurchase agreement, or other means) the funds or
other property held by the custodian. Cash collateral may be held in a
general deposit account with the custodian if the funds in the account
are used to purchase other forms of eligible collateral, such eligible
noncash collateral is segregated pursuant to Sec. 23.157, and such
purchase takes place within a time period reasonably necessary to
consummate such purchase after the cash collateral is posted as initial
margin.\285\
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\285\ As described earlier, collateral other than certain forms
of cash is subject to a haircut. As a result, when cash collateral
is used to purchase other forms of eligible collateral, a haircut
will need to be applied.
---------------------------------------------------------------------------
In response to the comments, the Commission notes that the ultimate
purpose of the custody agreement is twofold: (1) That the initial
margin be available to a counterparty when its counterparty defaults
and a loss is realized that exceeds the amount of variation margin that
has been collected as of the time of default; and (2) initial margin be
returned to the posting party after its swap obligations have been
fully discharged.
[[Page 671]]
The jurisdiction of the custodian is certainly one of the relevant
jurisdictions. Thus, a CSE must conduct sufficient legal review to
conclude with a well-founded basis and maintain sufficient written
documentation of that legal review that in the event of a legal
challenge, including one resulting from default or from receivership,
conservatorship, insolvency, liquidation, or similar proceedings of the
custodian, the relevant court or administrative authorities would find
the custodial agreement to be legal, valid, binding, and enforceable
under the law applicable to the custodian. A CSE would also be expected
to establish and maintain written procedures to monitor possible
changes in relevant law and to ensure that the agreement continues to
be legal, valid, binding, and enforceable under that law.
The jurisdiction of a CSE's counterparty, however, is also a
relevant jurisdiction. The CSE would have to ensure that if a
counterparty were to become insolvent, or otherwise be placed under the
control of a resolution authority, that there would not be a legal
basis to set aside the custodial arrangement, allowing the resolution
authority to reclaim for the estate assets that the counterparty had
placed with the custodian. Thus, the CSE would have to conduct a
sufficient legal review to conclude with a well-founded basis that in
the event of a legal challenge, including one resulting from default or
from receivership, conservatorship, insolvency, liquidation, or similar
proceedings of the counterparty, the relevant court or administrative
authorities would find the custodial agreement to be legal, valid,
binding, and enforceable by the CSE under the law applicable to the
counterparty. For this reason, the Commission declines to follow the
commenters' request that the Commission clarify that the only relevant
jurisdiction is that of the custodian.
Under Sec. 23.156, eligible collateral for initial margin includes
``immediately available cash funds'' that are denominated in a major
currency or the currency of settlement for the uncleared swap. However,
permitting initial margin collateral to be held in the form of a
deposit liability of the custodian bank is inconsistent with the final
rule's prohibition against rehypothecation of such collateral. In
addition, employing a deposit liability of the custodian bank--or
another depository institution--is inconsistent with the final rule's
prohibition against use of obligations issued by a financial firm.
On the other hand, as a practical matter, it is very difficult to
eliminate cash entirely. For example, the final rule's T+1 margin
collection requirement means that it will often be necessary to use
cash to cover the first days of a margin call. In addition, income
generated by non-cash assets in custody will be paid in cash.
Collateral reinvestments involving replacement of one category of non-
cash asset with another category of non-cash asset may create cash
balances between settlements. While the parties all have strong
business incentives to manage and limit these cash fund balances,
eliminating them entirely would result in a number of inefficiencies.
To address these concerns, the Commission has revised the final
rule to allow cash funds that are placed with a custodian bank in
return for a general deposit obligation to serve as eligible initial
margin collateral only in specified circumstances. However, the rule
requires the posting party to direct the custodian to reinvest the
deposited funds into eligible non-cash collateral of some type, or the
posting party to deliver eligible non-cash collateral to substitute for
the deposited funds. As noted above, the appropriate haircut must be
applied. This reinvestment must occur within a reasonable period of
time after the initial placement of cash collateral to satisfy the
initial margin requirement, and the amount of eligible collateral must
be sufficient to cover the initial margin amount in light of the
applicable haircut on the non-cash collateral pursuant to the final
rule.
CSEs must appropriately oversee their own initial margin collateral
posting and that of their counterparties in order to constrain the use
of cash funds, and achieve efficient reinvestment of cash funds in
excess of operational and liquidity needs into eligible margin
securities. In connection with implementing the final rule, CSEs should
ensure these procedures are adequate to assess the levels of cash
necessary under the circumstances of each counterparty relationship,
and to ensure the custodian will be directed to reinvest the remainder
in non-cash collateral promptly, or that the posting party will
substitute non-cash assets promptly, as applicable.
Section 23.157(c)(2) provides that, notwithstanding this
prohibition on rehypothecating, repledging, reusing or otherwise
transferring the funds or property held by the custodian, the posting
party may substitute or direct any reinvestment of collateral,
including, under certain conditions, collateral collected pursuant to
Sec. 23.152(a) or posted pursuant to Sec. 23.152(b).
In particular, for initial margin collected pursuant to Sec.
23.152(a) or posted pursuant to Sec. 23.152(b), the posting party may
substitute only funds or other property that meet the requirements for
eligible collateral under Sec. 23.156 and where the amount net of
applicable haircuts described in Sec. 23.156 would be sufficient to
meet the initial margin requirements of Sec. 23.152. The posting party
also may direct the custodian to reinvest funds only in assets that
would qualify as eligible collateral under Sec. 23.156 and ensure that
the amount net of applicable haircuts described in Sec. 23.156 would
be sufficient to meet the initial margin requirements of Sec. 23.152.
In the cases of both substitution and reinvestment, the final rule
requires the CSE to ensure that the value of eligible collateral net of
haircuts that is collected or posted remains equal to or above the
minimum requirements.
In the cases of both substitution and reinvestment, the final rule
requires the posting party to ensure that the value of eligible
collateral net of haircuts remains equal to or above the minimum
requirements contained in Sec. 23.152. In addition, the restrictions
on the substitution of collateral described above do not apply to cases
where a CSE has posted or collected more initial margin than is
required under Sec. 23.152. In such cases, the initial margin that has
been posted or collected in satisfaction of Sec. 23.152 is subject to
the restrictions on collateral substitution but any additional
collateral that has been posted or collected is not subject to the
restrictions on collateral substitution and, as noted above, is not
subject to any of the requirements of Sec. 23.157.
The Commission is adopting the segregation requirement in this rule
to help ensure the safety and soundness of CSEs subject to the rule and
to offset the greater risk to the financial system arising from the use
of uncleared swaps. The Commission has retained the requirement that
the custodian be unaffiliated with either the CSE or its counterparty.
In adopting this requirement, the Commission is more concerned that
customer confidence in a particular CSE could be correlated with
customer confidence in the affiliated custodian, especially in times of
high market stress, whereas the use of independent custodians should
offer counterparties a greater measure of confidence. Thus, the
Commission believes that it is necessary for the safety and soundness
of CSE and to minimize risk to the financial system that collateral be
held by a custodian that is neither a counterparty to the swap nor an
affiliate of either
[[Page 672]]
counterparty. This arrangement protects both counterparties from the
risk of the initial margin being held as part of one counterparty's
estate (or its affiliate's estate) in the event of failure, and
therefore not available to the other counterparty.
The Commission does not believe that the alternative arrangements
suggested by the commenters (e.g., arrangements involving title
transfer and charge back of margin) adequately ensure the safety and
soundness of the CSE nor adequately offset the risk to the financial
system arising from the use of uncleared swaps. In addition, the
Commission believes the specific structure of the custody arrangements
required by the rule are better left, on balance, to negotiations of
the parties, in accordance with the specific concerns of those parties.
Tri-party custody may be an optimal arrangement for some firms, while
for others, it has not typically been sought under established market
practice.
Further, the Commission is declining to revise the proposed
regulation to accommodate rehypothecation pursuant to some future model
that may be developed. Commenters who argued for allowing limited
rehypothecation did not propose a specific model, and hence the
Commission is not inclined to permit rehypothecation at this time due
to hypothetical scenarios that may or may not develop in the future.
b. Variation Margin
Section 23.157 does not require collateral that is collected or
posted as variation margin to be held by a third party custodian or
subject such collateral to restrictions on rehypothecation, repledging,
or reuse. So, subject to negotiations between the counterparties, a CSE
that is a depository institution could collect cash posted to it in
satisfaction of section 23.153 from a counterparty without establishing
a separate account for the counterparty. The cash funds would be the
property of the CSE, which would be permitted to reuse such funds
without restriction. Similarly, a CSE's counterparty would not be
required to segregate cash funds posted as variation margin by the CSE.
The same is true with respect to eligible non-cash collateral exchanged
as variation margin with a financial end user pursuant to Sec. 23.156;
the segregation and custody requirements of Sec. 23.157 do not apply.
Section 23.156(b) of the final rule permits eligible non-cash
collateral to be posted as variation margin for swaps between a CSE and
a financial end user. In such circumstances, a CSE or its financial end
user counterparty could reach an agreement under which either party
could itself hold non-cash collateral posted by the other and such non-
cash collateral could be rehypothecated, repledged, or reused.
The final rules in this area are consistent with those of the
Prudential Regulators.
I. Documentation
1. Proposal
The proposal sets forth documentation requirements for CSEs.\286\
For uncleared swaps between a CSE and a counterparty that is a swap
entity or a financial end user, the documentation would be required to
provide the CSE with the contractual right and obligation to exchange
initial margin and variation margin in such amounts, in such form, and
under such circumstances as are required by Sec. 23.150 through Sec.
23.161 of this part. For uncleared swaps between a CSE and a non-
financial end user, the documentation would be required to specify
whether initial and/or variation margin will be exchanged and, if so,
to include the information set forth in the rule. That information
would include the methodology and data sources to be used to value
positions and to calculate initial margin and variation margin, dispute
resolution procedures, and any margin thresholds.
---------------------------------------------------------------------------
\286\ Proposed Sec. 23.158.
---------------------------------------------------------------------------
The Commission proposal contains a cross-reference to an existing
Commission rule which already imposes documentation requirements on SDs
and MSPs.\287\ Consistent with that rule, the proposal would apply
documentation requirements not only to covered counterparties but also
to non-financial end users. Having comprehensive documentation in
advance concerning these matters would allow each party to a swap to
manage its risks more effectively throughout the life of the swap and
to avoid disputes regarding issues such as valuation during times of
financial turmoil. This would benefit not only the CSE but the non-
financial end user as well.
---------------------------------------------------------------------------
\287\ Commission Regulation 23.504.
---------------------------------------------------------------------------
2. Comments
The Commission received several comments regarding documentation.
Commenters sought clarification over aspects of the documentation
requirement.\288\ One commenter contended that the documentation
standards are too burdensome since initial margin methodologies may be
proprietary and complex while the other Commission regulations already
address documentation standards for valuations.\289\ Another commenter
argued that it would be difficult to comply with the documentation
standards with respect to valuations, and noting that valuation
standards are already addressed in other Commission regulations.\290\
Commenters remarked that non-financial end users should not be subject
to the documentation requirement.\291\
---------------------------------------------------------------------------
\288\ See Sifma (the Commission should clarify the dispute
resolution and documentation provisions to indicate that (i) the a
CSE would not violate its obligations if it releases margin
collateral to a counterparty at the conclusion of a dispute
mechanism consistent with the U.S. implementation of Basel; and (ii)
the parties would not be required to lock in dispute valuation
methods); JBA (seeking clarification on the level of documentation
and recommending that the documentation required take into account
the composition and size of derivative portfolios); ACLI
(documentation requirements should be clarified and harmonized with
the requirements from the Prudential Regulators and the SEC); and
FHLB (the final rule should require CSEs to have documentation that
provides for resolution of disputes regarding the calculation of
variation and initial margin and the value of collateral collected
or posted).
\289\ See ISDA.
\290\ See Freddie.
\291\ See CDEU (non-financial end users are already subject to
documentation requirements in other Commission regulations); and
COPE (noting that it is market practice for non-financial end users
to use ISDAs); BP; Joint Associations.
---------------------------------------------------------------------------
3. Discussion
The Commission is adopting the documentation requirements
substantially as proposed, with one exception for non-financial end
users. The Commission has removed the documentation requirements with
respect to non-financial end users. To the extent that other aspects of
the Commission's regulations address similar requirements, the
Commission believes that counterparties should be well-positioned to
comply with the documentation requirements and should reduce any
additional burdens in implementing this requirement.
Under the final rule, the documentation must grant the CSE the
contractual right to collect and to impose the obligation to post
initial and variation margin in such amounts, in such form, and under
such circumstances as are required by the rule. The documentation must
also specify the methods, procedures, rules, and inputs for determining
the value of each uncleared swap and the procedures by which any
disputes concerning the valuation of uncleared swaps may be resolved.
Finally, the documentation must also describe the methods, procedures,
rules, and inputs used to calculate initial and variation
[[Page 673]]
margin for uncleared swaps entered into between the CSE and the
counterparty.
J. Inter-Affiliate Trades
1. Proposal
The proposal effectively would have required two-way initial margin
and variation margin for swaps between CSEs and affiliates that were
swap entities or financial end users. The Prudential Regulators'
proposal set forth the same requirements.
2. Comments
Many commenters urged the Commission to exclude swaps between
affiliates from margin requirements.\292\ Commenters generally argued
that inter-affiliate swaps are already centrally risk managed and
requiring margin on inter-affiliate trades could discourage effective
risk management \293\ and the current practice of exchanging variation
margin should be sufficient to mitigate the risk posed by inter-
affiliate trades.\294\ They argued that requiring margin generally, and
initial margin in particular, on inter-affiliate swaps was unnecessary
for systemic stability. They further argued that imposing margin
requirements on inter-affiliate swaps would impose significant
costs,\295\ tie up liquidity,\296\ be inconsistent with the approach
taken in a number of other jurisdictions,\297\ and introduce group-wide
third-party credit risk.\298\ Sifma also argued that inter-affiliate
swaps should not count towards the margin thresholds and a covered swap
entity's material swaps exposure. Another commenter suggested that the
Commission conduct a study prior to imposing margin on inter-affiliate
trades.\299\
---------------------------------------------------------------------------
\292\ See ISDA, JFMC; Sifma, ABA, JBA, CS, Shell TRM (if inter-
affiliate transactions are subject to margin requirements, the
Commission should define the term ``affiliate'' consistently with
other Commission regulations); BP; and FSR. Sifma suggested
excluding inter-affiliate swaps from margin requirements if the
swaps are subject to a group-wide consolidated risk management
program and the exchange of variation margin, and the CSE is part of
a group that is subject to consolidated capital requirements
consistent with Basel. JBA argued that the risks posed by inter-
affiliate trades are generally lower and pointed out the
difficulties associated with entering into a CSA with all covered
counterparties within a limited timeframe.
\293\ See Sifma, JBA, ABA, TCH, and CS.
\294\ See ISDA, Sifma, and CS.
\295\ See ISDA, Sifma, ABA, and TCH.
\296\ See ISDA, ABA, TCH, and CS.
\297\ See ISDA.
\298\ See ISDA, ABA, TCH, and CS.
\299\ See FSR.
---------------------------------------------------------------------------
Commenters also suggested alternatives to a full two-way collect-
and-post regime for initial margin for affiliate swaps. For example,
some commenters proposed that instead of each CSE posting and
collecting segregated initial margin to and from its affiliate, the CSE
would only collect from its affiliate (subject to a wholly owned
subsidiary exemption and a de minimis exemption) and the CSE would be
permitted to segregate the initial margin within its group, so as to
prevent undue third-party custodial risk.\300\ Some suggested a CSE
would only collect from an affiliate that is not subject to margin and
capital requirements.\301\ These commenters further argued that certain
highly regulated affiliates like U.S. bank holding companies should
benefit from an exception to initial margin requirements.\302\ Some
commenters also suggested an alternative where the Commission would
permit the common parent of an affiliate pair to post a single amount
of segregated initial margin in which each affiliate would have a
security interest.\303\
---------------------------------------------------------------------------
\300\ See The Clearing House.
\301\ Id.
\302\ See ISDA.
\303\ See The Clearing House.
---------------------------------------------------------------------------
3. Discussion
The Commission has determined a CSE shall not be required to
collect initial margin from a margin affiliate provided that the CSE
meets the following conditions: (i) The swaps are subject to a
centralized risk management program that is reasonably designed to
monitor and to manage the risks associated with the inter-affiliate
swaps; and (ii) the CSE exchanges variation margin with the margin
affiliate. These two conditions are consistent with recommendations
from commenters. They are similar to conditions that were previously
established by the Commission when providing an exemption from the
clearing requirement for certain inter-affiliate swaps.\304\
---------------------------------------------------------------------------
\304\ See Sec. 50.52.
---------------------------------------------------------------------------
The Commission has determined, however, to require CSEs to collect
initial margin from non-U.S. affiliates that are financial end users
that are not subject to comparable initial margin collection
requirements on their own outward-facing swaps with financial end
users. For many of the reasons listed by the commenters, as well as in
light of the treatment of inter-affiliate swaps by the prudential
regulators, the Commission has determined not to otherwise require CSEs
to collect initial margin from, or to post initial margin to,
affiliates that are CSEs or financial end users. (As discussed below,
pursuant to the Prudential Regulators' rules, CSEs would be required to
post initial margin to affiliates that are swap entities subject to
those rules.)
The Commission first notes that the Prudential Regulators decided
not to impose a general two-way initial margin requirement. Instead,
the Prudential Regulators have required swap entities subject to their
rules to collect initial margin from affiliates that are swap entities
or financial end users. Thus, if a CSE enters into a swap with a swap
entity subject to the Prudential Regulators' rules, the CSE will post
initial margin but will not collect initial margin for the transaction.
The Commission considered the comments that inter-affiliate swaps
do not increase the overall risk profile or leverage of the group. The
Commission further considered the fact that inter-affiliate two-way
margin would substantially increase the overall amount of margin being
collected, and thus the cost of swap transactions generally, without a
commensurate benefit to risk reduction to the overall group. The
Commission notes that considering the risk exposure of the overall
group of which a CSE is a part is consistent with the approach taken in
its margin rules (and the Prudential Regulators' rules) in other key
areas--as in the calculation of material swaps exposure to determine
overall swaps exposure and the calculation of the initial margin
threshold amount to determine whether there is an obligation to collect
or post initial margin.
Second, the Commission notes that the treatment of inter-affiliate
transactions is related to what the Commission did when it adopted an
exemption to the clearing mandate for inter-affiliate transactions in
2013. In that rulemaking, it considered, but decided against, requiring
the exchange of initial margin or variation margin as a condition to
using the exemption. It stated that such requirements ``would limit the
ability of U.S. companies to efficiently allocate risk among affiliates
and manage risk centrally.'' \305\
---------------------------------------------------------------------------
\305\ Clearing Exemption for Swaps between Certain Affiliated
Entities, 78 FR 21750 at 21760 (April 11, 2013).
---------------------------------------------------------------------------
Third, the Commission considered the decision of the Prudential
Regulators' not to impose two-way initial margin and impose a collect
only obligation instead. If the Commission were to impose two-way
margin, it would be inconsistent with the Prudential Regulators' rule.
The Commission further considered whether to impose a collect-only
obligation. However, this would result in a two-way requirement in
transactions between a swap dealer subject to the Prudential
Regulators'
[[Page 674]]
rules and a CSE, a result which the Prudential Regulators determined
not to impose. In addition, the Commission considered the difference in
mission and overall regulatory framework between the Prudential
Regulators and the Commission. For example, the Commission notes that
the imposition of a collect only initial margin requirement on swap
entities subject to the Prudential Regulators' rules is similar to
existing requirements of law, in that banks are subject to significant
regulatory restrictions and requirements on inter-affiliate
transactions under Sections 23A and 23B of the Federal Reserve Act. The
same cannot be said of a collect-only requirement imposed on CSEs,
since the restrictions under Sections 23A and 23B do not apply to
nonbank affiliates such as CSEs.
For purposes of symmetry, however, the Commission has determined to
require a CSE that enters into an inter-affiliate swap with a swap
entity that is subject to the rules of the Prudential Regulators to
post initial margin with that swap entity in an amount equal to the
amount that the swap entity is required to collect under the rules of
the Prudential Regulators. This provision imposes no additional burden
on the CSE because the other swap entity would be required to collect
the initial margin in any case. This provision simply means that a CSE
will be required under CFTC rules to post initial margin to the extent
that the other swap entity is required under Prudential Regulator rules
to collect it.
The Commission also considered its objective of harmonizing its
margin rules as much as possible with international standards. The BCBS
standards, for example, state that the exchange of initial and
variation margin by affiliated parties ``is not customary'' and that
initial margin in particular ``would likely create additional liquidity
demands.'' \306\ The Commission recognized that requiring the posting
and collection of initial margin for inter-affiliate swaps would be
likely to put CSEs at a competitive disadvantage to firms in other
jurisdictions. The Commission understands that many authorities, such
as those in Europe and Japan, are not expected to require initial
margin for inter-affiliate swaps. These savings could enable such firms
to offer swaps to third parties on better terms than firms that incur
the costs of inter-affiliate initial margin.
---------------------------------------------------------------------------
\306\ BCBS IOSCO Report at 21.
---------------------------------------------------------------------------
The Commission has determined, however, to require CSEs to exchange
variation margin with affiliates that are swap entities or financial
end users, as is also required under the Prudential Regulators' rules.
Marking open positions to market each day and requiring the posting or
collection of variation margin will reduce the risks of inter-affiliate
swaps.
As noted above, CSEs will be required to collect initial margin
from non-U.S. affiliates that are not subject to comparable initial
margin collection requirements on their own outward-facing swaps with
financial entities. These affiliates generally would include entities
located in jurisdictions for which substituted compliance has not been
granted with regard to the collection of initial margin. This
requirement would also apply in the case of a series of transactions
involving, directly or indirectly, an affiliate that is not subject to
comparable initial margin collection requirements. That is, even if the
CSE is only in privity of contract with an affiliate who is subject to
such requirements, but that affiliate, directly or indirectly, is
transacting with another affiliate who is not subject to such
requirements, the CSE would be required to collect initial margin.
This provision is an important anti-evasion measure. It is designed
to prevent the potential use of affiliates to avoid collecting initial
margin from third parties. For example, suppose that an unregistered
non-U.S. affiliate of a CSE enters into a swap with a financial end
user and does not collect initial margin. Suppose further that the
affiliate then enters into a swap with the CSE. Effectively, the risk
of the swap with the third party would have been passed to the CSE
without any initial margin. The rule would require this affiliate to
post initial margin with the CSE in such cases. The rule would further
require that the CSE collect initial margin even if the affiliate
routed the trade through one or more other affiliates.
K. Implementation Schedule
1. Proposal
The proposed rules set out an implementation schedule for initial
margin ranging from December 1, 2015 to December 1, 2019.\307\ This
extended schedule was designed to give market participants ample time
to develop the systems and procedures necessary to exchange margin and
to make arrangements to have sufficient assets available for margin
purposes. The requirements would be phased-in in steps from the largest
covered parties to the smallest.
---------------------------------------------------------------------------
\307\ Proposed Sec. 23.160.
---------------------------------------------------------------------------
Variation margin requirements would be implemented on the scheduled
first date.
2. Comments
Commenters generally stated that, to the extent practicable, there
should be international harmonization of implementation dates for
margin and capital requirements.\308\ While one commenter supported the
proposed compliance date schedules set out in the 2014 proposal,\309\ a
number of commenters argued that compliance with the final rule should
be delayed for 18 months to 2 years in order to allow for operational
changes and the need for additional or revised documentation that will
be required for CSEs to comply with the rule.\310\
---------------------------------------------------------------------------
\308\ See Sifma; ABA; Australian Banks.
\309\ See CME.
\310\ See JFMC; GPC; JBA; ISDA; Sifma-AMG; JBA; CPFM; and
Freddie. ISDA further argues that financial end users that fall
below the implementation schedule threshold for each relevant time
period should not be subject to initial margin.
---------------------------------------------------------------------------
With respect to phasing-in the implementation of the initial margin
requirements, a commenter stated that the phase-in provisions should be
revised to apply only to uncleared swaps between CSEs.\311\ The
commenter further stated that non-CSEs should not be required to comply
with the initial margin requirements until December 2019. The
Commission also received a comment stating that the implementation of
the compliance date schedule should not coincide with code freezes and
that margin requirements for over-the-counter derivatives should be
taken into consideration when finalizing this rule.\312\ Still another
commenter argued for a delay in implementation to allow the use of the
latest developments from BCBS regarding margin calculation best
practices and the development of a universal model.\313\
---------------------------------------------------------------------------
\311\ See GPC.
\312\ See Sifma.
\313\ See CS.
---------------------------------------------------------------------------
Several commenters urged that the compliance date for variation
margin requirements be phased in, in a manner similar to the compliance
dates for the initial margin requirements.\314\ These commenters
argued, among other things, that the phase-in of the variation margin
requirements would allow CSEs the time to re-document all necessary
swap contracts at one time. Commenters stated that variation margin
requirements should be phased in based
[[Page 675]]
on decreasing notional amount thresholds over a two-year period
commencing upon the latter of the publication of the margin rules for
over-the-counter derivatives in the U.S., the EU and Japan or the
publication of the Commission's comparability determinations with
respect to the EU and Japan.\315\
---------------------------------------------------------------------------
\314\ See ACLI; MefLife; ICI; Sifma; Sifma-AMG; JFMC; GPC; JBA;
ISDA; ABA; Freddie; CDEU; and FHLB.
\315\ See Sifma; ABA.
---------------------------------------------------------------------------
Certain commenters also requested that the Commission extend the
meaning of swaps entered into prior to the compliance date to include
(1) swaps entered into prior to the applicable compliance date (legacy
swaps) that are amended in a non-material manner; (2) novations; and
(3) new derivatives that result from portfolio compression of legacy
derivatives.\316\ These commenters urged that if a general exclusion
for novated legacy swaps is not provided, there should be an exclusion
for novated swaps between affiliates resulting from organizational
restructuring or regulatory requirements such as the swaps push-out
rule.
---------------------------------------------------------------------------
\316\ See CS; ISDA.
---------------------------------------------------------------------------
One commenter urged that, during the phase-in period, only entities
whose swap volume currently exceeds the applicable threshold should be
subject to the margin requirements.\317\ The commenter stated that, if
the swap activity of either party to a swap declines below the
applicable threshold, that party should cease being subject to the
initial margin requirements until such time as it exceeds the
applicable threshold. Another commenter asked how the margin
requirements would apply in the event of a change in status of the
counterparty.\318\ One commenter requested that the Commission revise
the phase-in schedule so that entities that are not CSEs would be
subject to the margin requirements in December 2019.\319\
---------------------------------------------------------------------------
\317\ See ISDA.
\318\ See ISDA.
\319\ See GPC (noting issues with providing confidential
position information regarding its uncleared swaps to CSEs).
---------------------------------------------------------------------------
3. Discussion
a. Initial Margin
Under the proposal, the implementation of both initial and
variation margin requirements would have started on December 1, 2015.
With respect to initial margin requirements, the requirements would
have been phased-in between December 1, 2015 and December 1, 2019.
Variation margin requirements for all CSE with respect to covered swaps
with any counterparty would have been effective as of December 1, 2015.
This proposed set of compliance dates was consistent with those set
forth in the 2013 international framework.
On March 18, 2015, the BCBS and IOSCO issued a press release
announcing that the implementation of the 2013 international framework
would be delayed by nine months. This announcement was in response to
the fact that to date in March 2015, no jurisdiction had yet finalized
rules for margin requirements for non-centrally cleared derivatives.
Accordingly, the final rule has been revised to delay the
implementation of both initial and variation margin requirements by
nine months from the compliance schedule set forth in the proposal.
This delay results in a uniform approach with respect to compliance
dates across the final rule and the international framework.
The changes to the proposed compliance dates should help address
concerns raised by commenters. The Commission agrees that international
harmonization of margin and capital requirements are prudent. In light
of the concerns raised by the commenters and the delay of the
implementation of the 2013 international framework, the Commission has
incorporated into the final rule provisions reflecting the
implementation schedule for the 2013 international framework that was
recently set out by the BCBS and IOSCO.
The final rule adopts a phase-in arrangement for variation margin
requirements that is different from the proposal. The Commission
believes that a phase-in of variation margin requirements similar to
the phase-in of initial margin requirements is not necessary because
the collection of daily variation margin is currently an industry best
practice and will not require many changes in current swaps business
operations for CSE covered swaps entities. However, the Commission has
revised the 2014 proposal to include the phase-in of compliance dates
for variation margin as set forth above to align with the dates
suggested by the BCBS and IOSCO on March 18, 2015.
The Commission further believes that classifying new swap
transactions as swaps entered into prior to the compliance date could
create significant incentives to engage in amendments and novations for
the purpose of evading the margin requirements. Moreover, limiting the
extension to ``material'' amendments or ``legitimate'' novations is
difficult to do within the final rule as the specific motivation for an
amendment or novation is generally not observable. Finally, the
Commission believes that classifying some new swap transactions and
transactions entered into prior to the compliance date would make the
process of identifying those swaps to which the rule applies overly
complex and non-transparent. Accordingly, the Commission has elected
not to extend the meaning of swaps entered into prior to the compliance
date in this manner requested by some commenters at this time. The
Commission recognizes that questions have arisen about the effect of
compression exercises which may have implications in a variety of
contexts. The Commission is open to further discussion before
implementation about the best way to address these questions.
For purposes of initial margin, as reflected in the table below,
the compliance dates range from September 1, 2016, to September 1,
2020, depending on the average daily aggregate notional amount of
uncleared swaps, uncleared security-based swaps, foreign exchange
forwards and foreign exchange swaps (``covered swaps'') of the CSE and
its counterparty (accounting for their respective affiliates) for
March, April and May of that year.\320\
---------------------------------------------------------------------------
\320\ ``Foreign exchange forward'' and ``foreign exchange swap''
are defined to mean any foreign exchange forward, as that term is
defined in section 1a(24) of the Commodity Exchange Act (7 U.S.C.
1a(24)), and foreign exchange swap, as that term is defined in
section 1a(25) of the Commodity Exchange Act (7 U.S.C. 1a(25)).
------------------------------------------------------------------------
Compliance date Initial margin requirements
------------------------------------------------------------------------
September 1, 2016................. Initial margin where both the CSE
combined with all its affiliates
and its counterparty combined with
all its affiliates have an average
daily aggregate notional amount of
covered swaps for March, April and
May of 2016 that exceeds $3
trillion.
September 1, 2017................. Initial margin where both the CSE
combined with all its affiliates
and its counterparty combined with
all its affiliates have an average
daily aggregate notional amount of
covered swaps for March, April and
May of 2017 that exceeds $2.25
trillion.
[[Page 676]]
September 1, 2018................. Initial margin where both the CSE
combined with all its affiliates
and its counterparty combined with
all its affiliates have an average
daily aggregate notional amount of
covered swaps for March, April and
May of 2018 that exceeds $1.5
trillion.
September 1, 2019................. Initial margin where both the CSE
combined with all its affiliates
and its counterparty combined with
all its affiliates have an average
daily aggregate notional amount of
covered swaps for March, April and
May of 2019 that that exceeds $0.75
trillion.
September 1, 2020................. Initial margin for any other CSE
with respect to covered swaps with
any other covered counterparty.
------------------------------------------------------------------------
In calculating the amount of covered swaps as set forth in the
table above, the final rule provides that a CSE shall count the average
daily aggregate notional amount of an uncleared swap, an uncleared
security-based swap, a foreign exchange forward or a foreign exchange
swap between the entity and an affiliate only one time, and shall not
count a swap that is exempt from the Commission's margin requirements
under Sec. 23.150(b).\321\ These provisions were not included in the
proposed rule. The purpose of the first provision in the final rule is
to prevent double counting of covered swaps between affiliates, a
concern raised by number of commenters, which could artificially
increase a CSE's average daily aggregate notional amount. The purpose
of the second provision is to ensure that swaps that have been exempted
from the margin requirements are fully exempted and do not influence
other aspects of the rule such as whether an entity maintains a
material swaps exposure.
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\321\ See Sec. 23.150(b) of the final rule.
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The Commission expects that CSEs likely will need to make a number
of operational and legal changes to their current swaps business
operations in order to achieve compliance with the provisions of the
final rule relating to the initial margin requirements, including
potential changes to internal risk management and other systems,
trading documentation, collateral arrangements, and operational
technology and infrastructure. In addition, the Commission expects that
CSEs that wish to calculate initial margin using an initial margin
model will need sufficient time to develop such models and obtain
regulatory approval for their use. Accordingly, the compliance dates
have been structured to ensure that the largest and most sophisticated
CSEs and counterparties that present the greatest potential risk to the
financial system comply with the requirements first. These swap market
participants should be able to make the required operational and legal
changes more rapidly and easily than smaller entities engaging in swaps
less frequently and pose less risk to the financial system.
b. Variation Margin
For purposes of variation margin, the compliance dates are
September 1, 2016 and March 1, 2017. Theses compliance dates also
depend on the average daily aggregate notional amount of covered swaps
of the CSE combined with its affiliates and its counterparties
(combined with that counterparty's affiliates) for March, April and May
of that year (the ``calculation period'').\322\ Thus, a given CSE may
have multiple compliance dates depending on both the combined average
daily aggregate notional amount of covered swaps of the CSE and its
affiliates during the calculation period as well as the combined
average daily notional amount of covered swaps of its counterparties
and that counterparty's affiliates during the calculation period.
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\322\ See Regulation 23.161.
------------------------------------------------------------------------
Compliance date Initial margin requirements
------------------------------------------------------------------------
September 1, 2016................. Variation margin where both the CSE
combined with all its affiliates
and its counterparty combined with
all its affiliates have an average
daily aggregate notional amount of
covered swaps for March, April and
May of 2016 that exceeds $3
trillion.
March 1, 2017..................... Variation margin for any other CSE
with respect to covered swaps with
any other counterparty that is a
swap entity or financial end user.
------------------------------------------------------------------------
Calculating the amount of covered swaps set forth in the table
above for the purposes of determining variation margin is done in the
same manner as calculating the amount of covered swaps for purposes of
determining initial margin.\323\ A CSE shall count the average daily
aggregate notional amount of a uncleared swap, an uncleared security-
based swap, a foreign exchange forward or a foreign exchange swap
between the entity and an affiliate only one time, and shall not count
a swap that is exempt from the Commission's margin requirements under
Sec. 23.150(b).
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\323\ As a specific example of the calculation, consider a U.S.
based financial end user (together with its affiliates) with a
portfolio consisting of two uncleared swaps (e.g., an equity swap,
an interest rate swap) and one uncleared security-based credit swap.
Suppose that the notional value of each swap is exactly $1 trillion
on each business day of March, April and May of 2016. Furthermore,
suppose that a foreign exchange forward is added to the entity's
portfolio at the end of the day on April 29, 2016, and that its
notional value is $1 trillion on every business day of May 2016. On
each business day of March and April of 2016, the aggregate notional
amount of uncleared swaps, security-based swaps and foreign exchange
forwards and swaps is $3 trillion. Beginning on May 1, 2016, the
aggregate notional amount of uncleared swaps, security-based swaps
and foreign exchange forwards and swaps is $4 trillion. The daily
average aggregate notional value for March, April and May 2016 is
then (23 x $3 trillion + 21 x $3 trillion + 21 x $4 trillion)/(23 +
21 + 21) = $3.3 trillion, in which case this entity would have a
gross notional exposure that would result in its compliance date
beginning on September 1, 2016.
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c. Changes in Material Swaps Exposure
Once a CSE and its counterparty must comply with the margin
requirements for uncleared swaps based on the compliance dates set
forth in Sec. 23.161, the CSE and its counterparty shall remain
subject to the margin requirements from that point forward. For
example, September 1, 2017 is the relevant compliance date where both
the CSE combined with all its affiliates and its counterparty combined
with all its affiliates have an average aggregate daily notional amount
of covered swaps that exceeds $2.25 trillion. If the notional amount of
the swap activity for the CSE or the counterparty drops below that
threshold amount of covered swaps in subsequent years, their swaps
would nonetheless remain subject to the margin requirements. On
September 1, 2020, any CSE that did not have an earlier compliance date
becomes subject
[[Page 677]]
to the initial margin requirements with respect to uncleared swaps.
The Commission has declined to make a change in the final rule that
would allow a counterparty whose swap activity declines below the
applicable threshold set forth in Sec. 23.161 to cease being subject
to margin requirements. The Commission believes that allowing entities
coverage status to change over time results in additional complexity
with little benefit since all entities will be subject to the rule as
of September 1, 2020. Accordingly, allowing an entity's coverage status
to fluctuate would only be consequential for a limited period of time.
d. Changes in Counterparty Status
The Commission has added Sec. 23.161(c) to the final rule to
clarify the applicability of the margin requirements in the event a CSE
's counterparty changes its status (for example, if the counterparty is
a financial end user without material swaps exposure and becomes a
financial end user without material swaps exposure). Under Sec.
23.161(c), in the event a counterparty changes its status such that an
uncleared swap with that counterparty becomes subject to stricter
margin requirements, then the CSE shall comply with the stricter margin
requirements for any uncleared swap entered into with that counterparty
after the counterparty changes its status.
Section 23.161(c) states that in the event a counterparty changes
its status such that a uncleared swap with that counterparty becomes
subject to less strict margin requirements (such as when a counterparty
changes status from a financial end user with material swaps exposure
to a financial end user without material swaps exposure), then the CSE
may comply with the less strict margin requirements for any swap
entered into with that counterparty after the counterparty changes its
status as well as for any outstanding uncleared swap entered into after
the applicable compliance date and before the counterparty changed its
status. As a specific example, if a CSE's counterparty transitioned
from a financial end user with material swaps exposure to a financial
end user without material swaps exposure, initial margin that had been
previously collected could be returned if agreed by both parties since
the rule would not require an exchange of initial margin on pre-
existing or future uncleared swaps.
e. Applicable EMNA
A CSE may enter into swaps on or after the final rule's compliance
date pursuant to the same master netting agreement that governs
existing swaps entered into with a counterparty prior to the compliance
date. The final rule permits a CSE to (1) calculate initial margin
requirements for swaps under an EMNA with the counterparty on a
portfolio basis in certain circumstances, if it does so using an
initial margin model; and (2) calculate variation margin requirements
under the final rule on an aggregate, net basis under an EMNA with the
counterparty. Applying the final rule in such a way would, in some
cases, have the effect of applying it retroactively to swaps entered
into prior to the compliance date under the EMNA.
The Commission received several comments expressing concern that
the proposal might require swaps entered into before the compliance
dates to be documented under a different EMNA than swaps entered into
after the compliance dates in order for the margin requirements not to
apply to the pre-compliance dates swaps. As described further above,
the Commission has revised the final rule to allow for the
establishment of separate netting sets under a single ENMA to avoid
this outcome.
f. Standards Expressed in U.S. Dollars
The proposal contained a number of numerical amounts that are
expressed in U.S. dollar terms. The amounts include the effective date
phase-in thresholds, the initial margin threshold amount, the material
swap exposure amount, and the minimum transfer amount. These numerical
amounts are expressed in the 2013 international framework in terms of
Euros. In the proposal, the Commission translated the Euro amounts from
the 2013 international framework using a Euro-U.S. Dollar exchange rate
that was broadly consistent with the exchange rate that prevailed at
the time of the proposal's publication.
In the proposal, the Commission sought comment on how to deal with
fluctuations in exchange rates and how such fluctuations may create
inconsistencies in the numerical amounts that are established across
differing jurisdictions. One commenter suggested using an average
exchange rate calculated over a period of time. Another commenter
suggested that the Commission should periodically recalibrate these
amounts in response to broad movements in underlying exchange rates.
The Commission believes that persistent and significant
fluctuations in exchange rates could result in significant differences
across jurisdictions that would complicate cross-border transactions
and create competitive inequities. The Commission does not agree,
however, that the final rule's numerical amounts should be mechanically
linked to either prevailing exchange rates or average exchange rates
over a period of time as short term fluctuations in exchange rates
would result in high frequency changes that would create significant
operational and logistical burdens. Rather, and consistent with the
view of one commenter, the Commission expects to consider periodically
the numerical amounts expressed in the final rule and their relation to
amounts denominated in other currencies in differing jurisdictions. The
Commission will then propose adjustments, as appropriate, to these
amounts.
In the final rule, the Commission is adjusting the numerical
amounts described above in light of significant shifts in the Euro-U.S.
Dollar exchange rates since the publication of the proposal.
Specifically, the Commission is reducing the value of each numerical
quantity expressed in dollars to be consistent with a one for one
exchange rate with the Euro. As a specific example, the amount of the
initial margin threshold is being changed from $65 million in the
proposal to $50 million in the final rule. This change will align the
U.S dollar denominated numerical amounts in the final rule with those
in the 2013 international framework, will be consistent with amounts
that have been proposed in margin rules by the European and Japanese
authorities, and will be more consistent with the Euro-U.S. Dollar
exchange rate prevailing at the time the final rule is published.
III. Interim Final Rule
A. Background
Title VII of the Dodd-Frank Act established a comprehensive new
regulatory framework for derivatives, which the Act generally
characterizes as ``swaps'' and ``security-based swaps.'' \324\ As part
of this new regulatory framework, sections 731 of the Dodd-Frank Act
added a new section 4s to the CEA which requires registration with the
CFTC of swap dealers and major swap participants.\325\
[[Page 678]]
These registrants are collectively referred to in this preamble as
``swap entities.''
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\324\ ``Swaps'' are defined in section 721 of the Dodd-Frank Act
to include interest rate swaps, commodity-based swaps, equity swaps
and credit default swaps. See 7 U.S.C. 1a(47).
\325\ See 7 U.S.C. 6s; 15 U.S.C. 78o-10. Section 731 of the
Dodd-Frank Act requires swap dealers and major swap participants to
register with the CFTC, which is vested with primary responsibility
for the oversight of the swaps market under Title VII of the Dodd-
Frank Act.
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As noted earlier, sections 731 of the Dodd-Frank Act requires the
Commission to adopt rules that apply to all swap dealer and major swap
participants without a prudential regulator, imposing capital
requirements and initial and variation margin requirements on all
uncleared swaps. The capital and margin requirements under sections 731
of the Dodd-Frank Act apply to uncleared swaps and complement other
provisions of the Dodd-Frank Act that require the Commission to make
determinations as to whether certain swaps, or a group, category, or
class of such transactions, should be required to be cleared.\326\ If
the CFTC has made such a determination, it is generally unlawful for
any person to engage in such a swap unless the transaction is submitted
to a derivatives clearing organization, as applicable, for clearing.
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\326\ 7 U.S.C. 2(h). The CEA sets out standards that the
Commission is required to apply when making determinations about
clearing, which generally address whether a swap is sufficiently
standardized to be cleared. 7 U.S.C. 2(h)(2)(D). To date, the
Commission has determined that certain interest rate swaps and
credit default swaps are required to be cleared. 17 CFR 50.4.
---------------------------------------------------------------------------
The clearing requirements, however, do not apply to an entity that
is not a financial entity, is using a swap to hedge or mitigate
commercial risk, and notifies the Commission, in a manner set forth by
the Commission, how it generally meets its financial obligations.\327\
Thus, a particular swap might be subject to the capital and margin
requirements of section 731 either because it is not subject to the
mandatory clearing requirement, or because one of the parties to the
swap is eligible for, and elects to use, an exception or exemption from
the mandatory clearing requirement. Such a swap is a ``uncleared'' swap
for purposes of the capital and margin requirements established under
sections 731 of the Dodd-Frank Act.
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\327\ See 7 U.S.C. 2(h)(7). Further, the Commission has
authority to exempt swaps from the clearing requirement. 7 U.S.C.
6(c)(1).
---------------------------------------------------------------------------
Sections 731 direct the Commission to impose initial and variation
margin requirements on all swaps that are not cleared. Under the
proposed rule, the Commission distinguished among different types of
counterparties on the basis of risk.\328\
---------------------------------------------------------------------------
\328\ The final rule takes a similar approach. In implementing
this risk-based approach, the final rule distinguishes among four
separate types of swap counterparties: (i) Counterparties that are
themselves swap entities; (ii) counterparties that are financial end
users with a material swaps exposure; (iii) counterparties that are
financial end users without a material swaps exposure, and (iv)
other counterparties, including nonfinancial end users, sovereigns,
and multilateral development banks.
---------------------------------------------------------------------------
On January 12, 2015, President Obama signed into law TRIPRA. Title
III of TRIPRA, the ``Business Risk Mitigation and Price Stabilization
Act of 2015,'' amends statutory provisions added by the Dodd-Frank Act
relating to margin requirements for swaps and security-based swaps.
Specifically, section 302 of TRIPRA's Title III amends sections 731 and
764 of the Dodd-Frank Act to provide that the initial and variation
margin requirements do not apply to certain transactions of specified
counterparties that would qualify for an exemption or exception from
clearing, as explained more fully below. Uncleared swaps that are
exempt under section 302 of TRIPRA will not be subject to the
Commission's rules implementing margin requirements. In section 303 of
TRIPRA, Congress required that the Commission implement the provisions
of Title III by promulgating an interim final rule and seeking public
comment on the interim final rule.
The Commission is therefore promulgating this interim final rule
with a request for comment. As noted above, swaps may be uncleared
swaps either because (i) there is an exemption or exception from
clearing available; or (ii) the Commission has not determined that such
swap is required to be cleared. The exclusions and exemptions from the
final margin rule will apply to both categories of uncleared swaps when
they involve a counterparty that meets the requirements for an
exception or exemption from clearing (e.g., a non-financial end user
using swaps to hedge or mitigate commercial risk).
Clearing requirements pursuant to the CEA began to take effect with
respect to certain interest rate and credit default swap indices swaps
on March 11, 2013.\329\ CSEs have accordingly already established
methods and procedures to engage in transactions with counterparties
that are eligible for the clearing exceptions or exemptions and for
recording and reporting the eligibility of these transactions for the
exception or exemptions as required under the statute.\330\ The
Commission expects these processes will function equally well as a
basis for the parallel statutory exemptions from initial and variation
margin requirements for uncleared swaps implemented pursuant to this
interim final rule.
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\329\ 17 CFR 50.25. See 77 FR 44441 (July 30, 2012)
\330\ See, e.g., 17 CFR 50.50(b).
---------------------------------------------------------------------------
B. Description of the Interim Final Rule
This interim final rule, which adds a new section 23.150(b) to the
final rule, adopts the statutory exemptions and exceptions as required
under TRIPRA. TRIPRA provides that the initial and variation margin
requirements do not apply to the uncleared swaps of three categories of
counterparties. In particular, section 302 of TRIPRA amends section 731
so that initial and variation margin requirements will not apply to a
swap in which a counterparty (to a CSE) is (1) a non-financial entity
(including small financial institution and a captive finance company)
that qualifies for the clearing exception under section 2(h)(7)(A) of
the Act; (2) a cooperative entity that qualifies for an exemption from
the clearing requirements issued under section 4(c)(1) of the Act; or
(3) a treasury affiliate acting as agent that satisfies the criteria
for an exception from clearing in section 2(h)(7)(D) of the Act.
1. Entities Qualifying for a Clearing Exception
TRIPRA provides that the initial and variation margin requirements
of the final rule shall not apply to a uncleared swap in which a
counterparty qualifies for an exception under section 2(h)(7)(A) of the
CEA.\331\ Section 2(h)(7)(A) excepts from clearing swaps where one of
the counterparties is not a financial entity, is using the swap to
hedge or mitigate commercial risk, and notifies the Commission how it
generally meets its financial obligations associated with entering into
uncleared swaps. A number of different types of counterparties may
qualify for an exception from clearing under section 2(h)(7)(A),
including: Non-financial end users, small banks, savings associations,
Farm Credit System Institutions, and credit unions. In addition,
captive finance companies qualify for an exception from clearing under
section 2(h)(7)(A).
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\331\ See 7 U.S.C. 2(h)(7)(A); 15 U.S.C. 78c-3(g)(1).
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a. Non-Financial End Users
A counterparty that is not a financial entity \332\ (sometimes
referred to as
[[Page 679]]
``commercial end users'') that is using swaps to hedge or mitigate
commercial risk generally would qualify for an exception from clearing
under section 2(h)(7)(A) and thus from the requirements of the final
rule for uncleared swaps pursuant to section 23.150(b).
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\332\ See 7 U.S.C. 2(h)(7)(A); 15 U.S.C. 78c-3(g)(1); 17 CFR
50.50. A ``financial entity'' is defined to mean (i) a swap dealer;
(ii) a security-based swap dealer; (iii) a major swap participant;
(iv) a major security-based swap participant; (v) a commodity pool;
(vi) a private fund as defined in section 202(a) of the Investment
Advisers Act of 1940; (vii) an employee benefit plan as defined in
sections 3(3) and 3(32) of the Employment Retirement Income Security
Act of 1974; (viii) a person predominantly engaged in activities
that are in the business of banking, or in activities that are
financial in nature, as defined in section 4(k) of the Bank Holding
Company Act of 1956. See 7 U.S.C. 2(h)(7)(C)(i); 15 U.S.C. 78c-
3(g)(3).
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b. Small Banks, Savings Associations, Farm Credit System Institutions,
and Credit Unions
The definition of ``financial entity'' in section 2(h)(7)(C)(ii)
provides that the Commission shall consider whether to exempt small
banks, savings associations, Farm Credit System Institutions, and
credit unions with total assets of $10 billion or less. Pursuant to
this authority, the Commission has exempted small banks, savings
associations, Farm Credit System Institutions, and credit unions with
total assets of $10 billion or less from the definition of ``financial
entity,'' thereby permitting these institutions to avail themselves of
the clearing exception when they are using swaps to hedge or mitigate
risk.\333\ As a result, these small financial institutions that are
using uncleared swaps to hedge or mitigate commercial risk would also
qualify for an exemption from the initial and variation margin
requirements of the final rule pursuant to section 23.150(b).
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\333\ See 7 U.S.C. 2(h)(7)(C)(ii); 17 CFR 50.50; 77 FR 42560
(July 19, 2012); as recodified by 77 FR 74284 (Dec 13,2012).
---------------------------------------------------------------------------
c. Captive Finance Companies
Section 2(h)(7)(C) also provides that the definition of ``financial
entity'' does not include an entity whose primary business is providing
financing and uses derivatives for the purposes of hedging underlying
commercial risks relating to interest rate and foreign exchange
exposures, 90 percent or more of which arise from financing that
facilitates the purchase or lease of products, 90 percent or more of
which are manufactured by the parent company or another subsidiary of
the parent company (``captive finance company'').\334\ These entities
can avail themselves of a clearing exception when they are using swaps
to hedge or mitigate commercial risk and thus would be eligible for the
exemption in the Commission's margin rules pursuant to section
23.150(b).
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\334\ See 7 U.S.C. 2(h)(7)(C)(iii).
---------------------------------------------------------------------------
2. Certain Cooperative Entities
TRIPRA provides that the initial and variation margin requirements
shall not apply to an uncleared swap in which a counterparty qualifies
for an exemption issued under section 4(c)(1) of the Commodity Exchange
Act from the clearing requirements of section 2(h)(1)(A) of the
Commodity Exchange Act for cooperative entities as defined in such
exemption.\335\ The Commission, pursuant to its authority under section
4(c)(1) of the Commodity Exchange Act, adopted a regulation that allows
cooperatives that are financial entities to elect an exemption from
mandatory clearing of swaps that: (1) They enter into in connection
with originating loans for their members; or (2) hedge or mitigate
commercial risk related to loans to members or swaps with their members
which are not financial entities or are exempt from the definition of
financial entity.\336\ The swaps of these cooperatives that would
qualify for an exemption from clearing also would qualify pursuant to
section 23.150(b) for an exemption from the margin requirements of the
final rule.
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\335\ See 7 U.S.C. 6(c)(1). The CFTC, pursuant to its authority
under section 4(c)(1) of the Commodity Exchange Act, adopted 17 CFR
50.51, which allows cooperative financial entities that meet certain
qualifications to elect not to clear certain swaps that are
otherwise required to be cleared pursuant to section 2(h)(1)(A) of
the Commodity Exchange Act.
\336\ See 7 U.S.C. 6(c)(1);17 CFR 50.51.
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3. Treasury Affiliates Acting as Agent
TRIPRA provides that the initial and variation margin requirements
shall not apply to an uncleared swap in which a counterparty satisfies
the criteria in section 2(h)(7)(D) of the Commodity Exchange Act. These
sections provide that, where a person qualifies for an exception from
the clearing requirements, an affiliate of that person (including an
affiliate predominantly engaged in providing financing for the purchase
of the merchandise or manufactured goods of the person) may qualify for
the exception as well, but only if the affiliate is acting on behalf of
the person and as an agent and uses the swap to hedge or mitigate the
commercial risk of the person or other affiliate of the person that is
not a financial entity (``treasury affiliate acting as agent'').\337\ A
treasury affiliate acting as agent that meets the requirements for a
clearing exemption would also be eligible for an exemption pursuant to
section 23.150(b) from the Commission's final rule.
---------------------------------------------------------------------------
\337\ See 7 U.S.C. 2(h)(7)(D); 15 U.S.C. 78c-3(g)(4). This
exception does not apply to a person that is a swap dealer,
security-based swap dealer, major swap participant, major security-
based swap participant, an issuer that would be an investment
company as defined in section 3 of the Investment Company Act of
1940 (15 U.S.C. 80a-3) but for section 3(c)(1) or 3(c)(7) of that
Act, a commodity pool, or a bank holding company with over $50
billion in consolidated assets.
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The Commission requests comments on all aspects of the interim
final rule.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') requires that agencies
consider whether the regulations they propose will have a significant
economic impact on a substantial number of small entities.\338\ The RFA
does not require agencies to consider the impact of the final rule,
including its indirect economic effects, on small entities that are not
subject to the requirements of the final rule.\339\ In the Proposal,
the Commission certified that the proposed rule would not have a
significant economic impact on a substantial number of small entities.
Following the publication of the proposal, the Commission received a
comment on the potential for costs to be passed on to market
participants using swaps, including small entities that are not subject
to the margin requirements.\340\
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\338\ 5 U.S.C. 601 et seq.
\339\ See e.g., In Mid-Tex Electric Cooperative v. FERC, 773
F.2d 327 (D.C. Cir. 1985); United Distribution Cos. v. FERC, 88 F.3d
1105, 1170 (D.C. Cir. 1996); Cement Kiln Recycling Coalition v. EPA,
255 F.3d 855 (D.C. Cir. 2001).
\340\ NERA's comment is addressed below.
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The final rule implements the new statutory framework of Section
4s(e) of the CEA, added by Section 731 of the Dodd-Frank Act, which
requires the Commission to adopt capital and initial and variation
margin requirements for CSEs on all uncleared swaps in order to offset
the greater risk to the swap entity and the financial system arising
from the use of swaps and security-based swaps that are not cleared.
The final margin requirements will apply to uncleared swaps between
covered swap entities and their financial end user counterparties.\341\
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\341\ In contrast to the proposal, the final rule does not
require a CSE to calculate hypothetical initial and variation margin
amounts each day for positions held by non-financial end users that
have MSEs to the CSE. This should further reduce the possibility
that small entities may be indirectly impacted by the final rule.
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As discussed in the Proposal, the Commission previously established
certain definitions of ``small entities'' to be used in evaluating the
impact of its regulations on small entities in accordance with the
RFA,\342\ and that it has determined that SDs, MSPs and eligible
contract participants (``ECPs'') are not small entities for purposes of
the RFA.\343\ Accordingly, CSEs that are subject to the final rule are
not small entities for purposes of the RFA.
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\342\ 47 FR 18618 (Apr. 30, 1982).
\343\ See 77 FR 30596, 30701 (May 23, 2012) (SDs and MSPs); 66
FR 20740, 20743 (April 25, 2001) (ECPs).
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[[Page 680]]
With respect to certain financial end users \344\ that may be
impacted by the Proposed Rule, the Commission expects that such
entities would be similar to eligible contract participants (``ECPs'')
and, as such, they would not be small entities.\345\ As discussed
above, the final rule applies on a cross-border basis and therefore, to
uncleared swaps between CSEs and foreign financial end users. Even
assuming that there are any foreign financial entities that would not
be considered ECPs (and thus, would be small entities), the Commission
expects that only a small number of foreign financial entities that are
not ECPs, if any, would trade in uncleared swaps.
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\344\ The RFA focuses on direct impact to small entities and not
on indirect impacts on these businesses, which may be tenuous and
difficult to discern. See Mid-Tex Elec. Coop., Inc. v. FERC, 773
F.2d 327, 340 (D.C. Cir. 1985); Am. Trucking Assns. v. EPA, 175 F.3d
1027, 1043 (D.C. Cir. 1985).
\345\ As noted in paragraph (1)(xii) of the definition of
``financial end user'' in section 23.151 of the final rule, a
financial end user includes a person that would be a financial
entity described in paragraphs (1)(i)-(xi) of that definition, if it
were organized under the laws of the United States or any State
thereof. The Commission believes that this prong of the definition
of financial end user would capture the same type of U.S. financial
end users that are ECPs, but for them being foreign financial
entities. Therefore, for purposes of the Commission's RFA analysis,
these foreign financial end users will be considered ECPs and
therefore, like ECPs in the U.S., not small entities.
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The Commission notes that to the extent that small entities may be
impacted, the final rule contains numerous provisions that are intended
to mitigate--or have the effect of mitigating--the cost on such
entities. For example, under the final rule, the level of the aggregate
notional amount of transactions that give rise to material swaps
exposure has been raised from $3 billion to $8 billion, which should
result in a fewer financial end users being required to post initial
margin. In addition, the final rule provides an initial margin
threshold of $50 million from all uncleared swaps between a covered
swap entity and its counterparties, which should further reduce the
impact of the rule on financial counterparties that may be small
entities.
For the reasons discussed above, the Commission finds that there
will not be a substantial number of small entities impacted by the
final rule. Therefore, the Chairman, on behalf of the Commission,
hereby certifies pursuant to 5 U.S.C. 605(b) that the final rule will
not have a significant economic impact on a substantial number of small
entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') \346\ imposes certain
requirements on Federal agencies, including the Commission, in
connection with their conducting or sponsoring any collection of
information, as defined by the PRA. This final rule will result in a
mandatory collection of information within the meaning of the PRA. The
collection is necessary to implement section 4s(e) of the CEA, which
directs the Commission to adopt rules governing margin requirements for
SDs and MSPs. In accordance with the requirements of the PRA, the
Commission may not conduct or sponsor, and a person is not required to
respond to, this collections of information unless it displays a
currently valid OMB control number.
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\346\ 44 U.S.C. 3501 et seq.
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As described below, all of the collections of information required
by the final rule are covered by existing OMB Control Number 3038-0024
and OMB Control Number 3038-0088, with OMB Control Number 3038-0024
requiring a revision of the burden hours. The titles for these
collections of information are ``Regulations and Forms Pertaining to
Financial Integrity of the Market Place, OMB control number 3038-0024''
and ``Swap Trading Relationship Documentation Requirements for Swap
Dealers and Major Swap Participants, OMB control number 3038-0088.''
\347\
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\347\ The Commission notes that certain provisions of Regulation
23.158 are already covered by OMB Control Number 3038-0104, which is
not affected by this final rule.
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1. Clarification of Collection 3038-0088
The final rule contains reporting and recordkeeping requirements
that are part of the existing Commission regulations pertaining to swap
trading relationship documentation requirements. The collection of
information related to that existing Commission regulation is covered
by OMB Control Number 3038-0088.\348\
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\348\ See OMB Control No. 3038-0088, available at http://www.reginfo.gov/public/do/PRAOMBHistory?ombControlNumber=3038-0088.
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Specifically, under the final rule, both the formula employed in
the standardized method and the approach of the risk-based model that
reflect offsetting exposures require that offsets be reflected only for
swaps that are subject to the same eligible master netting agreement
(``EMNA''). Regulation 23.151 defines the term EMNA and provides that a
CSE that relies on the agreement for purpose of margin calculation must
establish and maintain written procedures for monitoring relevant
changes in the law and to ensure that the agreement continues to
satisfy the requirements of this section. Regulation 23.153(d) further
specifies that a CSE must demonstrate upon request to the satisfaction
of the Commission that it has made appropriate efforts to collect or
post the required margin. In addition, Regulation 23.154 establishes
standards for initial margin models and requires CSEs to describe to
the Commission any remedial actions being taken, and report internal
audit findings regarding the effectiveness of the initial margin model
to the CSE's board of directors or a committee thereof, to adequately
documents all material aspects of its initial margin model; and, to
adequately documents internal authorization procedures, including
escalation procedures that require review and approval of any change to
the initial margin calculation under the initial margin model,
demonstrable analysis that any basis for any such change is consistent
with the requirements of this section, and independent review of such
demonstrable analysis and approval. Regulation 23.155(b) requires a
covered swap entity to create and maintain documentation setting forth
the variation margin methodology, evaluate the reliability of its data
sources at least annually, and make adjustments, as appropriate. It
also provides that the Commission at any time may require a covered
swap entity to provide further data or analysis concerning the
methodology or a data source. Regulation 23.157(c) requires the
custodian to act pursuant to a custody agreement that prohibits the
custodian from re-hypothecating, repledging, reusing, or otherwise
transferring the funds held by the custodian. Regulation 23.158
requires a covered swap entity to execute trading documentation with
each counterparty that is either a swap entity or financial end user
regarding credit support arrangements.
The reporting and recordkeeping requirements of Regulations
23.154(b)(4) through 23.154(b)(7), and Regulations 23.155(b), 23.157(c)
and 23.158, described above, fall under the Commission Regulations
23.500 through 23.506 \349\ and are covered by OMB
[[Page 681]]
Control Number 3038-0088. Further, the reporting and recordkeeping
requirements in Regulation 23.154(b)(4) through 23.154(b)(7) and
Regulations 23.155(b), 23.157(c) and 23.158, would not materially
impact the burden estimates currently provided for in OMB Control
Number 3038-0088.\350\
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\349\ See 77 FR 55904 (Sept. 12, 2012). Commission Regulation
23.504(b) requires an SD or MSP to maintain written swap trading
relationship documentation that must include all terms governing the
trading relationship between the SD or MSP and its counterparty, and
Commission Regulation 23.504(d) requires that each SD and MSP
maintain all documents required to be created pursuant to Commission
Regulation 23.504. Commission Regulation 23.502(c) requires each SD
and MSP to notify the Commission and any applicable Prudential
Regulator of any swap valuation dispute in excess of $20 million if
not resolved in specified timeframes.
\350\ The Commission is publishing a separate notice in the
Federal Register to renew OMB Control Number 3038-0088, which will
revise the burden estimates relating to the collection titled ``Swap
Trading Relationship Documentation Requirements for Swap Dealers and
Major Swap Participants.''
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2. Revisions to Collection 3038-0024
As noted above, the final will require a new information
collection, which is covered by OMB Control Number 3038-0024.\351\
However, the final rule will revise the burden hours associated with
the collection, as discussed below.
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\351\ The Commission previously proposed to adopt regulations
governing standards and other requirements for initial margin models
that would be used by SDs and MSPs to margin uncleared swap
transactions. See Capital Requirements of Swap Dealers and Major
Swap Participants, 76 FR 27,802 (May 12, 2011). As part of the
October 3, 2014 proposal, the Commission submitted proposed
revisions to collection 3038-0024 for the estimated burdens
associated with the margin model to OMB.
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Regulation 23.154(b)(1) requires CSEs that wish to use initial
margin models to obtain the Commission's approval, and to demonstrate,
on a continuing basis, to the Commission that the models satisfy
standards established in Regulation 23.154. These standards include:
(i) A requirement that a CSE notify the Commission in writing 60 days
before extending the use of the model to additional product types,
making certain changes to the initial margin model, or making material
changes to modeling assumptions; and (ii) a variety of quantitative
requirements, including requirements that the CSE validate and
demonstrate the reasonableness of its process for modeling and
measuring hedging benefits, demonstrate to the satisfaction of the
Commission that the omission of any risk factor from the calculation of
its initial margin is appropriate, demonstrate to the satisfaction of
the Commission that incorporation of any proxy or approximation used to
capture the risks of the covered swap entity's non-cleared swaps is
appropriate, periodically review and, as necessary, revise the data
used to calibrate the initial margin model to ensure that the data
incorporate an appropriate period of significant financial stress.
Currently, there are approximately 106 SDs and MSPs provisionally
registered with the Commission. The Commission further estimates that
approximately 54 of the SDs and MSPs will be subject to the
Commission's margin rules as they are not subject to a Prudential
Regulator. The Commission further estimates that all SDs and MSPs will
seek to obtain Commission approval to use models for computing initial
margin requirements. The Commission estimates that the information
collection requirement associated with this aspect of the final rule
will impose an average of 240 burden hours per registrant.
Based upon the above, the estimated additional hour burden for
collection 3038-0024 was calculated as follows:
Number of registrants: 54.
Frequency of collection: Initial submission and periodic
updates.
Estimated annual responses per registrant: 1.
Estimated aggregate number of annual responses: 54.
Estimated annual hour burden per registrant: 240 hours.
Estimated aggregate annual hour burden: 12,960 hours [54
registrants x 240 hours per registrant].
V. Cost Benefit Considerations
A. Introduction
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its discretionary actions before promulgating a
regulation under the CEA or issuing certain orders.\352\ Section 15(a)
further specifies that the costs and benefits shall be evaluated in
light of five broad areas of market and public concern: (1) Protection
of market participants and the public; (2) efficiency, competitiveness,
and financial integrity of futures markets; (3) price discovery; (4)
sound risk management practices; and (5) other public interest
considerations. In this section, the Commission discusses the costs and
benefits resulting from its discretionary determinations with respect
to the section 15(a) factors.\353\ This rulemaking implements the new
statutory framework of Section 4s(e) of the CEA, added by Section 731
of the Dodd-Frank Act, which requires the Commission to adopt capital
and initial and variation margin requirements for CSEs. Section 4(s)(e)
of the CEA requires the Commission to adopt initial and variation
margin requirements for CSEs on all of their uncleared swaps, which
should be designed to ensure the CSE's safety and soundness and be
appropriate for the risk associated with the uncleared swap. In
addition, section 4s(e)(3)(D) of the CEA provides that the Commission,
the Prudential Regulators, and the SEC, must ``to the maximum extent
practicable'' establish and maintain comparable margin rules.
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\352\ 7 U.S.C. 19(a).
\353\ The Commission notes that the costs and benefits
considered in finalizing the margin rule, and highlighted below,
have informed the policy choices described throughout this release.
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The Commission recognizes that there are inherent trade-offs in
developing minimum collateral standards for uncleared swaps. Margin
rules for uncleared swaps are designed to reduce the probability of
default by the CSE and limit the amount of leverage that can be
undertaken by CSEs (and other market participants, in the aggregate),
which ultimately mitigates the possibility of a systemic event. The
financial crisis of 2008 has had profound and long-lasting adverse
effects on the economy, and therefore reducing the potential for
another systemic event provides significant, if unquantifiable,
benefits. At the same time, the final margin rule will entail new costs
for CSEs and financial end users as they will need to provide liquid,
high-quality collateral to meet those requirements that exceed current
practice and as a result, incur costs in terms of lost returns from
investments or in securing additional sources of funding (e.g.,
interest expenses associated with borrowing funds).\354\ In addition,
CSEs and financial end users will face certain startup and ongoing
costs relating to technology and other operational infrastructure, as
well as new or updated legal agreements.\355\ The final rule reflects
the Commission's reasoned judgment of how best to ensure the safety and
soundness of CSEs and the U.S. financial system, in a manner that
considers the economic consequences of its policy choices.
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\354\ See Appendix A for the Commission's estimates of the
funding costs for initial margin and variation margin, as well as a
more detailed discussion of certain administrative costs.
\355\ For the reasons discussed in Appendix A, these
administrative costs are difficult to quantify at this time.
Therefore, the Commission discusses the administrative costs related
to margin for uncleared swaps qualitatively instead.
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The Commission also recognizes that many CSEs are part of bank
holding companies with global operations that are subject to
overlapping jurisdictions by multiple supervisory authorities, both
domestic and foreign. Significant disparities in margin rules can lead
to undue competitive distortions and ultimately, opportunities for
regulatory arbitrage.\356\ It could also lead to
[[Page 682]]
operational inefficiencies as entities within the same corporate group
may be precluded from utilizing congruent operational and compliance
infrastructure. In light of these concerns, and in accordance with the
statutory mandate, the Commission, in developing the final rule,
closely consulted and coordinated with the Prudential Regulators and
foreign regulators in order to harmonize our respective margin rules to
the greatest extent possible.\357\
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\356\ That is, if the Commission's margin rules are
substantially stricter than that of the Prudential Regulators, such
difference could make it less costly to conduct swaps trading in a
bank swap dealer as compared to a non-bank swap dealer. Likewise,
U.S. and financial end users could be advantaged or disadvantaged
depending on how the Commission's margin rule compares with
corresponding requirements in other jurisdictions.
\357\ The Commission, in a separate rulemaking, will address the
cross-border application of the Commission's margin rules, including
the availability of substituted compliance and exclusion, as
appropriate. The cross-border margin rules are intended to further
promote global harmonization of margin rules and consequently,
mitigate the potential for competitive distortions and market
inefficiencies.
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The baseline against which the costs and benefits associated with
this rule will be compared is the status quo, i.e., the uncleared swaps
markets as they exist today. At present, swap market participants are
not legally required to post either initial or variation margin when
engaging in uncleared swaps. Nevertheless, the Commission understands
that, for risk management purposes, many CSEs collect initial margin
from certain non-CSE counterparties and exchange variation margin with
CSEs and financial end users for uncleared swaps. Further, section
4s(e), read together with section 2(i) of the CEA,\358\ applies the
margin rules to a CSE's swap activities outside the United States,
regardless of the domicile of the CSE (or its counterparties). Because
the Commission found no information that indicates that there are
material differences in the costs and benefits discussed herein between
foreign and cross-border swaps activities of CSEs and financial end
users affected by the rule, the Commission's consideration of the costs
and benefits of the final rule applies to all swap activities, domestic
and cross-border, to which the final rule applies. CSEs, wherever
domiciled, by definition are involved in a large volume of swaps
activity in, or significantly affecting, United States markets and are
registered with the Commission. Accordingly, they can be expected
already to have in place personnel and infrastructure for compliance
with United States law. To the extent that there may be differences in
the particulars of costs to foreign CSEs or financial end users, the
record of this proceeding generally did not provide information that
would permit the evaluation of any such differences.\359\
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\358\ See 7 U.S.C. 2(i). Section 2(i) of the CEA states that the
provisions of the Act relating to swaps that were enacted by the
Wall Street Transparency and Accountability Act of 2010 (including
any rule prescribed or regulation promulgated under that Act), shall
not apply to activities outside the United States unless those
activities (1) have a direct and significant connection with
activities in, or effect on, commerce of the United States; or (2)
contravene such rules or regulations as the Commission may prescribe
or promulgate as are necessary or appropriate to prevent the evasion
of any provision of this Act that was enacted by the Wall Street
Transparency and Accountability Act of 2010.
\359\ As foreign jurisdictions put in place their own margin
rules in the future, the existence of these rules may affect the
costs and benefits of the Commission's rules for foreign CSEs and
financial end users. However, the still developing state of foreign
law in this area and the absence of specific information in the
record of this proceeding does not permit a detailed evaluation of
such possible effects in the present proceeding. As noted above, the
Commission will be addressing certain issues relating to the effects
of foreign margin rules, including the availability of substituted
compliance, in a separate rulemaking.
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In the sections that follow, the Commission considers: (i) The
costs and benefits associated with its choices regarding the scope and
extent to which it would apply its margin rule to uncleared swaps of a
CSE and certain financial end users; (ii) the alternatives considered
by the Commission and the costs and benefits relative to the approach
adopted herein; and (iii) impact of the margin rule on the market and
the public, in light of the 15(a) factors, as applicable. In the
proposing release, the Commission addressed the costs and benefits of
the proposed rules, taking into account the considerations described
above. The Commission also requested comments on these assessments and
for any data or other information that would be useful in estimation of
the quantifiable costs and benefits of this rulemaking. A total of 59
comment letters were received. Some commenters generally addressed the
cost-and-benefit aspect of the proposed rule; \360\ one commenter
provided quantitative data and analysis of the Commission's proposal.
The discussion of the costs and benefits that follows is largely
qualitative in nature, although where possible the Commission attempts
to quantify these benefits and costs.
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\360\ As discussed in this release, the relevant comments have
informed the Commission's decisions regarding the final rule and are
highlighted below.
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B. Final Rule
1. Covered Entities: CSEs and Financial End Users
Margin requirements apply to uncleared swaps entered into by CSEs
\361\--and by extension, to the counterparties to such swaps. Because
different types of counterparties can pose different levels of risk,
the final rule establishes three categories of counterparty: (i) CSEs;
(ii) financial end users; and (iii) non-financial end users. Under the
final rule, the initial and variation margin requirements apply to
uncleared swaps of CSEs with certain counterparties, namely, other
CSEs, swap entities that are not a CSE and financial end users (and in
the case of initial margin, only those financial end users with
material swaps exposure).\362\ The final rule defines ``financial end
user'' as a counterparty that is not a swap dealer or a major swap
participant but which falls within one of the categories of entities
primarily engaged in financial activities.\363\ These categories are
nearly identical to the Prudential Regulators' definition of
``financial end user.'' \364\
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\361\ As discussed above, however, certain uncleared swaps of
CSEs with their affiliates are not subject to initial margin; the
related cost-benefit considerations are addressed below.
\362\ The Commission recognizes that a CSE may enter into a swap
with another non-CSE swap entity, which would result in the non-CSE
swap entity collecting under the Prudential Regulators' margin
regime. Therefore, this section does not consider costs and benefits
as they relate to the non-CSE swap entity.
\363\ Sec. 23.151.
\364\ The Commission notes that its definition of ``financial
end user'' includes security-based swap dealers and major security-
based swap participants, as these entities are included in the
Prudential Regulators' definition of swap entities.
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In developing the definition of financial end user, the Commission
was mindful of the significant new costs associated with the new
minimum collateral requirements and has attempted to tailor the
definition carefully to avoid undue burden on market participants,
without undermining the objectives of the margin rules. Accordingly,
the definition is intended to capture those market participants that by
the nature and scope of their financial activities present a higher
level of risk of default and are integral to the financial system, and
thus, pose greater risk to the safety and soundness of their CSE
counterparties and the stability of the financial system. Consistent
with this risk-based approach to the definition, the definition
specifically excludes entities that may be considered financial in
nature but that perform different functions in the financial system
than those included in the definition of financial end user. These
include, among others, multi-lateral development banks, the Bank for
International Settlements, and a subset
[[Page 683]]
of financial entities that engage in swaps to hedge or mitigate
commercial risks.
A number of commenters also requested that the Commission exclude
from the financial end user definition structured finance vehicles,
including securitization special purpose vehicles (``SPVs'') and
covered bond issuers.\365\ These commenters argued that margin
requirements on structured finance vehicles would restrict their
ability to hedge interest rate and currency risk and potentially force
these vehicles to exit the swaps market since these vehicles generally
do not have ready access to liquid collateral. Other commenters argued
that pension plans should not be subject to margin requirements because
they are highly regulated, highly creditworthy, have low leverage and
are prudently managed counterparties whose swaps are used primarily for
hedging and, as such, pose little risk to their counterparties or the
broader financial system.\366\
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\365\ See SIFMA, SFIG and ISDA.
\366\ See ABA (pension plans should not be subject to margin and
should be treated as non-financial end users); AIMA (benefit plans
should not be subject to margin and there is ambiguity involving
whether non-U.S. public and private employee benefit plans would be
financial end users); JBA (securities investment funds should be
exempt from variation margin).
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The Commission is not excluding, as commenters urged, pension
plans, and structured finance vehicles. The Commission observes that
these entities engage in the same range of activities as the other
entities encompassed by the final rule's definition of financial end
user. The Commission notes that the increase in the material swaps
exposure threshold, as finalized in the final rule, should address some
of the concerns raised by these commenters regarding the applicability
of initial margin requirements.\367\
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\367\ In addition, with respect to pension plans, the Commission
notes that Congress explicitly listed employee benefit plans as
defined in paragraph (3) and (32) of section 3 of the Employee
Retirement Income Security Act of 1974 in the definition of
``financial entity'' in the Dodd-Frank Act. As a result, pension
plans do not benefit from an exclusion from clearing even where they
use swaps to hedge or mitigate commercial risk.
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The enumerated list in the definition of financial end user is
intended to provide enhanced clarity to ease the burden associated with
determining whether a counterparty is a financial end user.\368\ The
Commission also considered alternative definitions, including using a
broad-based definition similar to that listed in section 2(h)(7)(C) of
the CEA. The Commission is not adopting this approach because it
believes that it would be difficult for the market participants to
implement and the Commission to monitor. In addition, the broad-based
definition would not provide the level of clarity that an enumerated
list provides market participants when engaging in uncleared swaps.
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\368\ In this regard, the Commission recognizes that the
definition--particularly, the test that deems an entity a financial
end user if it were organized under the laws of the United States--
may impose a greater incremental cost with respect to foreign
counterparties. However, the Commission believes that it is
necessary to cover all financial end users that are counterparties
to a CSE, including those that are foreign-domiciled, to effectuate
the purposes of the margin requirements.
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Initial margin requirements apply only to those financial end users
that meet the specified MSE threshold. The MSE threshold is intended to
identify entities that engage in significant derivatives activity as
measured by the end user's overall exposure in the market. In the
proposal, the Commission proposed to define materiality as $3 billion
average notional amount. The final rule increases the level of the
aggregate notional amount of transactions that gives rise to MSE to $8
billion, which is broadly consistent with the [euro]8 billion
established by the 2013 international framework and consistent with the
EU and Japanese proposals. The increased MSE threshold should further
reduce the number of financial end users subject to the initial margin
requirement in relation to the Commission's proposal.
The final rule defines ``material swaps exposure'' as the aggregate
notional amount of swaps not only of a particular entity, but also of
its affiliates and subsidiaries. The Commission recognizes that
calculation of MSE on an aggregate basis across affiliates and
subsidiaries would require new reporting and tracking systems. As
discussed above, the aggregation requirement is primarily intended to
address the potential circumvention, as CSEs may disperse their swap
activities through their affiliates to avoid exceeding the MSE
threshold. The aggregation approach provides the Commission with a more
complete picture of a firm's systemic risk profile by measuring the
risk at the consolidated level. The Commission believes that
aggregating exposure across affiliates is necessary to achieve the
objectives of the margin requirements.
The definition of MSE also contains a number of other changes from
the proposed definition to address commenters' concerns. Notably, in
response to commenters, a financial end user needs to count only one
side of an inter-affiliate swap in calculating its MSE. The Commission
believes that double counting (as proposed) would result in an
inaccurate measure of the swaps exposure of a financial end user as it
would inflate the total exposure within the consolidated group. By
modifying the calculation in this way, the Commission believes that it
is reducing the number of financial end users with MSE, which should
lessen the costs for financial entities that would have exceeded the $8
billion threshold.\369\
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\369\ The Commission made a similar change to the definition of
``initial margin threshold amount'' as described in Regulation
23.151.
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The final affiliate definition uses financial accounting standards
as the trigger for affiliation, rather than a legal control test. The
Commission believes that determining affiliate status based on whether
a company is or would be consolidated with another company on financial
statements prepared in accordance with U.S. GAAP, the International
Financial Reporting Standards or other similar standards, reflects a
more accurate method for discerning control and should be less
burdensome to apply.\370\ The Commission expects that most entities
prepare financial statements under an acceptable accounting standard.
For companies that do not prepare these statements, the Commission
believes that industry participants are more familiar with the relevant
accounting standards and tests, and they will be less burdensome to
apply.
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\370\ Commenters raised the concern that the proposed
``control'' test was difficult to apply and over-inclusive. See
e.g., ACLI.
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2. Initial Margin
Initial margin is intended to address potential future exposure.
That is, in the event of a counterparty default, initial margin
protects the non-defaulting party from the loss that may result from a
swap or portfolio of swaps, during the period of time needed to close
out the swap(s). Initial margin augments variation margin, which
secures the current mark-to-market value of swaps. Under the final
rule, CSEs would be required to both collect initial margin from and to
post initial margin to financial end users with material swaps
exposure. This represents a departure from current industry practice
and hence, introduces new costs for CSEs and their covered
counterparties, but is in accordance with the BCBS-IOSCO framework and
the Prudential Regulators' final rules.
These costs include the costs of the requisite collateral, namely,
the cost of securing external funds or the foregone return from
investments. It is difficult to estimate these costs due to the fact
that funding costs would vary widely depending on the type of entities
and
[[Page 684]]
their sources of liquidity, differences in funding costs over time,
differences on their return on investments and differences in the rate
of return on different collateral assets that may be used to satisfy
the initial margin requirements, among other things.\371\
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\371\ Further, it is expected that due to the cost of the final
rules, some market participants may be incentivized to use
alternatives to uncleared swaps. Futures contracts and cleared
swaps, which tend to be more standardized and liquid than uncleared
swaps, typically require less initial margin; however, this may
result in basis risk given the standardization of these products. A
futures contract has a one day minimum liquidation time and a
cleared swap has a three- to five-day minimum liquidation time; in
contrast, under the final rule, a ten day minimum liquidation time
is required for uncleared swaps.
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At one extreme, it may be that some entities providing initial
margin, such as pension funds and asset managers, will provide assets
as initial margin that they already own and would have owned even if no
requirements were in place. In such cases the economic cost of
providing initial margin collateral is anticipated to be low. In other
cases, entities engaging in uncleared swaps will have to raise
additional funds to secure assets that can be pledged as initial
margin. The greater the costs of their funding, relative to the rates
of return on the initial margin collateral, the greater the cost of
providing collateral assets.\372\
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\372\ To the extent that the same funding could have been used
to fund investment opportunities, there is also an opportunity cost
on that lost investment.
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At the same time, a two-way exchange of initial margin protects
both the CSE and the financial end user from the build-up of
counterparty credit risk from uncollateralized credit exposures. As
noted above, these entities are critical to the stability of the
financial system and therefore, need the protection of initial margin
in the event of the default of a CSE, as the potential of a cascading
event is increased without the collection of initial margin by these
financial end users. In regards to the CSE, posting margin restricts
the CSE from accumulating too large of an exposure in relation to its
financial capacity. Therefore, the two-way exchange of initial margin
should increase the overall stability of the financial system.
Further, as a result of the reduced risk of default, the posting
party could receive a benefit from changes to the relationship between
the CSE and the counterparty. As a result of the reduction in the
overall credit exposure with the CSE, the counterparty may be able to
realize better credit terms when transacting with the CSE and it
consolidated group. To the extent any such benefit is realized, it
would offset a portion of the cost incurred in posting collateral.
Some commenters recommended that the Commission adopt a ``collect-
only'' approach with respect to foreign end users.\373\ In response,
the Commission notes that, in contrast to the proposed Japanese and
European margin regimes, which would cover a very broad array of
financial entities, a collect-only regime under the U.S. regime would
be applicable only to CSEs and thus could leave a large number of
financial entities with significant uncollateralized future exposures
to their swap dealers.\374\
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\373\ See, e.g., ISDA.
\374\ The Commission notes that under the latest EU proposal, if
a counterparty to a European-registered entity is a non-European
registered entity, then the European-registered entity must post
initial margin to the non-European registered entity. See, Second
Consultation Paper on draft regulatory technical standards on risk-
mitigation techniques for OTC-derivative contracts not cleared by a
CCP under Article 11(15) of Regulation (EU) No 648/2012 (for the
European Market Infrastructure Regulation) (Jun. 10, 2015),
available at https://www.eba.europa.eu/documents/10180/1106136/JC-CP-2015-002+JC+CP+on+Risk+Management+Techniques+for+OTC+derivatives+.pdf.
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The Commission is requiring that CSEs calculate initial margin on a
daily basis and that initial margin be posted within one day after the
date of execution. The Commission is adopting this approach to preserve
the margin period of risk, e.g., 10 day calculation period for initial
margin models. Daily calculation is necessary as the risk factors and
the portfolio are subject to daily change. If the Commission were to
adopt a less restrictive timeframe for posting initial margin, the
margin period of risk would increase, reducing the protection provided
by initial margin. The Commission considered adding days to the 10 day
margin period of risk to account for the additional time given to post
initial margin collateral; however, the Commission believes that it
would be difficult to implement as models would need to be adjusted to
account for different posting timeframes, which could create
difficulties for the Commission in validating the initial margin model
calculations.
The Commission recognizes that the T+1 posting requirement may lead
to additional funding costs in the form of excess margin being held at
the custodian to meet the one day requirement.\375\ However, the
Commission expects that counterparties will post cash or some other
eligible assets that can be pledged in one day and subsequently
substitute other eligible assets for these highly liquid assets, which
should mitigate the burdens placed by this requirement. The Commission
notes that it has modified the date of execution to account for
different time zones and holidays to further reduce the burdens
associated with the T+1 requirement.
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\375\ The excess amount held at the custodian would only need to
be the incremental change from day-to-day.
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Under the final rule, consistent with the BCBS-IOSCO standard,
initial margin will not be required to be collected or posted by a CSE
to its covered counterparty, to the extent that the aggregate un-
margined exposure to its covered counterparty remains below $50
million. In effect, the $50 million threshold will provide a certain
level of relief to all counterparties that are required to post and
collect initial margin. It should also serve to reduce the aggregate
amount of initial margin--and consequently, incrementally reduce
overall funding cost--of all covered counterparties. At the same time,
the Commission recognizes that the $50 million threshold represents
uncollateralized risk of potential future exposure. However, the
Commission believes that this amount of uncollateralized swaps
exposure, calculated on a consolidated basis within a corporate group,
is acceptable in the context of initial margin, particularly in light
of the benefits to the financial system. To further ease the
transaction costs associated with the exchange of margin, the
Commission is not requiring a CSE to collect or post any amount below
the transfer amount of $500,000.\376\
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\376\ This amount applies to both initial and variation margin
transfers on a combined basis.
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3. Calculation of Initial Margin
Under the final rule, a CSE must calculate the required amount of
initial margin daily, on the basis of either a risk-based model or a
table-based method. The use of either model is predicated on the
satisfaction of certain baseline requirements to ensure that initial
margin is calculated in a manner that is sufficient to protect CSEs as
intended. Further, the choice of two alternatives allows CSEs to choose
the methodology that is the most cost efficient for managing their
business risks and thereby better compete. The costs and benefits
associated with the use of each approach are addressed below.
a. Risk-Based Model
Generally, the baseline requirements of this risk-based model
reflect the current practice for calculating bank regulatory capital
and value at risk
[[Page 685]]
(``VaR'') and conform to the BCBS/IOSCO standard for calculating margin
for uncleared swaps.\377\ To the extent CSEs are familiar with these
requirements and have infrastructure in place to calculate the initial
margin amount under this model approach, burdens associated with
utilizing the model should be mitigated.
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\377\ The same model requirements have been proposed by the EU,
Japan, and Singapore. See ``Consultation Paper: Draft regulatory
technical standards on risk-mitigation techniques for OTC-derivative
contracts not cleared by a CCP under Article 11(15) of Regulation
(EU) No 648/2012,'' available at https://www.eba.europa.eu/documents/10180/655149/JC+CP+2014+03+%28CP+on+risk+mitigation+for+OTC+derivatives%29.pdf;
``Publication of draft amendments to the ``Cabinet Office Ordinance
on Financial Instruments Business'' and ``Comprehensive Guidelines
for Supervision'' with regard to margin requirements for non-
centrally cleared derivatives,'' available at http://www.fsa.go.jp/news/26/syouken/20140703-3.html; and ``Policy Consultation for
Margin for Non-Centrally Cleared OTC Derivatives,'' available at
http://www.mas.gov.sg/~/media/MAS/News%20and%20Publications/
Consultation%20Papers/
Policy%20Consultation%20on%20Margin%20Requirements%20for%20NonCentral
ly%20Cleared%20OTC%20Derivatives%201Oct.pdf.
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Under this model, a CSE would be required to generally calculate
their initial margin based on the assumption of a ``holding period'' of
10 business days with a one-tailed 99% confidence interval. The
Commission believes that a 10 day close-out period is necessary to
ensure that the non-defaulting party has sufficient time to close out
and replace its positions in the event of counterparty default.\378\
The Commission recognizes that certain swaps may not require a 10 day
period to liquidate or replace and hence a 10 day close-out period may
lead to excessive initial margin. However, the Commission expects that
most of the instruments that could be liquidated in less than 10 days
are currently being cleared, and therefore, the impact of the requisite
10 day close-out period may be limited. Moreover, the Commission
believes that under market stress, these same instruments that may be
replaced or liquidated in less than 10 days may not maintain that same
level of liquidity.
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\378\ Studies on capital requirements conducted by BCBS-IOSCO
have shown that a 10 day margin period of risk is adequate to
address the moves in the market. See ``Margin Requirements for Non-
Centrally Cleared Derivatives,'' BCBS-IOSCO, Sept. 2013, available
at http://www.bis.org/publ/bcbs261.pdf.
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The Commission considered the alternative of setting the individual
margin period of liquidation for separate instruments or by broad asset
class. However, under these alternatives, there would be substantial
operational burdens on market participants in determining the
appropriate margin period of risk for each individual swap or broad
asset class. Substantial burdens would be imposed on regulators as well
as they would be required to review each CSE's determination of
appropriate liquidation periods, which would not be uniform across each
CSE for each individual swap or asset class, resulting in disputes as a
result of each CSE determining its own liquidation period for the
specific swap or swap asset class.
The Commission is also requiring that the data used in calculating
initial margin be based on an equally-weighted historical observation
period of at least 1 year and not more than 5 years, and must
incorporate a period of significant financial stress for each broad
asset class that is appropriate to the uncleared swaps to which the
initial margin model is applied. The Commission believes that this
approach would give an estimation period that is more representative of
the underlying risks over time and thus, mitigate the pro-cyclical
nature of initial margin calculations. In addition, under the final
rule, the initial margin model must be recalibrated on an on-going
basis to incorporate any change that results from a current period
stress. The Commission believes that this aspect of the final rule is
necessary as the initial margin calculated without a period of
financial instability would not be adequate to ensure the safety and
soundness of CSEs or the stability of financial markets during a period
of significant market volatility. The Commission understands that this
stress period element may increase the level of initial margin
required; however, in a time of stress, any change in the required
margin amount should be not be pro-cycle, as the amount requirement
would already contain a period of stress.
Under a risk-based model, offsetting risk exposures for a swap may
be recognized only in relation to another swap in the same category;
offsetting risk exposures may not be recognized across asset classes.
This will result in a greater amount of initial margin, all things
being equal. The Commission is concerned that cross-asset class
correlations break down during times of stress, increasing the
likelihood that in the event of default, the initial margin amount
calculated using these correlations would be insufficient to cover the
amount needed to replace the positions.
The risk-based model must also include material risks arising from
non-linear price characteristics, as many swaps have optionality. The
Commission understands that this requirement may increase costs in
developing models and result in a greater amount of initial margin.
However, the Commission believes that without this requirement the
initial margin calculation would not be adequate to cover the inherent
risks of the swap or a portfolio of swaps. Moreover, the Commission
understands that these risks are already imputed in the price of the
swap. Therefore, the incremental burden should be minimal.
A CSE using a risk-based model to calculate initial margin would be
required to establish and maintain a rigorous risk controls process to
re-evaluate, update, and validate the model as necessary to ensure its
continued applicability and compliance with the baseline requirements.
While certain of these measures may already be in place as part of a
CSE's risk management program (established under section
23.600(c)(4)(i)), others will result in additional costs for CSEs.\379\
The Commission believes that these measures are essential to ensuring
the efficacy of risk-based models used by CSEs. In addition, given that
a CSE subject to the Commission's margin rules may be affiliated with
one or more prudentially-supervised swap entities, the Commission would
closely coordinate with the Prudential Regulators for expedited review
of the model. The expedited review process should reduce unnecessary
delay or duplication.\380\
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\379\ See Sec. 23.504(b)(4).
\380\ Additionally, the final rule provides that a CSE may use
models that have been approved by NFA.
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b. Standardized Approach
As an alternative to a risk-based model, a CSE may calculate
initial margin using a standardized table. The standardized approach
could result in excess initial margin being calculated. For this
reason, the standardized approach is likely to appeal to those CSEs
with smaller swap portfolios with limited offsets, for whom a risk-
based margin model would not be cost-effective. Since many CSEs and
financial end users with material swaps exposure tends to have large
swaps positions with significant offsets, the Commission expects that
the risk-based model will be more widely favored.
c. Netting
Netting should reduce overall initial margin in relation to initial
margin that would result from a calculation based on a gross measure.
Both the formula employed in the standardized method and the approach
of the risk-based model require that offsets be reflected only for
swaps that are subject to the same eligible master netting agreement
[[Page 686]]
(``EMNA''). The eligibility criteria for netting are consistent with
industry standards currently being used for bank regulatory capital
purposes,\381\ which should reduce the administrative costs that would
be incurred in connection with any renegotiation of the terms of
existing netting agreements.
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\381\ See 12 CFR 3.2, 12 CFR 217.2, and 12 CFR 324.2. Regulatory
Capital Rules, Liquidity Coverage Ratio: Interim Final Revisions to
the Definition of Qualifying Master Netting Agreement and Related
Definitions, 79 FR 78287 (Dec. 30, 2014).
---------------------------------------------------------------------------
A number of commenters argued that, in order to allow close-out
netting and contain costs, the final rule should not require new master
agreements to separate pre- and post-compliance date swaps, and that
parties should be permitted to use credit support annexes that are part
of the EMNA instead of new master agreements to distinguish pre-and
post-compliance date swaps.\382\ In response to commenters, the final
rule provides that an EMNA may identify one or more separate netting
portfolios that independently meet the requirement for close-out
netting \383\ and to which, under the terms of the EMNA, the collection
and posting of margin applies on an aggregate net basis separate from
and exclusive of any other uncleared swaps covered by the agreement.
This rule should facilitate the ability of the parties to document two
separate netting sets, one for uncleared swaps that are subject to the
final rule and one for swaps that are not subject to the margin
requirements. A netting portfolio that contains only uncleared swaps
entered into before the applicable compliance date is not subject to
the requirements of the final rule.
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\382\ See TIAA-CREF; CPFM; ICI; SIFMA; ISDA; SIFMA-AMG; ABA;
JBA; CS; AIMA; MFA; FSR; Freddie; ACLI; and FHLB.
\383\ See Sec. 23.151 (paragraph 1 of the EMNA definition).
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Notably, for an agreement to qualify as an EMNA, the CSE must
conduct sufficient legal review to conclude with a well-founded basis
that the agreement, among other things, would be legal, valid, binding,
and enforceable under the law of the relevant jurisdictions. The
Commission recognizes that the requisite ``sufficient legal review''
will require, as a practical matter, a legal opinion, which will
adversely affect costs for CSEs. Additionally, to the extent that a
``sufficient legal review'' cannot be obtained (e.g., because the
foreign jurisdiction is lacking in comparable close-out netting
arrangements), a CSE would need to collect and post on a gross basis.
Nevertheless, given the importance of a legally binding and enforceable
netting arrangement in the event of default, the Commission is
retaining the legal review requirement.
Finally, CSEs may include legacy swaps in the same EMNA through the
use of multiple CSAs. This approach would allow CSEs to preserve the
benefit of close-out netting with all their swaps with a specific
counterparty. However, legacy swaps may not be included when multiple
CSAs are used in calculating the initial margin amount for that
counterparty. The Commission designed this approach to prevent cherry-
picking as a CSE could select specific legacy trades that would reduce
the amount of initial margin required on any certain day.
4. Variation Margin
Variation margin provides an important risk mitigation function by
preventing the build-up of total uncollateralized credit exposure of
outstanding uncleared swaps. Under the final rule, a CSE must collect
variation margin from or pay variation margin to its counterparty on or
before the business day after the date of execution of an uncleared
swap. Variation margin would be required for all financial end users,
regardless of whether the entity has material swaps exposure. In this
regard, the final rule is consistent with the Prudential Regulators'
rules and the 2013 International Standards. In addition, the Commission
is requiring a daily, two-way exchange of variation margin since mark-
to-market is based on unrealized gains of either party (i.e., if one
party has an unrealized gain, the other party has an unrealized loss).
The exchange of variation margin would result in additional costs
to CSEs and financial end users that currently are exchanging variation
margin or exchanging variation margin less frequently than daily. These
financial entities may also need to adjust their portfolio to ensure
the availability of eligible collateral for exchanging variation
margin.\384\
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\384\ The next section discusses the expanded eligible
collateral for variation margin.
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The final rule requires certain control and validation mechanisms
for the calculation of variation margin to ensure that the variation
margin calculated would be adequate to cover the current exposure of
the uncleared swaps, including the requirement to create and maintain
documentation setting forth the CSEs' calculation methodology with
sufficient specificity to allow the counterparty, the Commission and
any applicable Prudential Regulator to calculate a reasonable
approximation of the margin requirement independently; and evaluate the
reliability of its data sources at least annually, and make
adjustments, as appropriate. Implementation of these measures will
result in additional costs to CSEs. Nevertheless, the Commission is
adopting these control and validation mechanisms as they are necessary
to ensure the accuracy of the variation margin calculation methodology
used by a CSE.
There are, however, several factors that should have a mitigating
effect on the cost of variation margin. First, as discussed below, the
final rule expands the list of eligible collateral for non-CSE
financial end users, which may reduce funding costs. In addition, the
final rule will include a minimum transfer threshold of $500,000, which
should mitigate some of the administrative burdens and counter-cyclical
effects associated with the daily exchange of variation margin, without
resulting in an unacceptable level of uncollateralized credit risk. In
addition, competitive disparities may be lessened by the fact that
daily exchange of variation margin is required with respect to all
financial end users under both the final rule and international
standards.
5. Eligible Collateral
Limiting eligible collateral to the most highly liquid categories
could limit the potential that a CSE would incur a loss following
default of a counterparty based on changes in market values of less
liquid collateral that occur before the CSE is able to sell the
collateral, and therefore could limit the potential for a default by
the CSE to other counterparties. On the other hand, an overly
restrictive eligibility standard could have the effect of draining
liquidity from the counterparty in a way that may not be necessary to
account for the CSE's potential future exposure to the counterparty,
and may increase costs for both counterparties.\385\ The Commission
considered these competing concerns in developing the list of eligible
collateral.
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\385\ This could also lead to a greater demand on a relatively
few instruments.
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For example, the Commission is allowing certain equities as
eligible collateral to prevent adverse effect on investment returns for
collective investment vehicles, insurance companies, and pension
funds.\386\ To accommodate the concern of certain commenters that
argued for an inclusion of money market mutual funds and bank
certificates of deposit in the list of
[[Page 687]]
eligible collateral for initial margin, the final rule also adds
redeemable securities in a pooled investment fund that holds only
securities that are issued by, or unconditionally guaranteed as to the
timely payment of principal and interest by, the U.S. Department of the
Treasury, and cash funds denominated in U.S. dollars.
---------------------------------------------------------------------------
\386\ See, e.g., ICI; ISDA; CPFM; GPC; SIFMA-AMG; IECA; Freddie;
and CDEU.
---------------------------------------------------------------------------
Although the Commission received several comments concerning the
proposal's treatment of the securities of certain GSEs, only modest
changes have been made in the final rule. The Commission continues to
believe the final rule should treat GSE securities differently
depending on whether or not the GSE enjoys explicit government support,
in the interests of both the safety and soundness of CSEs and the
stability of the financial system. In other words, the treatment of GSE
securities by market participants as if those securities were nearly
equivalent to Treasury securities in the absence of explicit Treasury
support creates a potential threat to financial market stability,
especially if vulnerabilities arise in markets where one or more GSEs
are dominant participants, as occurred during the summer of 2008. The
final rule's differing treatment of GSE collateral based on whether or
not the GSE has explicit support of the U.S. government helps address
this source of potential financial instability and recognizes that
securities issued by an entity explicitly supported by the U.S.
government might well perform better during a crisis than those issued
by an entity operating without such support.
In addition, the final rule prohibits the use of certain assets as
collateral because their use might compound risk, i.e., wrong way risk.
The list of prohibited assets include instruments that represent an
obligation of the party providing such asset or an affiliate of that
party and instruments issued by bank holding companies, depository
institutions, systemically important financial institutions, and market
intermediaries. The Commission notes that the price and liquidity of
securities issued by these entities are likely to lose value at the
same time that the counterparty's obligation under the swap increases,
resulting in an additional increase in risk. For this reason,
notwithstanding the additional funding costs that may result, the
Commission believes that including these instruments as eligible
collateral would be inappropriate.
Under the final rule, for swaps between a CSE and a financial end
user, the Commission is expanding the form of eligible collateral that
can be posted for variation margin to accommodate the assets held by
the affected financial end users. The Commission believes that this
should mitigate the potential for investment drag of financial end
users, as well as mitigate the pro-cyclical effects potentially
resulting from restricting eligible collateral to cash.
As noted above, the Commission is limiting eligible collateral to
cash for variation margin between CSEs since these entities pose a
significant level of risk to the financial system and cash is the most
liquid asset and holds its value in times of stress. Since CSEs
currently exchange variation margin in cash, the cash-only requirement
could have minimal impact on CSEs. On the other hand, the Commission
understands that, in times of stress when cash may be difficult to
obtain, it is possible that CSEs may be cash constrained and therefore,
could fall into a technical default. The Commission considered these
competing concerns in developing this requirement.
The Commission is adopting standardized haircuts on instruments
other than cash.\387\ For example, in the case where equities are used
as eligible collateral, there is a requirement for a minimum 15 percent
haircut on equities in the S&P 500 Index and a minimum 25 percent
haircut for those in the S&P 1500 Composite Index but not in the S&P
500 Index.\388\ The Commission is not allowing CSEs to use internal
models to calculate haircuts on eligible collateral. The Commission
recognizes that, as a result, more assets would be required to be
posted as margin, which may result in additional funding costs.\389\ On
the other hand, a more conservative approach reflected in the final
rule would result in a greater amount of assets posted, which provides
a greater buffer to cover losses in the event of a default.
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\387\ The Commission recognizes that these haircuts apply to
certain currencies, under certain circumstances.
\388\ As discussed in Appendix A, the Commission recognizes that
due to certain investment constraints, including regulatory
limitations, not every financial entity is going to be able to
pledge all types of eligible collateral, which will have an effect
on its funding costs of collateral.
\389\ The Commission would expect that under the model based
approach, calculated haircut would be less than the standardized
haircut approach.
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6. Segregation
Posted collateral must be properly protected in order to avoid
undermining the benefits of the margin requirements. The Commission
understands that, to the extent that the final rule's segregation
requirements diverge from existing industry practices, CSEs may incur
substantial administrative costs.
Under the final rule, required initial margin must be kept in
accordance with the following: (1) All funds collected and posted as
required initial margin must be held by a third-party custodian
(unaffiliated with either counterparty to the swap); (2) the third-
party custodian is prohibited from re-hypothecating, re-using, or re-
pledging (or otherwise transferring) the initial margin; (3) the
initial margin collected or posted may not be reinvested in any asset
that would not qualify as eligible collateral; and 4) the custodial
agreement is legal, valid, binding and enforceable in the event of
bankruptcy, insolvency, or similar proceedings.
While several commenters supported the mandated use of a third-
party custodian, others objected, citing concerns about complexities
that additional parties bring to the relationship, as well as increased
costs arising from the negotiation of custodial contracts and the cost
of developing operational infrastructure as using a third-party
custodian is not the current practice for certain financial
entities.\390\ The Commission is also aware that many custodians are
affiliated with one or more CSE or financial end users; as a result,
the mandated use of a third-party custodian may lead to collateral
assets being held at a limited number of custodians.
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\390\ See GPC.
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The Commission believes that it is necessary to require the use of
an independent third-party custodian to safeguard required initial
margin in order to best ensure that those assets would be available to
the non-defaulting counterparty in the event of a counterparty default.
A custodian that is affiliated with either counterparty to a swap
raises the concern that in the event of a default by its affiliate
counterparty, the custodian's affiliation may compromise its ability to
act swiftly to release funds to the non-defaulting counterparty. As to
concerns regarding the high concentration of custodians that could
result from the independence element, the Commission notes that
segregated accounts would be protected--regardless of the concentration
level of custodians--as they would not be part of the estate of the
defaulting custodian under the current bankruptcy regime.
Several commenters recommended lifting the restriction on
rehypothecation and reuse of initial margin collateral, either
generally or on a conditional basis.\391\ The Commission
[[Page 688]]
is not allowing the rehypothecation of initial margin collateral.
Rehypothecation would allow the collateral posted by one counterparty
to be used by the other counterparty as collateral for additional
swaps, resulting in rehypothecation chains and embedded leverage
throughout the financial system. The increased leverage, along with the
additional connections between market participants, resulting from
rehypothecating margin, could have a destabilizing effect on the
financial system.\392\ The Commission understands that prohibition
against rehypothecation will impose significant costs on market
participants as this will increase their funding costs for margin.
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\391\ See CPFM; CCMR; IFM; ISDA; SIFMA; ABA; CS; and FSR.
\392\ For example, a default or liquidity event that occurs at
one link along the rehypothecation chain may induce further defaults
or liquidity events for other links in the rehypothecation chain as
access to the collateral for other positions may be obstructed by a
default further up the chain. Also, in the event of one default
along the chain, there is an increased chance that each party along
the chain will ask for the rehypothecated collateral to be returned
to them at the same time, leaving just one party with the
collateral. This spiraling event is the result of only one asset
being pledged for all the positions along the rehypothecation chain.
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The Commission is not allowing cash to be posted as initial margin
collateral without it being converted into other eligible collateral.
As noted above, cash held at a custodian in a deposit account can be
used by the custodial bank and as such, posting of cash as initial
margin would run afoul of the prohibition against rehypothecation. This
requirement may lead to additional funding costs in the form of excess
margin being held at the custodian. However, the Commission expects
that counterparties will post some other form of eligible collateral
and subsequently substitute the cash with other eligible assets,
including a sweep vehicle, which should mitigate the burdens placed by
this requirement.
7. Documentation
Comprehensive documentation of counterparties' rights and
obligations to exchange margin allows each party to manage risks more
effectively throughout the life of the swap and to avoid disputes
regarding the terms of the swap during times of financial turmoil. In
furtherance of that goal, the final rule requires that CSEs enter into
contractual documentation with counterparties addressing, among other
things, how swaps would be valued for purposes of determining margin
amounts, and how valuation disputes would be resolved. To the extent
that other Commission regulations address similar requirements, burdens
on CSEs should be minimal.
8. Non-Financial End Users
The Commission's proposal did not require CSEs to exchange margin
with non-financial end users as the Commission believes that such
entities, which generally are using swaps to hedge commercial risk,
pose less risk to CSEs than financial entities. Instead, the proposal
would have required a CSE, for transactions with non-financial end
users with material swaps exposure to such CSE, each day to calculate
both initial and variation margin as if they were a CSE. These
calculations would serve as risk management tools to assist the CSE in
measuring its exposure and to assist the Commission in conducting
oversight of the CSE. The majority of commenters opposed the
hypothetical margin calculation requirement for non-financial end
users.\393\ Commenters generally noted the significant burdens this
requirement may place on CSEs and the non-financial end user, who must
monitor their swaps exposures to determine if they exceed the material
swaps exposure threshold.
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\393\ See ISDA; SIFMA; Joint Associations; JBA; FSR; ETA; NGCA/
NCSA; CDEU; COPE; BP; Shell TRM; and CEWG.
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In response to the comments, the Commission is not adopting the
hypothetical margin calculation requirements concerning non-financial
end users. Although the Commission continues to believe that
hypothetical margin calculation requirements would promote the
financial soundness of CSEs, the Commission recognizes the additional
administrative burdens such measure could impose on CSEs and on non-
financial end users. The Commission has determined that removing the
hypothetical margin calculation is appropriate, particularly in light
of the comprehensive risk management program that all CSEs are required
to establish and maintain under existing Commission regulations.\394\
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\394\ See, e.g., Sec. 23.600 of the Commission's regulations.
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The proposal also would have required documentation between a CSE
and a non-financial end user to state whether margin is required to be
exchanged and, if so, the applicable thresholds below which margin is
not required. In response to commenters' concern that the standards are
too burdensome and that other Commission regulations adequately address
the subject, the Commission is not adopting any new documentation
requirement for uncleared swaps with non-financial end users.\395\
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\395\ See ISDA.
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9. Inter-Affiliate Swaps
Under the final rule, the Commission is requiring the exchange of
variation margin for swaps between a CSE and its affiliate. Initial
margin is required to be collected from an affiliate if the affiliate
is in a jurisdiction without comparable margin requirements with
respect to the affiliate's outward-facing (i.e., third-party)
transaction. In addition, where the risk is being transferred to the
CSE through a chain of inter-affiliate swaps, with the risk originating
from a third-party transaction, that third-party transaction must be
subject to comparable margin requirements with respect to that
particular transaction; otherwise, the CSE must collect initial margin
from its affiliate counterparty.
The Commission understands that CSEs currently exchange variation
margin when entering into swaps with their affiliates. Therefore, the
Commission expects that CSEs will incur incremental costs associated
with funding variation margin under the final rule. Because the
Commission in most cases is not requiring posting and collection of
initial margin for inter-affiliate swaps, this may result in a CSE, in
the event of a default of an affiliate counterparty (or the default of
any of the affiliates in a chain of inter-affiliate swaps that has a
cascading effect), not having enough margin to cover its losses on an
inter-affiliate swap. However, viewed as a consolidated entity, the
overall risk to the entity and the financial system, in terms of credit
risk and leverage, should not be increased, as a result of the
Commission's requirement, as the affiliate entering into an outward-
facing swap must collect margin or the CSE must collect margin from its
affiliated counterparty. In addition, as these inter-affiliate trades
are typically designed to move risk to the most liquid market (in terms
of breath and depth), this will permit the CSE to efficiently manage
that risk. In addition, by not posting initial margin on their inter-
affiliate swaps, the affected affiliates may compete more effectively
by passing the cost savings to clients.
The Commission believes that the Prudential Regulators' approach,
which requires swap dealers subject to the Prudential Regulators'
margin rules to collect only for initial margin, would be too costly to
the extent that the subject inter-affiliate trade is viewed as shifting
risks within the consolidated group. This difference may make it less
costly
[[Page 689]]
to conduct inter-affiliates swaps for Commission-regulated swap dealers
than prudentially regulated swap dealers and CSEs. As a result of
higher costs in transacting with prudentially regulated swap dealers
than CSEs, the consolidated parent would favor inter-affiliates swaps
with a CSE over a prudentially regulated swap entity.
10. Compliance Schedule
As discussed above, the Commission expects that affected entities
will need to update their current operational infrastructure to comply
with the provisions of the final rule, including potential changes to
internal risk management and other systems, netting agreements, trading
documentation, and collateral arrangements. In addition, the Commission
expects that CSEs that opt to calculate initial margin using an initial
margin model will modify such models and obtain regulatory approval for
their use.\396\ In this regard, the Commission recognizes that CSEs and
other affected counterparties can benefit from additional time to come
into compliance with the new margin regime; at the same time, it is
important that the final rule is implemented without undue delay so as
to protect CSEs and the U.S. financial system as Congress intended.
Accordingly, the Commission has determined to adopt a phase-in schedule
for compliance.\397\ The phase-in schedule is also responsive to
commenters supporting international harmonization of implementation
dates for margin requirement.
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\396\ The Commission understands that under current practices,
CSEs already use models to calculate initial margin requirements for
certain clients, including hedge funds.
\397\ See Sec. 23.161.
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Under the phase-in schedule, the largest and most sophisticated
covered swap entities that present the greatest potential risk to the
financial system comply with the requirements first. The Commission
expects that this would be less of a burden on these entities as they
currently have the infrastructure in place to meet the requirements and
would require the least amount of modification.
C. Section 15(a) Factors
1. Protection of Market Participants and the Public
Under the final rule, the market and the public will benefit from
the required collateralization of uncleared swaps. More specifically,
the margin requirements should mitigate the overall credit risk in the
financial system, reduce the probability of financial contagion, and
ultimately reduce systemic risk.
The primary reason for collecting margin from counterparties is to
protect an entity in the event of its counterparty default. That is, in
the event of a default by a counterparty, margin protects the non-
defaulting counterparty by allowing it to use the margin provided by
the defaulting entity to absorb the losses and to continue to meet all
of its obligations. In addition, margin functions as a risk management
tool by limiting the amount of leverage that either counterparty can
incur. Specifically, the requirement to post margin ensures that each
counterparty has adequate collateral to enter into an uncleared swap.
In this way, margin serves as a first line of defense in protecting an
entity from risk arising from uncleared swaps, which ultimately
mitigates the possibility of a systemic event.
Protecting financial entities from the risk of failure has direct
benefit to the public as the failure of these entities could result in
immediate financial loss to its counterparties or customers. Given the
importance of these entities to the financial system, their failure
could spill over to other parts of the broader economy, with
detrimental impact on the general public.
The final rule may also have the effect of promoting centralized
clearing. Specifically, the final rule's robust margin requirements for
uncleared contracts may create incentives for participants to clear
swaps, where available and appropriate for their needs.\398\ Central
clearing can provide systemic benefits by limiting systemic leverage
and aggregating and managing risks by a central counterparty.
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\398\ As a result of the cost effects on the Commission's final
rule, it is expected that some market participants may change their
practice of using uncleared swaps to alternative instruments.
Futures and cleared swaps, which tend to be more standardized and
liquid than uncleared swaps, typically require less initial margin;
however, this may result in basis risk, as a result of
standardization of these products. A futures contract has a one day
minimum liquidation time. A cleared swap has a three to five day
minimum liquidation time whereas the Commission's margin rules
requires a ten day minimum liquidation time for uncleared swaps.
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On the other hand, required margin may reduce the availability of
liquid assets for purposes other than posting collateral and therefore
affect the ability of CSEs to engage in swaps activities and financial
end users to manage or hedge the risks arising from their business
activities. In addition, as detailed below in Appendix A, the
Commission's margin requirements will increase the cost of entering
into a swap transaction. The final margin rule incorporates various
cost-mitigating provisions--such as the initial margin thresholds,
expansion of eligible collateral for variation margin for financial end
users, and minimum transfer amount--to contain potentially adverse
impacts on the market and the public.
2. Efficiency, Competitiveness, and Financial Integrity of Swap Markets
In finalizing the rule, the Commission strived to promote
efficiency and financial integrity of the swaps market, and where
possible, mitigate undue competitive disparities. Most notably, the
Commission, in finalizing the margin rule, aligned the rule with that
of the Prudential Regulators to the greatest extent possible. This
should promote greater operational efficiencies for those CSEs that are
part of a bank holding company as they may be able to avoid creating
individualized compliance and operational infrastructures to account
for the final rule and instead, rely on the infrastructure supporting
the bank CSE.
The final rule also provides for built-in flexibilities that should
enhance the efficiency in the application of the rule. For example, the
final rule provides counterparties the flexibility to post a variety of
collateral types to meet the margin requirements which may result in
increased efficiencies for end users and promote the use of swaps to
hedge or manage risks. For initial margin calculation methodology, the
final rule provides CSEs with the choice of two alternatives to allow
them to choose the methodology that is the most cost efficient for
managing their business risks.
Proper documentation of swaps is crucial to reducing risk in the
bilaterally-traded swaps market. Accordingly, the final rule requires
that CSEs enter into contractual documentation with counterparties
addressing, among other things, how swaps would be valued for purposes
of determining margin amounts, and how valuation disputes would be
resolved. Documentation of counterparties' rights and obligations to
exchange margin should allow each party to manage risks more
effectively throughout the life of the swap and to avoid disputes
regarding the terms of the swap during times of financial turmoil.
The safety and soundness of CSEs--given the nature and scope of
their activities--are critical to the financial integrity of markets.
As discussed above, margin serves as a first line of defense to protect
a CSE in the event of a default by its counterparty. It also
[[Page 690]]
helps to reduce the risk of a systemic event by containing the risk of
a cascade of defaults occurring. A cascade occurs when one participant
defaulting causes subsequent defaults by its counterparties, and so on,
resulting in a domino effect and a potential financial crisis.
The Commission also notes that the final margin rule, like other
requirements under the Dodd-Frank Act, could have a substantial impact
on the relative competitive position of market participants operating
within the United States and across various jurisdictions. U.S. or
foreign firms could be advantaged or disadvantaged depending on how the
Commission's margin rule compares with corresponding requirements under
Prudential Regulators' margin regime or in other jurisdictions. To
mitigate undue competitive disparities, the Commission, in developing
the final rule, harmonized the final rule with those of the Prudential
Regulators and the BCBS-IOSCO framework.
3. Price Discovery
The Commission is requiring a ten-day margin period of risk for
uncleared swaps, as compared to a three- to five-day margin period of
risk for cleared swaps. Also, the Commission is only allowing limited
netting for uncleared swaps. Together, these provisions of the final
rule may result in the use of more standardized products.
Increase in the use of standardized products may lead to greater
transparency in the cleared swaps and futures markets. If market
participants migrate to standardized products, price discovery process
for such swaps and futures may improve with higher volumes. Conversely,
lower volumes for uncleared swaps may negatively impact the price
discovery process for such swaps. However, the Commission believes that
since these uncleared swaps are customized, the potential reduction in
the efficacy of the price discovery process for uncleared swaps is less
of a concern.
4. Sound Risk Management Practices
A well-designed risk management system helps to identify, evaluate,
address, and monitor the risks associated with a firm's business. As
discussed above, margin plays an important risk management function.
Initial margin addresses potential future exposure. That is, in the
event of a counterparty default, initial margin protects the non-
defaulting party from the loss that may result from a swap or portfolio
of swaps, during the period of time needed to close out the swap(s).
Initial margin augments variation margin, which secures the current
mark-to-market value of swaps. This, in turn, forces market
participants to recognize losses promptly and to adjust collateral
accordingly and helps to prevent the accumulation of large unrecognized
losses and exposures.
The final rule permits CSEs to calculate initial margin by using
either a risk-based model or standardized table method. The choice of
two alternatives may enhance a CSE's risk management program by
allowing the CSE to choose the methodology that is the most effective
for managing their business risks.
The Commission is also requiring a ten-day margin period of risk
for uncleared swaps and only a five-day margin period of risk for
cleared swaps. Thus, the rule may result in the use of more
standardized cleared swaps at the expense of more customized swaps
which may be harder to evaluate and risk manage; however, this may
encourage market participants to use less ideal hedging techniques, as
noted above, which may result in a different type of risk at a firm.
Finally, the Commission is imposing strong model governance,
oversight and control standards that are designed to ensure the
integrity of the initial margin model and provide margin requirements
that are commensurate with the risk of uncleared swaps. For the
foregoing reasons, the final rule promotes sound risk management
practices by CSEs.
5. Other Public Interest Considerations
The Commission has not identified any additional public interest
considerations related to the costs and benefits of the final rule.
Appendix A to the Preamble
In this Appendix, the Commission provides its estimate of the
funding costs related to the final initial and variation margin
requirements and discusses certain key aspects of overall
administrative costs. As noted below, there are a number of
challenges presented in conducting a quantitative analysis of the
costs associated with the final rule. In this exercise, the
Commission looked to data sources that were representative of the
current swaps market and scaled the data to limit its estimate to
CSEs and their uncleared swaps. Given the complexity of this final
rule and its inter-relationship to other rulemakings, the
Commission's estimate is subject to considerable uncertainty. The
Commission's estimates are based on available data and assumptions
set out below.
In the proposal, the Commission requested commenters to provide
data or other information that would be useful in estimation of the
quantifiable costs and benefits of this rulemaking. No commenters,
with the exception of NERA, provided any data; NERA provided its
estimate of the overall costs of the margin requirements under the
Prudential Regulators' and Commission's proposed rules.\399\ The
Commission's estimate of the funding cost of initial margin diverges
from that of NERA, as explained below.
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\399\ NERA provided recommendations for reducing the costs for
the final rule; these recommendations are discussed above.
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I. Margin Costs
A. Funding Cost
The Commission reviewed various industry studies estimating the
total cost of initial margin that would be required by the margin
rules, as proposed, by the Prudential Regulators and the CFTC.\400\
These studies rely on a different set of assumptions in calculating
the funding costs of the margin rules, as explained below. The
Commission used this set of industry data, which provides global
estimates of the margin required under such rules, to construct its
own estimates of costs. The cost estimates include two major
components. The first component is an estimate of the amount of
initial margin subject to the Commission's margin regime,
constructed by scaling the global estimates of the margin to the
relevant basis. The second component is an annual funding cost. The
Commission multiplied these two components in order to obtain an
annual cost of funding margin as required by the rules. This
methodology is similar to that used by the Prudential Regulators in
their quantitative analysis in finalizing their margin rules.
Details of the methodology are described in the text that follows.
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\400\ As discussed below, these studies did not distinguish
between CSEs and prudentially-regulated swap dealers.
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Table A, below, presents estimated amounts of initial margin
that would be required for CSEs under the final rule.\401\ These
estimates are based on the assumption that the final rule is
effective (i.e., in the post-transitional period).
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\401\ The Commission is unable to quantify certain swaps that
may fall under the final rule. Specifically, there are swaps entered
into by some non-U.S. swap dealers and foreign counterparties that
would be swept into this rulemaking under a 2(i) analysis (relating
to the Commission's authority to regulate cross-border swaps) that
are not reported. The Commission acknowledges that these costs are
not reflected in the Commission's estimates because the Commission
does not require regulatory reporting of all transaction data on
swaps transacted globally by derivatives dealers covered by the
rule. Hence, the Commission notes the limitation of the estimates
shown in Table A, but is unable to make a reasonable estimate of the
notional amount of derivatives not covered by its estimates.
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The initial margin estimates in Table A are based on two
different studies that estimate the potential impact of the 2013
international framework: BCBS and IOSCO \402\ and
[[Page 691]]
ISDA \403\ studies. Each study reports an estimate of the global
impact of margin requirements, which is displayed under the column
heading ``Global ($BN).'' Most notably, these studies provide
estimates based on the assumption that margin requirements apply to
all uncleared swaps of all market participants covered by the 2013
international framework.
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\402\ See Basel Committee on Banking Supervision and the
International Organization of Securities Commissions (2013), Margin
Requirements for Non-Centrally Cleared Derivatives: Second
Consultative Document, report (Basel, Switzerland: Bank for
International Settlements, February).
\403\ Documents on initial margin requirements are available on
the International Swaps and Derivatives Association Web site.
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To estimate the funding costs of the initial margin requirement,
the Commission modified the ISDA and BCBS IOSCO survey estimates in
two stages. In the first stage, the Commission multiplied the survey
estimates by 57% to align the global estimates better with the
impact of the U.S. rules. The Commission utilized Swap Data
Repository (SDR) data on uncleared interest rate swaps, which
represent the majority of the notional value associated with
uncleared swaps, to compute the 57% scale factor. The 57% scaling is
designed to represent the notional amount of uncleared interest rate
swaps reported to the SDRs as a fraction of the global notional
amount of uncleared interest rate swaps represented in the surveys.
The Commission's Weekly Swaps Report shows $100.9 trillion in
notional outstanding for uncleared interest rate swaps reported to
SDRs as of June 5, 2015, whereas the BCBS-IOSCO survey represents
$175.6 trillion in global notional outstanding of uncleared interest
rate swaps. Hence, the ratio between the two is approximately 57%
(100.9/175.6 = 57.46%). The Commission applied this 57% scale factor
to the global notional amount of margin estimated in each of the
surveys.\404\
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\404\ The BCBS-IOSCO survey estimate is based on a global
notional amount outstanding of $281.3 trillion of uncleared swaps.
We apply the ratio 100.9/175.6 = 57% to each of the global margin
figures to reduce them to the relevant basis for the rule.
---------------------------------------------------------------------------
These estimates inherit the limitations of the global estimates
provided by the underlying studies, which applied rules that are
similar, but not identical, to the Commission's rules. For example,
the BCBS-IOSCO survey results do not apply the $8 billion material
swaps exposure threshold, and in fact did not apply any such
threshold. It also did not exclude swaps with a non-financial end
user as a counterparty. The results are likely to be conservative
and overstate the actual impact of the U.S. rules.
In a second stage, the Commission multiplied the results
obtained in the first stage by 25%. This 25% scale factor reduces
the estimates to account for the narrower scope of the Commission's
rule as compared to the scope of SDR data. For a variety of reasons,
many of the uncleared swaps reported to the SDRs do not require
margin under the Commission's rule. For example, margin may instead
be required under the Prudential Regulators' rule. Alternatively,
margin would not be required if a covered swap entity's counterparty
to a swap is a non-financial end user. The Commission has used SDR
data to compute this 25% scale factor applied in its cost estimates.
This scale factor is computed by comparing the notional amount of
swaps covered by the Commission's rule to the total notional amount
represented by SDR data.\405\ The Commission believes that 25% is an
appropriate scale factor to adjust the total notional value of
uncleared swaps, reported to the SDR, to the relevant notional
value.
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\405\ For the purposes of this calculation, the impact of the $8
billion material swaps exposure threshold for financial end users
was approximated in the following manner. Entities estimated to have
had less than $8 billion total notional of open IRS swaps on June 5,
2015 were considered not to have material swaps exposure. The
Commission understands that it is possible that its estimate of the
number of financial end users with material swaps exposure may over-
or underestimate the total number of covered counterparties as
certain instruments that are used in the calculation are not
included in this estimate and certain entities that may be excluded
from the Commission's margin rule may be included.
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The Commission has estimated this 25% scale factor based on the
uncleared outward-facing open interest rate swaps reported to DTCC
as of June 5, 2015. The scale factor compares the notional value of
swaps covered by the Commission's rule to the total notional value
of all swaps reported to the SDR. Because the identity of both
counterparties to a trade is relevant for the computation, notional
values for each trade side are utilized to construct the ratio
(i.e., notional values are double-counted). If both counterparties
of a swap are subject to the Commission's margin rule, the notional
amount is counted twice (once for each counterparty).If one
counterparty is subject to the Commission's margin rule, but the
other counterparty is subject to the Prudential Regulators' margin
rule, the notional amount is counted once (for the counterparty
covered by the Commission's rule).
Based on the SDR data, the Commission estimates that the total
notional amount of uncleared interest rate swaps subject to the
Commission's initial margin requirement is roughly $42 trillion
(where both trade sides are potentially counted). The total notional
value, reported to the SDR, used in this calculation is $202
trillion (which is twice the $100.9 trillion, one-sided, total
notional value noted earlier). The ratio of these two values is
therefore 21% (which equals 42 divided by 202). To be conservative,
the Commission assumes that the total notional amount between the
CSEs and their covered counterparties account for roughly 25% of the
total notional value of uncleared swaps reported to the SDRs.\406\
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\406\ The Commission assumed that on June 5, 2015, there were 54
CSEs. The Commission based this number on the number of
provisionally registered swap dealers and major swap participants.
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The net effect of applying these two scale factors to the survey
estimates is to multiply the raw, survey estimates of initial margin
by approximately 14% (57% x 25% = 14.25%). These estimates are
displayed in Table A under the column heading ``Covered Swap
Entities ($BN).'' \407\
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\407\ The BCBS-IOSCO impact study discusses the impact of
several different margin regimes, e.g., regimes with and without an
initial margin threshold. In addition, the estimate costs reported
in Table A from the BCBS-IOSCO study reflects an estimate from the
study that is most comparable to the Commission's final rule.
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Table A presents a range of estimates based on the ISDA and
BCBS-IOSCO studies. Both the ISDA's low estimate and the BCBS-IOSCO
estimate assume that all initial margin requirements are calculated
according to an internal model with parameters consistent with those
required by the final rule. The ISDA's high estimate assumes that
all initial margin requirements are calculated according to a
standardized gross margin approach. Further, the ISDA standardized
approach does not allow for the recognition of any netting
offsets.\408\ The Commission anticipates that most entities will use
internal models to calculate initial margin.
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\408\ The ISDA study was conducted based on the BCBS-IOSCO
February 2013 consultative document which did not include any
recognition of offsets in the standardized initial margin regime.
Recognition of offsets was included in the final 2013 international
framework.
Applying the standardized approach on SDR data for June 5, 2015,
the Commission estimated total gross initial margin due to the new
margin requirements at $1.174 trillion for IRS and CDS, which is
less than the ISDA-standardized initial margin estimates of $1,454
billion shown in Table A.
[[Page 692]]
Table A--Estimated Initial Margin Requirements for Outward Facing Swaps, Based on Prior Estimates of Global
Margin Required
----------------------------------------------------------------------------------------------------------------
Covered swap
Source Method Global ($BN) entities *
($BN)
----------------------------------------------------------------------------------------------------------------
ISDA.......................................... Standardized.................... 10,200 \409\ 1,454
ISDA.......................................... Model Based..................... 800 \410\ 114
BCBS-IOSCO.................................... Model Based..................... 900 \411\ 128
----------------------------------------------------------------------------------------------------------------
* Assumes uncleared swaps between CSEs and their covered counterparties is approximately 14% of global notional
outstanding, as described in the text.
Table B presents a matrix of the annual cost estimates
associated with the initial margin requirements.\412\
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\409\ 10,200 x 14.25% = 1,454.
\410\ 800 x 14.25% = 114.
\411\ 900 x 14.25% = 128.
\412\ The cost of funding initial margin for CSEs or covered
counterparties is a function of the entities' business model,
including their financial structure, financial activities and
services, and risk profile. The most direct cost of providing
initial margin is generally the difference between the cost of
funding the required margin, including the opportunity cost on the
use of the margin, less the rate of return on the assets used as
margin. In some cases, for example, certain registered investment
companies will have no additional incremental funding costs, as they
will be able to post assets that they currently hold on their
balance sheet as eligible collateral. Alternatively, certain
entities may have to raise additional funds to purchase eligible
assets, as they may not have any or may need more of eligible
collateral.
---------------------------------------------------------------------------
The three rows of the matrix correspond to the ISDA
Standardized, ISDA Model Based, and BCBS-IOSCO Model Based
approaches for determining initial margin amounts that are presented
and discussed above (in relation to Table A). The matrix includes
four columns, two of which contain final funding-cost estimates for
initial margin required under the final rule. The two funding-cost
columns identify the Commission's estimated lower-end and upper-end
range for funding costs based on three different methods (i.e.,
BCBS-IOSCO, ISDA Model Based, and ISDA Standardized).
For the purposes of this matrix, the Commission assumed that the
opportunity cost of funding initial margin is between 25 basis
points and 160 basis points. The Commission acknowledges that this
opportunity cost range is expansive, but based on the Commission's
experience and understanding of the entities covered by its margin
rule (e.g., swap dealers, insurance companies, collective investment
vehicles), it believes that range addresses the idiosyncrasies of
these entities. As noted above, some entities covered under the
margin rule (e.g., certain registered mutual funds) will be able to
post eligible collateral that are already on their balance sheets
(i.e., investments). Given this possibility, the Commission makes a
conservative assumption that the opportunity cost of pledging
collateral on the lower end is 25 basis points.
For the purposes of determining the higher-end of opportunity
costs, the Commission accepted Duff & Phelps' weighted average cost
of capital of 4.6% for large security brokers and dealers, and then
subtracted the 3% return on 30-year Treasury collateral to arrive at
1.6% of funding costs.\413\ The Commission assumes that the 160
basis points address situations where, for example, a swap dealer
does not have sufficient eligible collateral on its balance sheet.
As a result, the swap dealer would need to raise capital by issuing
debt or equity to purchase eligible collateral, for instance, 30-
year Treasuries to meet the final rule's initial margin
requirements. Under this hypothetical, the swap dealer's opportunity
costs related to posting eligible collateral are increased.\414\
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\413\ For SIC code 621, Security Brokers, Dealers, Flotation,
the Weighted Average Cost of Capital (``WACC'') is computed to be
4.6% for large firms as of March 31, 2015 by Duff & Phelps, ``2015
Valuation Handbook: Industry Cost of Capital.'' WACC is estimated
over a time horizon that includes a stressed period.
\414\ It should be noted that the entity is also forgoing the
use of the borrowed funds, as an investment asset. Therefore, this
opportunity cost is also imbedded in this cost.
\415\ 1,454 x 0.25% = 3.64.
\416\ 1,454 x 1.6% = 23.26.
\417\ 114 x 0.25% = 0.29.
\418\ 114 x 1.6% =1.82.
\419\ 128 x 0.25% = 0.32.
\420\ 128 x 1.6% =2.05.
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Each annual funding cost estimate in table B is computed by
multiplying the initial margin amount for CSEs (from Table A)
identified in each row by the opportunity cost of funding initial
margin identified in each column. The amounts presented in Table B
are reported in billions.
Table B--Estimated Annual Cost of Initial Margin Requirements for CSEs and Their Covered Counterparties
----------------------------------------------------------------------------------------------------------------
Final cost ($BN)
-------------------------------
Opportunity Opportunity
Source Method cost of cost of
funding funding
initial margin initial margin
(at 0.25%) (at 1.6%)
----------------------------------------------------------------------------------------------------------------
ISDA.......................................... Standardized.................... \415\ 3.64 \416\ 23.26
ISDA.......................................... Model........................... \417\ 0.29 \418\ 1.82
BCBS-IOSCO.................................... Model........................... \419\ 0.32 \420\ 2.05
----------------------------------------------------------------------------------------------------------------
The estimated annual cost of the initial margin requirements
depend on the specific initial margin estimate (which depends in
large part on whether the standardized or model approach is used)
and opportunity cost of funding initial margin. As discussed above,
the Commission expects the costs of the final margin rule to be more
consistent with the amounts based on the model approach (both ISDA
and BCBS-IOSCO), rather than the standardized approach for
determining initial margin amounts. Using the estimates based on the
model-based approaches, the Commission therefore, expects that the
costs of the final rule would most likely range from $290 million to
$2.05 billion.
B. Variation Margin
Under the final rule, the Commission is requiring the daily
exchange of variation margin. The requirement is intended to
mitigate the build-up of uncollateralized risk at swap
counterparties. In requiring the exchange of daily variation margin
the Commission acknowledges that there will additional costs to some
market participants,
[[Page 693]]
particularly to those who are not currently exchanging variation
margin daily.\421\
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\421\ As discussed above, it should be noted that the
Commission's final rule includes a minimum transfer amount, which is
designed to mitigate some of the costs of exchanging variation
margin daily.
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Presuming that a CSE maintains a relatively flat swap book,\422\
the cost of the cash only requirement is small when the CSEs collect
enough cash to post to other CSEs.\423\ However, when a CSE needs to
convert non-cash collaterals collected from financial end users into
cash to post to their swap dealer and major swap participant
counterparties,\424\ it places additional costs on a CSE.\425\ In
this case, a CSE may use a repurchase agreement to turn non-cash
collaterals into cash. The cost of repo transactions depend on many
factors, including duration and quality of collateral posted. For
example, on September 2, 2015, Bloomberg quotes one week treasury GC
repo rate of 0.24%.\426\ However, in times of severe financial
stress, the repo market may not provide access to market
participants. If this happens, a CSE may not be able to turn non-
cash collateral into cash which might cause technical defaults. In
order to avoid technical defaults, a CSE may elect to pay for a
committed repo agreement that gives them the right to enter into a
repurchase agreement for a fee at a predetermined repo rate
(presumably at a rate significantly above the normal repo
rate).\427\ This additional cost may be priced into a non-cleared
swap agreement and eventually be passed onto financial end users who
post non-cash collaterals.\428\ A CSE might also require financial
end users to only post cash, matching it collateral exposure.\429\
Despite these possibilities, the Commission notes that most of the
variation margin by total volume continues to be in the form of cash
exchanged between swap dealers.\430\
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\422\ The Commission is assuming this as CSEs are dealers and
typically do not take proprietary long or short positions, in
contrast to other market participants (e.g., hedge funds).
\423\ According to the 2015 ISDA Margin Survey, each of the
largest dealers receives and pays, on average, roughly 6 billion USD
variation margin on a given day. When a swap dealer receives more
cash than it needs to pay, or an equal amount, the cost is minimal.
\424\ As the final rule requires cash to be posted between a CSE
and its swap entity counterparty, while permitting all types of
eligible collateral when it transacts with a financial end user,
this may result in a collateral mismatch.
\425\ For instance, this might happen when a CSE has posted all
the non-cash collateral that it can with financial end users as
variation margin.
\426\ According to the 2015 ISDA Margin Survey, each of the
largest dealers receives and pays, on average, roughly 6 billion USD
variation margin on a given day. If 1 percent of variation margin
received is non-cash collateral which needs to be turned into cash
using a repo agreement, then the daily cost will be roughly $400,
which is calculated as 60 million x 0.24%/360.
\427\ This is similar to a market participant paying a fee to
access to a revolving credit facility.
\428\ To the extent that these predetermined repos are used as a
funding mechanism for the entire operations of the entity, these
costs might not be completely passed on in the price or other aspect
of the relationship between the CSE and the financial end user.
\429\ It should be noted that this requirement may result in
better pricing terms or possibly some other beneficial change in the
relationship with the CSE.
\430\ According to the 2015 ISDA Margin Survey, 77 percent of
variation margin received and 75 percent of variation margin
delivered is in the form of cash. Available at https://www2.isda.org/functional-areas/research/surveys/margin-surveys/.
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The Commission anticipates that many CSEs will have cheaper
access to liquidity than most financial end users and may be able to
pass along this cost savings to financial end users.\431\ The cash
only variation margin requirement only holds for swaps between a CSE
and another swap entity. The cash only variation margin requirement
does not apply to swaps between a CSE and a financial end user. This
change from the proposal should provide the flexibility to financial
end users to post and to hold the same types of financial
instruments in their portfolios for variation margin, as they did
prior to the final rule, which should result in less performance
drag.\432\ Financial end users may still end up paying for the
liquidity demanded on CSEs, but, overall, the CSEs' costs are likely
to be lower compared to the alternative of requiring cash only
variation margin for financial end users, because CSEs may be able
to pass on their liquidity advantage to financial end users.
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\431\ The CSE may be able to pool liquidity needs for end users.
Due to CSE liquidity demands, they may need to establish or maintain
relationships with banks that have access to cheaper liquidity
through the payment system and the Federal Reserve System, in
general.
\432\ As suggested by NERA, this change should reduce the
possibility of pro-cyclicality in time of stress.
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C. Administrative Costs
CSEs and financial end users will face certain startup and
ongoing costs relating to technology and other operational
infrastructure, as well as new or updated legal agreements. These
administrative costs related to margin for uncleared swaps are
difficult to quantify at this time; the Commission will discuss
these costs qualitatively instead.\433\
---------------------------------------------------------------------------
\433\ In the proposal the Commission requested comments
regarding the administrative costs involved in implementing its
proposed margin rule; however, the Commission did not receive any
quantitative data to assist it in its analysis therefore, the
Commission is undertaking a qualitative analysis.
---------------------------------------------------------------------------
The per-entity costs related to changes in technology,
infrastructure, and legal agreements are likely to vary widely,
depending on each market participant's existing technology
infrastructure, legal agreements, and operations, among other
things. As discussed in the preamble and below, the Commission
expects that certain aspects of the final rule--such as minimum
initial margin threshold and expanded list of eligible collaterals--
will have mitigating impact on the overall costs to an affected
entity. Moreover, the higher degree of harmonization between various
regulators and jurisdictions should result in lower administrative
costs.\434\ Longer lead times for industry to build out compliance
systems will lower administrative costs, because it gives industry
more time to plan and execute buildouts, which should result in less
operational errors and costs.
---------------------------------------------------------------------------
\434\ As discussed above, the Commission's final rule is very
similar to the Prudential Regulators' final margin rule and the 2013
International Standards.
---------------------------------------------------------------------------
Examples of the key documents related to administrative costs
include: (1) Certain self-disclosure documents, (2) credit support
annexes; and (3) tri-party segregation of margin collateral that
have to be arranged by the parties involved.\435\
---------------------------------------------------------------------------
\435\ Costs of these requirements are estimated above in the PRA
section.
---------------------------------------------------------------------------
The Commission expects that counterparties will have to make
certain representations regarding their status. These
representations will impose certain costs on CSEs and their swap
entity and financial end user counterparties. There are at least
three types of information when making self-disclosures: (a)
Jurisdictional information, (b) status information, and (c) initial
margin information. Jurisdictional information anticipates possible
multi-jurisdictional counterparties. Status information would
include, among other information, whether a party is a Commission-
registered swap dealer and material swaps exposure information.
Initial margin information includes among other information the
amount of initial margin for the consolidated group.
There may be multiple credit support annexes between
counterparties executing swaps because, among other reasons, the
final rule provides for a separate netting treatment of legacy swaps
and for calculation of initial margin by netting sets of broad asset
classes. Consequently, market participants will need to amend or
enter into new credit support agreements to account for the
differences from the current arrangement(s), resulting in additional
administrative costs.
Tri-party segregation agreements will have to be negotiated as
well.\436\ These arrangements can be costly as they involve multiple
parties and typically customized to the counterparties' needs.\437\
---------------------------------------------------------------------------
\436\ The Commission notes that some of these agreements will
need to be re-negotiated as a result of the final rule.
\437\ The final rule's requirements should provide some level of
standardization.
---------------------------------------------------------------------------
The Commission is aware of certain industry initiatives to
standardize documentation in order to create efficiencies and
mitigate costs. For example, ISDA plans to implement the following:
(1) ISDA Amend Platform, (2) ISDA bookstore for Master Agreements
and CSAs, and (3) Protocols.\438\ The ISDA Amend Platform is
technology that would allow swap contracts between counterparties to
be standardized, but with customized options to reduce costs.
---------------------------------------------------------------------------
\438\ In discussions with ISDA, the Commission understands that
these initiatives are currently in progress.
---------------------------------------------------------------------------
ISDA is also planning to create a database of standardized
Master Agreements and CSAs, updated to reflect the new margin
requirements. This initiative should result in more standardized
agreements and lower the costs to market participants.
Finally, ISDA is considering developing protocols to facilitate
the creation of multilateral agreements based on multiple bilateral
agreements. These protocols should
[[Page 694]]
provide efficiencies and lower the cost of documentation.
Appendix B to the Preamble
------------------------------------------------------------------------
Seq. Date received Organization
------------------------------------------------------------------------
1.......................... 11/11/2014 Chris Barnard.
2.......................... 11/21/2014 Japan Financial Markets
Council (JFMC).
3.......................... 11/24/2014 ICI Global.
4.......................... 11/24/2014 Investment Company
Institute.
5.......................... 11/24/2014 Committee on Capital
Markets Regulation.
6.......................... 11/24/2014 Structured Finance Industry
Group.
7.......................... 11/24/2014 ISDA (International Swaps
and derivatives
Association).
8.......................... 11/24/2014 Global FX Division (GFXD)
of the Global Financial
Markets Association
(GFMA).
9.......................... 11/24/2014 Alberta Investment Mgt
Corp; British Columbia
Investment Mgt Corp;
Caisse de
d[eacute]p[ocirc]t et
placement du
Qu[eacute]bec; Canada
Pension Plan Investment
Bd; Healthcare of Ontario
Pension Plan Trust Fund;
OMERS Administration Corp;
Public Sector Pension
Investment Bd.
10......................... 11/24/2014 American Public Gas
Association (APGA).
11......................... 11/24/2014 Securities Industry and
Financial Markets
Association.
12......................... 11/24/2014 State Street Corporation on
behalf of itself, Northern
Trust Corporation and Bank
of New York Mellon
Corporation.
13......................... 11/24/2014 Metropolitan Life Insurance
Company.
14......................... 11/24/2014 SIFMA.
15......................... 11/24/2014 Skadden, Arps, Slate,
Meagher & Flom LLP (on
behalf of the Global
Pension Coalition).
16......................... 11/24/2014 Institute of International
Bankers.
17......................... 11/24/2014 TIAA-CREF.
18......................... 11/25/2014 Securities Industry and
Financial Markets
Association (SIFMA).
19......................... 11/25/2014 American Bankers
Association (ABA).
20......................... 11/25/2014 Credit Suisse.
21......................... 11/25/2014 KfW Bankengruppe.
22......................... 11/26/2014 Credit Suisse.
23......................... 11/27/2014 Instituto de Cr[eacute]dito
Oficial (``ICO'').
24......................... 12/2/2014 Japanese Bankers
Association (JBA).
25......................... 12/2/2014 Alternative Investment
Management Association
(AIMA).
26......................... 12/2/2014 Managed Funds Association.
27......................... 12/2/2014 TriOptima.
28......................... 12/2/2014 MFX Solutions, Inc. (MFX).
29......................... 12/2/2014 The Financial Services
Roundtable.
30......................... 12/2/2014 White & Case LLP.
31......................... 12/2/2014 FMS Wertmanagement.
32......................... 12/2/2014 MasterCard International
Incorporated First Data
Corporation Vantiv, Inc.
33......................... 12/2/2014 Public Citizen.
34......................... 12/2/2014 American Gas Association
American Public Power
Association Edison
Electric Institute
Electric Power Supply
Association Large Public
Power Council National
Rural Electric Cooperative
Association.
35......................... 12/2/2014 National Corn Growers
Association & Natural Gas
Supply Association.
36......................... 12/2/2014 Freddie Mac.
37......................... 12/2/2014 National Rural Utilities
Cooperative Finance
Corporation.
38......................... 12/2/2014 CME Group.
39......................... 12/2/2014 Coalition of Physical
Energy Companies (COPE).
40......................... 12/2/2014 Sutherland Asbill & Brennan
LLP on behalf of the
Federal Home Loan Banks.
41......................... 12/2/2014 National Economic Research
Associates, Inc.
42......................... 12/2/2014 American Council of Life
Insurers.
43......................... 12/2/2014 International Energy Credit
Association.
44......................... 12/2/2014 Coalition for Derivatives
End users.
45......................... 12/2/2014 BP Energy Company.
46......................... 12/2/2014 Shell Trading Risk
Management.
47......................... 12/2/2014 Sutherland Asbill & Brennan
LLP on behalf of The
Commercial Energy Working
Group.
48......................... 12/2/2014 Better Markets.
49......................... 12/9/2014 Vanguard.
50......................... 12/2/2014 National Rural Electric
Cooperative Association
(NRECA).
51......................... 12/2/2014 Americans for Financial
Reform (AFR).
52......................... 12/3/2014 INTL FCStone Inc.
53......................... 12/18/2014 KfW Bankengruppe.
54......................... 12/11/2014 Australia and New Zealand
Banking Group Commonwealth
Bank of Australia
Macquarie Bank Ltd
National Australia Bank
Ltd Westpac Banking Corp.
55......................... 3/12/2015 Global Pension Coalition.
56......................... 5/15/2015 Managed Funds Association.
57......................... 6/1/2015 The Clearing House
Association L.L.C. (TCH);
American Bankers
Association (ABA); ABA
Securities Association
(ABASA), and the
Securities Industry and
Financial Markets
Association (SIFMA).
58......................... 6/9/2015 William J Harrington.
59......................... 8/7/2015 ISDA (International Swaps
and Derivatives
Association).
------------------------------------------------------------------------
[[Page 695]]
List of Subjects
17 CFR Part 23
Swaps, Swap dealers, Major swap participants, Capital and margin
requirements.
17 CFR Part 140
Authority delegations (Government agencies), Organization and
functions (Government agencies).
For the reasons discussed in the preamble, the Commodity Futures
Trading Commission amends 17 CFR chapter I as set forth below:
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
0
1. The authority citation for part 23 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,
9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.
0
2. Add subpart E to part 23 to read as follows:
Subpart E--Capital and Margin Requirements for Swap Dealers and
Major Swap Participants
Sec.
23.100-23.149 [Reserved]
23.150 Scope.
23.151 Definitions applicable to margin requirements.
23.152 Collection and posting of initial margin.
23.153 Collection and posting of variation margin.
23.154 Calculation of initial margin.
23.155 Calculation of variation margin.
23.156 Forms of margin.
23.157 Custodial arrangements.
23.158 Margin documentation.
23.159 Special rules for affiliates.
23.160 [Reserved]
23.161 Compliance dates.
23.162-23.199 [Reserved]
Subpart E--Capital and Margin Requirements for Swap Dealers and
Major Swap Participants
Sec. Sec. 23.100-23.149 [Reserved]
Sec. 23.150 Scope.
(a) The margin requirements set forth in Sec. Sec. 23.150 through
23.161 shall apply to uncleared swaps, as defined in Sec. 23.151, that
are executed after the applicable compliance dates set forth in Sec.
23.161.
(b) The requirements set forth in Sec. Sec. 23.150 through 23.161
shall not apply to a swap if the counterparty:
(1) Qualifies for an exception from clearing under section
2(h)(7)(A) of the Act and implementing regulations;
(2) Qualifies for an exemption from clearing under a rule,
regulation, or order issued by the Commission pursuant to section
4(c)(1) of the Act concerning cooperative entities that would otherwise
be subject to the requirements of section 2(h)(1)(A) of the Act; or
(3) Satisfies the criteria in section 2(h)(7)(D) of the Act and
implementing regulations.
Sec. 23.151 Definitions applicable to margin requirements.
For the purposes of Sec. Sec. 23.150 through 23.161:
Bank holding company has the meaning specified in section 2 of the
Bank Holding Company Act of 1956 (12 U.S.C. 1841).
Broker has the meaning specified in section 3(a)(4) the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)).
Business day means any day other than a Saturday, Sunday, or legal
holiday.
Company means a corporation, partnership, limited liability
company, business trust, special purpose entity, association, or
similar organization.
Counterparty means the other party to a swap to which a covered
swap entity is a party.
Covered counterparty means a financial end user with material swaps
exposure or a swap entity that enters into a swap with a covered swap
entity.
Covered swap entity means a swap dealer or major swap participant
for which there is no prudential regulator.
Cross-currency swap means a swap in which one party exchanges with
another party principal and interest rate payments in one currency for
principal and interest rate payments in another currency, and the
exchange of principal occurs on the date the swap is entered into, with
a reversal of the exchange of principal at a later date that is agreed
upon when the swap is entered into.
Currency of Settlement means a currency in which a party has agreed
to discharge payment obligations related to an uncleared swap or a
group of uncleared swaps subject to a master netting agreement at the
regularly occurring dates on which such payments are due in the
ordinary course.
Day of execution means the calendar day at the time the parties
enter into an uncleared swap, provided:
(1) If each party is in a different calendar day at the time the
parties enter into the uncleared swap, the day of execution is deemed
the latter of the two dates; and
(2) If an uncleared swap is--
(i) Entered into after 4:00 p.m. in the location of a party; or
(ii) Entered into on a day that is not a business day in the
location of a party, then the uncleared swap is deemed to have been
entered into on the immediately succeeding day that is a business day
for both parties, and both parties shall determine the day of execution
with reference to that business day.
Data source means an entity and/or method from which or by which a
covered swap entity obtains prices for swaps or values for other inputs
used in a margin calculation.
Dealer has the meaning specified in section 3(a)(5) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(5)).
Depository institution has the meaning specified in section 3(c) of
the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).
Eligible collateral means collateral described in Sec. 23.156.
Eligible master netting agreement means a written, legally
enforceable agreement provided that:
(1) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default following any stay permitted by paragraph (2) of this
definition, including upon an event of receivership, conservatorship,
insolvency, liquidation, or similar proceeding, of the counterparty;
(2) The agreement provides the covered swap entity the right to
accelerate, terminate, and close-out on a net basis all transactions
under the agreement and to liquidate or set off collateral promptly
upon an event of default, including upon an event of receivership,
conservatorship, insolvency, liquidation, or similar proceeding, of the
counterparty, provided that, in any such case, any exercise of rights
under the agreement will not be stayed or avoided under applicable law
in the relevant jurisdictions, other than:
(i) In receivership, conservatorship, or resolution under the
Federal Deposit Insurance Act (12 U.S.C. 1811 et seq.), Title II of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5381 et seq.), the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992, as amended (12 U.S.C. 4617), or the Farm Credit
Act of 1971, as amended (12 U.S.C. 2183 and 2279cc), or laws of foreign
jurisdictions that are substantially similar to the U.S. laws
referenced in this paragraph (2)(i) in order to facilitate the orderly
resolution of the defaulting counterparty; or
(ii) Where the agreement is subject by its terms to, or
incorporates, any of the laws referenced in paragraph (2)(i) of this
definition;
[[Page 696]]
(3) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make a lower
payment than it otherwise would make under the agreement, or no payment
at all, to a defaulter or the estate of a defaulter, even if the
defaulter or the estate of the defaulter is a net creditor under the
agreement); and
(4) A covered swap entity that relies on the agreement for purposes
of calculating the margin required by this part must:
(i) Conduct sufficient legal review to conclude with a well-founded
basis (and maintain sufficient written documentation of that legal
review) that:
(A) The agreement meets the requirements of paragraph (2) of this
definition; and
(B) In the event of a legal challenge (including one resulting from
default or from receivership, conservatorship, insolvency, liquidation,
or similar proceeding) the relevant court and administrative
authorities would find the agreement to be legal, valid, binding, and
enforceable under the law of the relevant jurisdictions; and
(ii) Establish and maintain written procedures to monitor possible
changes in relevant law and to ensure that the agreement continues to
satisfy the requirements of this definition.
Financial end user means--
(1) A counterparty that is not a swap entity and that is:
(i) A bank holding company or a margin affiliate thereof; a savings
and loan holding company; a U.S. intermediate holding company
established or designated for purposes 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) and (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)) or any entity for which the Federal Housing
Finance Agency or its successor is the primary federal regulator;
(v) Any institution chartered in accordance with the Farm Credit
Act of 1971, as amended, 12 U.S.C. 2001 et seq. that is regulated by
the Farm Credit Administration;
(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 Securities and Exchange Commission under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.), a company
that has elected to be regulated as a business development company
pursuant to section 54(a) of the Investment Company Act of 1940 (15
U.S.C. 80a-53(a)), or a person that is registered with the U.S.
Securities and Exchange Commission as a security-based swap dealer or a
major security-based swap participant pursuant to the Securities
Exchange Act of 1934 (15 U.S.C. 78a et seq.).
(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 (Sec. 270.3a-7 of this title) of the Securities and Exchange
Commission;
(viii) A commodity pool, a commodity pool operator, a commodity
trading advisor, a floor broker, a floor trader, an introducing broker
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 investing or trading or facilitating the investing or trading in
loans, securities, swaps, funds, or other assets; or
(xii) An entity that would be a financial end user described in
paragraph (1) of this definition or a swap entity if it were organized
under the laws of the United States or any State thereof.
(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 Act and implementing
regulations;
(v) An affiliate that qualifies for the exemption from clearing
pursuant to section 2(h)(7)(D) of the Act; or
(vi) An eligible treasury affiliate that the Commission exempts
from the requirements of Sec. Sec. 23.150 through 23.161 by rule.
Foreign bank means an organization that is organized under the laws
of a foreign country and that engages directly in the business of
banking outside the United States.
Foreign exchange forward has the meaning specified in section
1a(24) of the Act.
Foreign exchange swap has the meaning specified in section 1a(25)
of the Act.
Initial margin means the collateral, as calculated in accordance
with Sec. 23.154 that is collected or posted in connection with one or
more uncleared swaps.
Initial margin model means an internal risk management model that:
(1) Has been developed and designed to identify an appropriate,
risk-based amount of initial margin that the covered swap entity must
collect with respect to one or more non-cleared swaps to which the
covered swap entity is a party; and
(2) Has been approved by the Commission or a registered futures
association pursuant to Sec. 23.154(b).
[[Page 697]]
Initial margin threshold amount means an aggregate credit exposure
of $50 million resulting from all uncleared swaps between a covered
swap entity and its margin affiliates on the one hand, and a covered
counterparty and its margin affiliates on the other. For purposes of
this calculation, an entity shall not count a swap that is exempt
pursuant to Sec. 23.150(b).
Major currencies means--
(1) United States Dollar (USD);
(2) Canadian Dollar (CAD);
(3) Euro (EUR);
(4) United Kingdom Pound (GBP);
(5) Japanese Yen (JPY);
(6) Swiss Franc (CHF);
(7) New Zealand Dollar (NZD);
(8) Australian Dollar (AUD);
(9) Swedish Kronor (SEK);
(10) Danish Kroner (DKK);
(11) Norwegian Krone (NOK); and
(12) Any other currency designated by the Commission.
Margin affiliate. A company is a margin affiliate of another
company if:
(1) Either company consolidates the other on a financial statement
prepared in accordance with U.S. Generally Accepted Accounting
Principles, the International Financial Reporting Standards, or other
similar standards,
(2) Both companies are consolidated with a third company on a
financial statement prepared in accordance with such principles or
standards, or
(3) For a company that is not subject to such principles or
standards, if consolidation as described in paragraph (1) or (2) of
this definition would have occurred if such principles or standards had
applied.
Market intermediary means--
(1) A securities holding company;
(2) A broker or dealer;
(3) A futures commission merchant;
(4) A swap dealer; or
(5) A security-based swap dealer.
Material swaps exposure for an entity means that the entity and its
margin affiliates have an average daily aggregate notional amount of
uncleared swaps, uncleared 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 $8 billion,
where such amount is calculated only for business days. An entity shall
count the average daily aggregate notional amount of an uncleared swap,
an uncleared security-based swap, a foreign exchange forward, or a
foreign exchange swap between the entity and a margin affiliate only
one time. For purposes of this calculation, an entity shall not count a
swap that is exempt pursuant to Sec. 23.150(b) or a security-based
swap that qualifies for an exemption under section 3C(g)(10) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c-3(g)(4)) and
implementing regulations or that satisfies the criteria in section
3C(g)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78-c3(g)(4))
and implementing regulations.
Minimum transfer amount means a combined initial and variation
margin amount under which no actual transfer of funds is required. The
minimum transfer amount shall be $500,000.
Multilateral development bank means:
(1) The International Bank for Reconstruction and Development;
(2) The Multilateral Investment Guarantee Agency;
(3) The International Finance Corporation;
(4) The Inter-American Development Bank;
(5) The Asian Development Bank;
(6) The African Development Bank;
(7) The European Bank for Reconstruction and Development;
(8) The European Investment Bank;
(9) The European Investment Fund;
(10) The Nordic Investment Bank;
(11) The Caribbean Development Bank;
(12) The Islamic Development Bank;
(13) The Council of Europe Development Bank; and
(14) Any other entity that provides financing for national or
regional development in which the U.S. government is a shareholder or
contributing member or which the Commission determines poses comparable
credit risk.
Non-financial end user means a counterparty that is not a swap
dealer, a major swap participant, or a financial end user.
Prudential regulator has the meaning specified in section 1a(39) of
the Act.
Savings and loan holding company has the meaning specified in
section 10(n) of the Home Owners' Loan Act (12 U.S.C. 1467a(n)).
Securities holding company has the meaning specified in section 618
of the Dodd-Frank Wall Street Reform and Consumer Protection Act (12
U.S.C. 1850a).
Security-based swap has the meaning specified in section 3(a)(68)
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(68)).
Sovereign entity means a central government (including the U.S.
government) or an agency, department, ministry, or central bank of a
central government.
State means any State, commonwealth, territory, or possession of
the United States, the District of Columbia, the Commonwealth of Puerto
Rico, the Commonwealth of the Northern Mariana Islands, American Samoa,
Guam, or the United States Virgin Islands.
Swap entity means a person that is registered with the Commission
as a swap dealer or major swap participant pursuant to the Act.
Uncleared security-based swap means a security-based swap that is
not, directly or indirectly, submitted to and cleared by a clearing
agency registered with the Securities and Exchange Commission pursuant
to section 17A of the Securities Exchange Act of 1934 (15 U.S.C. 78a-1)
or by a clearing agency that the U.S. Securities and Exchange
Commission has exempted from registration by rule or order pursuant to
section 17A of the Securities Exchange Act of 1934 (15 U.S.C. 78a-1).
Uncleared swap means a swap that is not cleared by a registered
derivatives clearing organization, or by a clearing organization that
the Commission has exempted from registration by rule or order pursuant
to section 5b(h) of the Act.
U.S. Government-sponsored enterprise means an entity established or
chartered by the U.S. government to serve public purposes specified by
federal statute but whose debt obligations are not explicitly
guaranteed by the full faith and credit of the U.S. government.
Variation margin means collateral provided by a party to its
counterparty to meet the performance of its obligation under one or
more uncleared swaps between the parties as a result of a change in
value of such obligations since the trade was executed or the last time
such collateral was provided.
Variation margin amount means the cumulative mark-to-market change
in value to a covered swap entity of an uncleared swap, as measured
from the date it is entered into (or in the case of an uncleared swap
that has a positive or negative value to a covered swap entity on the
date it is entered into, such positive or negative value plus any
cumulative mark-to-market change in value to the covered swap entity of
an uncleared swap after such date), less the value of all variation
margin previously collected, plus the value of all variation margin
previously posted with respect to such uncleared swap.
Sec. 23.152 Collection and posting of initial margin.
(a) Collection--(1) Initial obligation. On or before the business
day after execution of an uncleared swap between a covered swap entity
and a covered counterparty, the covered swap entity shall collect
initial margin from the
[[Page 698]]
covered counterparty in an amount equal to or greater than an amount
calculated pursuant to Sec. 23.154, in a form that complies with Sec.
23.156, and pursuant to custodial arrangements that comply with Sec.
23.157.
(2) Continuing obligation. The covered swap entity shall continue
to hold initial margin from the covered counterparty in an amount equal
to or greater than an amount calculated each business day pursuant to
Sec. 23.154, in a form that complies with Sec. 23.156, and pursuant
to custodial arrangements that comply with Sec. 23.157, until such
uncleared swap is terminated or expires.
(b) Posting--(1) Initial obligation. On or before the business day
after execution of an uncleared swap between a covered swap entity and
a financial end user with material swaps exposure, the covered swap
entity shall post initial margin with the counterparty in an amount
equal to or greater than an amount calculated pursuant to Sec. 23.154,
in a form that complies with Sec. 23.156, and pursuant to custodial
arrangements that comply with Sec. 23.157.
(2) Continuing obligation. The covered swap entity shall continue
to post initial margin with the counterparty in an amount equal to or
greater than an amount calculated each business day pursuant to Sec.
23.154, in a form that complies with Sec. 23.156, and pursuant to
custodial arrangements that comply with Sec. 23.157, until such
uncleared swap is terminated or expires.
(3) Minimum transfer amount. A covered swap entity is not required
to collect or to post initial margin pursuant to Sec. Sec. 23.150
through 23.161 with respect to a particular counterparty unless and
until the combined amount of initial margin and variation margin that
is required pursuant to Sec. Sec. 23.150 through 23.161 to be
collected or posted and that has not been collected or posted with
respect to the counterparty is greater than $500,000.
(c) Netting. (1) To the extent that one or more uncleared swaps are
executed pursuant to an eligible master netting agreement between a
covered swap entity and covered counterparty, a covered swap entity may
calculate and comply with the applicable initial margin requirements of
Sec. Sec. 23.150 through 23.161 on an aggregate net basis with respect
to all uncleared swaps governed by such agreement, subject to paragraph
(c)(2) of this section.
(2)(i) Except as permitted in paragraph (c)(2)(ii) of this section,
if an eligible master netting agreement covers uncleared swaps entered
into on or after the applicable compliance date set forth in Sec.
23.161, all the uncleared swaps covered by that agreement are subject
to the requirements of Sec. Sec. 23.150 through 23.161 and included in
the aggregate netting portfolio for the purposes of calculating and
complying with the margin requirements of Sec. Sec. 23.150 through
23.161.
(ii) An eligible master netting agreement may identify one or more
separate netting portfolios that independently meet the requirements in
paragraph (1) of the definition of ``eligible master netting
agreement'' in Sec. 23.151 and to which collection and posting of
margin applies on an aggregate net basis separate from and exclusive of
any other uncleared swaps covered by the eligible master netting
agreement. Any such netting portfolio that contains any uncleared swap
entered into on or after the applicable compliance date set forth in
Sec. 23.161 is subject to the requirements of Sec. Sec. 23.150
through 23.161. Any such netting portfolio that contains only uncleared
swaps entered into before the applicable compliance date is not subject
to the requirements of Sec. Sec. 23.150 through 23.161.
(d) Satisfaction of collection and posting requirements. A covered
swap entity shall not be deemed to have violated its obligation to
collect or to post initial margin from a covered counterparty if:
(1) The covered counterparty has refused or otherwise failed to
provide, or to accept, the required initial margin to, or from, the
covered swap entity; and
(2) The covered swap entity has:
(i) Made the necessary efforts to collect or to post the required
initial margin, including the timely initiation and continued pursuit
of formal dispute resolution mechanisms, including pursuant to Sec.
23.504(b)(4), if applicable, or has otherwise demonstrated upon request
to the satisfaction of the Commission that it has made appropriate
efforts to collect or to post the required initial margin; or
(ii) Commenced termination of the uncleared swap with the covered
counterparty promptly following the applicable cure period and
notification requirements.
Sec. 23.153 Collection and posting of variation margin.
(a) Initial obligation. On or before the business day after the day
of execution of an uncleared swap between a covered swap entity and a
counterparty that is a swap entity or a financial end user, the covered
swap entity shall collect the variation margin amount from the
counterparty when the amount is positive, or post the variation margin
amount with the counterparty when the amount is negative as calculated
pursuant to Sec. 23.155 and in a form that complies with Sec. 23.156.
(b) Continuing obligation. The covered swap entity shall continue
to collect the variation margin amount from, or to post the variation
margin amount with, the counterparty as calculated each business day
pursuant to Sec. 23.155 and in a form that complies with Sec. 23.156
each business day until such uncleared swap is terminated or expires.
(c) Minimum transfer amount. A covered swap entity is not required
to collect or to post variation margin pursuant to Sec. Sec. 23.150
through 23.161 with respect to a particular counterparty unless and
until the combined amount of initial margin and variation margin that
is required pursuant to Sec. Sec. 23.150 through 23.161 to be
collected or posted and that has not been collected or posted with
respect to the counterparty is greater than $500,000.
(d) Netting. (1) To the extent that more than one uncleared swap is
executed pursuant to an eligible master netting agreement between a
covered swap entity and a counterparty, a covered swap entity may
calculate and comply with the applicable variation margin requirements
of this section on an aggregate basis with respect to all uncleared
swaps governed by such agreement subject to paragraph (d)(2) of this
section.
(2)(i) Except as permitted in paragraph (d)(2)(ii) of this section,
if an eligible master netting agreement covers uncleared swaps entered
into on or after the applicable compliance date set forth in Sec.
23.161, all the uncleared swaps covered by that agreement are subject
to the requirements of Sec. Sec. 23.150 through 23.161 and included in
the aggregate netting portfolio for the purposes of calculating and
complying with the margin requirements of Sec. Sec. 23.150 through
23.161.
(ii) An eligible master netting agreement may identify one or more
separate netting portfolios that independently meet the requirements in
paragraph (1) of the definition of ``eligible master netting
agreement'' in Sec. 23.151 and to which collection and posting of
margin applies on an aggregate net basis separate from and exclusive of
any other uncleared swaps covered by the eligible master netting
agreement. Any such netting portfolio that contains any uncleared swap
entered into on or after the applicable compliance date set forth in
Sec. 23.161 is subject to the requirements of Sec. Sec. 23.150
through 23.161. Any such netting portfolio that contains only uncleared
swaps entered into before the applicable compliance date is not subject
to the
[[Page 699]]
requirements of Sec. Sec. 23.150 through 23.161.
(e) Satisfaction of collection and payment requirements. A covered
swap entity shall not be deemed to have violated its obligation to
collect or to pay variation margin from a counterparty if:
(1) The counterparty has refused or otherwise failed to provide or
to accept the required variation margin to or from the covered swap
entity; and
(2) The covered swap entity has:
(i) Made the necessary efforts to collect or to post the required
variation margin, including the timely initiation and continued pursuit
of formal dispute resolution mechanisms, including pursuant to Sec.
23.504(b)(4), if applicable, or has otherwise demonstrated upon request
to the satisfaction of the Commission that it has made appropriate
efforts to collect or to post the required variation margin; or
(ii) Commenced termination of the uncleared swap with the
counterparty promptly following the applicable cure period and
notification requirements.
Sec. 23.154 Calculation of initial margin.
(a) Means of calculation. (1) Each business day each covered swap
entity shall calculate an initial margin amount to be collected from
each covered counterparty using:
(i) A risk-based model that meets the requirements of paragraph (b)
of this section; or
(ii) The table-based method set forth in paragraph (c) of this
section.
(2) Each business day each covered swap entity shall calculate an
initial margin amount to be posted with each financial end user with
material swaps exposure using:
(i) A risk-based model that meets the requirements of paragraph (b)
of this section; or
(ii) The table-based method set forth in paragraph (c) of this
section.
(3) Each covered swap entity may reduce the amounts calculated
pursuant to paragraphs (a)(1) and (2) of this section by the initial
margin threshold amount provided that the reduction does not include
any portion of the initial margin threshold amount already applied by
the covered swap entity or its margin affiliates in connection with
other uncleared swaps with the counterparty or its margin affiliates.
(4) The amounts calculated pursuant to paragraph (a)(3) of this
section shall not be less than zero.
(b) Risk-based models--(1) Commission or registered futures
association approval. (i) A covered swap entity shall obtain the
written approval of the Commission or a registered futures association
to use a model to calculate the initial margin required in Sec. Sec.
23.150 through 23.161.
(ii) A covered swap entity shall demonstrate that the model
satisfies all of the requirements of this section on an ongoing basis.
(iii) A covered swap entity shall notify the Commission and the
registered futures association in writing 60 days prior to:
(A) Extending the use of an initial margin model that has been
approved to an additional product type;
(B) Making any change to any initial margin model that has been
approved that would result in a material change in the covered swap
entity's assessment of initial margin requirements; or
(C) Making any material change to modeling assumptions used by the
initial margin model.
(iv) The Commission or the registered futures association may
rescind approval of the use of any initial margin model, in whole or in
part, or may impose additional conditions or requirements if the
Commission or the registered futures association determines, in its
discretion, that the model no longer complies with this section.
(2) Elements of the model. (i) The initial margin model shall
calculate an amount of initial margin that is equal to the potential
future exposure of the uncleared swap or netting portfolio of uncleared
swaps covered by an eligible master netting agreement. Potential future
exposure is an estimate of the one-tailed 99 percent confidence
interval for an increase in the value of the uncleared swap or netting
portfolio of uncleared swaps due to an instantaneous price shock that
is equivalent to a movement in all material underlying risk factors,
including prices, rates, and spreads, over a holding period equal to
the shorter of ten business days or the maturity of the swap or netting
portfolio.
(ii) All data used to calibrate the initial margin model shall be
based on an equally weighted historical observation period of at least
one year and not more than five years and must incorporate a period of
significant financial stress for each broad asset class that is
appropriate to the uncleared swaps to which the initial margin model is
applied.
(iii) The initial margin model shall use risk factors sufficient to
measure all material price risks inherent in the transactions for which
initial margin is being calculated. The risk categories shall include,
but should not be limited to, foreign exchange or interest rate risk,
credit risk, equity risk, and commodity risk, as appropriate. For
material exposures in significant currencies and markets, modeling
techniques shall capture spread and basis risk and shall incorporate a
sufficient number of segments of the yield curve to capture differences
in volatility and imperfect correlation of rates along the yield curve.
(iv) In the case of an uncleared cross-currency swap, the initial
margin model need not recognize any risks or risk factors associated
with the fixed, physically-settled foreign exchange transactions
associated with the exchange of principal embedded in the uncleared
cross-currency swap. The initial margin model must recognize all
material risks and risk factors associated with all other payments and
cash flows that occur during the life of the uncleared cross-currency
swap.
(v) The initial margin model may calculate initial margin for an
uncleared swap or netting portfolio of uncleared swaps covered by an
eligible master netting agreement. It may reflect offsetting exposures,
diversification, and other hedging benefits for uncleared swaps that
are governed by the same eligible master netting agreement by
incorporating empirical correlations within the following broad risk
categories, provided the covered swap entity validates and demonstrates
the reasonableness of its process for modeling and measuring hedging
benefits: Commodity, credit, equity, and foreign exchange or interest
rate. Empirical correlations under an eligible master netting agreement
may be recognized by the model within each broad risk category, but not
across broad risk categories.
(vi) If the initial margin model does not explicitly reflect
offsetting exposures, diversification, and hedging benefits between
subsets of uncleared swaps within a broad risk category, the covered
swap entity shall calculate an amount of initial margin separately for
each subset of uncleared swaps for which such relationships are
explicitly recognized by the model. The sum of the initial margin
amounts calculated for each subset of uncleared swaps within a broad
risk category will be used to determine the aggregate initial margin
due from the counterparty for the portfolio of uncleared swaps within
the broad risk category.
(vii) The sum of the initial margin calculated for each broad risk
category shall be used to determine the aggregate initial margin due
from the counterparty.
(viii) The initial margin model shall not permit the calculation of
any initial margin to be offset by, or otherwise take
[[Page 700]]
into account, any initial margin that may be owed or otherwise payable
by the covered swap entity to the counterparty.
(ix) The initial margin model shall include all material risks
arising from the nonlinear price characteristics of option positions or
positions with embedded optionality and the sensitivity of the market
value of the positions to changes in the volatility of the underlying
rates, prices, or other material risk factors.
(x) The covered swap entity shall not omit any risk factor from the
calculation of its initial margin that the covered swap entity uses in
its model unless it has first demonstrated to the satisfaction of the
Commission or the registered futures association that such omission is
appropriate.
(xi) The covered swap entity shall not incorporate any proxy or
approximation used to capture the risks of the covered swap entity's
uncleared swaps unless it has first demonstrated to the satisfaction of
the Commission or the registered futures association that such proxy or
approximation is appropriate.
(xii) The covered swap entity shall have a rigorous and well-
defined process for re-estimating, re-evaluating, and updating its
internal margin models to ensure continued applicability and relevance.
(xiii) The covered swap entity shall review and, as necessary,
revise the data used to calibrate the initial margin model at least
annually, and more frequently as market conditions warrant, to ensure
that the data incorporate a period of significant financial stress
appropriate to the uncleared swaps to which the initial margin model is
applied.
(xiv) The level of sophistication of the initial margin model shall
be commensurate with the complexity of the swaps to which it is
applied. In calculating an initial margin amount, the initial margin
model may make use of any of the generally accepted approaches for
modeling the risk of a single instrument or portfolio of instruments.
(xv) The Commission or the registered futures association may in
its discretion require a covered swap entity using an initial margin
model to collect a greater amount of initial margin than that
determined by the covered swap entity's initial margin model if the
Commission or the registered futures association determines that the
additional collateral is appropriate due to the nature, structure, or
characteristics of the covered swap entity's transaction(s) or is
commensurate with the risks associated with the transaction(s).
(3) [Reserved]
(4) Periodic review. A covered swap entity shall periodically, but
no less frequently than annually, review its initial margin model in
light of developments in financial markets and modeling technologies,
and enhance the initial margin model as appropriate to ensure that it
continues to meet the requirements for approval in this section.
(5) Control, oversight, and validation mechanisms. (i) The covered
swap entity shall maintain a risk management unit in accordance with
Sec. 23.600(c)(4)(i) that is independent from the business trading
unit (as defined in Sec. 23.600).
(ii) The covered swap entity's risk control unit shall validate its
initial margin model prior to implementation and on an ongoing basis.
The covered swap entity's validation process shall be independent of
the development, implementation, and operation of the initial margin
model, or the validation process shall be subject to an independent
review of its adequacy and effectiveness. The validation process shall
include:
(A) An evaluation of the conceptual soundness of (including
developmental evidence supporting) the initial margin model;
(B) An ongoing monitoring process that includes verification of
processes and benchmarking by comparing the covered swap entity's
initial margin model outputs (estimation of initial margin) with
relevant alternative internal and external data sources or estimation
techniques. The benchmark(s) must address the model's limitations. When
applicable the covered swap entity should consider benchmarks that
allow for non-normal distributions such as historical and Monte Carlo
simulations. When applicable validation shall include benchmarking
against observable margin standards to ensure that the initial margin
required is not less than what a derivatives clearing organization
would require for similar cleared transactions; and
(C) An outcomes analysis process that includes back testing the
model. This analysis shall recognize and compensate for the challenges
inherent in back testing over periods that do not contain significant
financial stress.
(iii) If the validation process reveals any material problems with
the model, the covered swap entity must promptly notify the Commission
and the registered futures association of the problems, describe to the
Commission and the registered futures association any remedial actions
being taken, and adjust the model to ensure an appropriately
conservative amount of required initial margin is being calculated.
(iv) In accordance with Sec. 23.600(e)(2), the covered swap entity
shall have an internal audit function independent of the business
trading unit and the risk management unit that at least annually
assesses the effectiveness of the controls supporting the initial
margin model measurement systems, including the activities of the
business trading units and risk control unit, compliance with policies
and procedures, and calculation of the covered swap entity's initial
margin requirements under this part. At least annually, the internal
audit function shall report its findings to the covered swap entity's
governing body, senior management, and chief compliance officer.
(6) Documentation. The covered swap entity shall adequately
document all material aspects of its model, including management and
valuation of uncleared swaps to which it applies, the control,
oversight, and validation of the initial margin model, any review
processes and the results of such processes.
(7) Escalation procedures. The covered swap entity must adequately
document--
(i) Internal authorization procedures, including escalation
procedures, that require review and approval of any change to the
initial margin calculation under the initial margin model;
(ii) Demonstrable analysis that any basis for any such change is
consistent with the requirements of this section; and
(iii) Independent review of such demonstrable analysis and
approval.
(c) Table-based method. If a model meeting the standards set forth
in paragraph (b) of this section is not used, initial margin shall be
calculated in accordance with this paragraph.
(1) Standardized initial margin schedule.
------------------------------------------------------------------------
Gross initial
margin (% of
Asset class notional
exposure)
------------------------------------------------------------------------
Credit: 0-2 year duration............................... 2
Credit: 2-5 year duration............................... 5
Credit: 5+ year duration................................ 10
Commodity............................................... 15
Equity.................................................. 15
Foreign Exchange/Currency............................... 6
Cross Currency Swaps: 0-2 year duration................. 1
Cross Currency Swaps: 2-5 year duration................. 2
Cross Currency Swaps: 5+ year duration.................. 4
Interest Rate: 0-2 year duration........................ 1
[[Page 701]]
Interest Rate: 2-5 year duration........................ 2
Interest Rate: 5+ year duration......................... 4
Other................................................... 15
------------------------------------------------------------------------
(2) Net to gross ratio adjustment. (i) For multiple uncleared swaps
subject to an eligible master netting agreement, the initial margin
amount under the standardized table shall be computed according to this
paragraph.
(ii) Initial Margin = 0.4 x Gross Initial Margin + 0.6 x Net-to-
Gross Ratio x Gross Initial Margin, where:
(A) Gross Initial Margin = the sum of the product of each uncleared
swap's effective notional amount and the gross initial margin
requirement for all uncleared swaps subject to the eligible master
netting agreement;
(B) Net-to-Gross Ratio = the ratio of the net current replacement
cost to the gross current replacement cost;
(C) Gross Current Replacement cost = the sum of the replacement
cost for each uncleared swap subject to the eligible master netting
agreement for which the cost is positive; and
(D) Net Current Replacement Cost = the total replacement cost for
all uncleared swaps subject to the eligible master netting agreement.
(E) In cases where the gross replacement cost is zero, the Net-to-
Gross Ratio shall be set to 1.0.
Sec. 23.155 Calculation of variation margin.
(a) Means of calculation. (1) Each business day each covered swap
entity shall calculate variation margin for itself and for each
counterparty that is a swap entity or a financial end user using
methods, procedures, rules, and inputs that to the maximum extent
practicable rely on recently-executed transactions, valuations provided
by independent third parties, or other objective criteria.
(2) Each covered swap entity shall have in place alternative
methods for determining the value of an uncleared swap in the event of
the unavailability or other failure of any input required to value a
swap.
(b) Control mechanisms. (1) Each covered swap entity shall create
and maintain documentation setting forth the variation methodology with
sufficient specificity to allow the counterparty, the Commission, the
registered futures association, and any applicable prudential regulator
to calculate a reasonable approximation of the margin requirement
independently.
(2) Each covered swap entity shall evaluate the reliability of its
data sources at least annually, and make adjustments, as appropriate.
(3) The Commission or the registered futures association at any
time may require a covered swap entity to provide further data or
analysis concerning the methodology or a data source, including:
(i) An explanation of the manner in which the methodology meets the
requirements of this section;
(ii) A description of the mechanics of the methodology;
(iii) The conceptual basis of the methodology;
(iv) The empirical support for the methodology; and
(v) The empirical support for the assessment of the data sources.
Sec. 23.156 Forms of margin.
(a) Initial margin--(1) Eligible collateral. A covered swap entity
shall collect and post as initial margin for trades with a covered
counterparty only the following types of collateral:
(i) Immediately available cash funds denominated in:
(A) U.S. dollars;
(B) A major currency;
(C) A currency of settlement for the uncleared swap;
(ii) A security that is issued by, or unconditionally guaranteed as
to the timely payment of principal and interest by, the U.S. Department
of Treasury;
(iii) A security that is issued by, or unconditionally guaranteed
as to the timely payment of principal and interest by, a U.S.
government agency (other than the U.S. Department of Treasury) whose
obligations are fully guaranteed by the full faith and credit of the
U.S. government;
(iv) A security that is issued by, or fully guaranteed as to the
payment of principal and interest by, the European Central Bank or a
sovereign entity that is assigned no higher than a 20 percent risk
weight under the capital rules applicable to swap dealers subject to
regulation by a prudential regulator;
(v) A publicly traded debt security issued by, or an asset-backed
security fully guaranteed as to the timely payment of principal and
interest by, a U.S. Government-sponsored enterprise that is operating
with capital support or another form of direct financial assistance
received from the U.S. government that enables the repayments of the
U.S. Government-sponsored enterprise's eligible securities;
(vi) A security that is issued by, or fully guaranteed as to the
payment of principal and interest by, the Bank for International
Settlements, the International Monetary Fund, or a multilateral
development bank;
(vii) Other publicly-traded debt that has been deemed acceptable as
initial margin by a prudential regulator;
(viii) A publicly traded common equity security that is included
in:
(A) The Standard & Poor's Composite 1500 Index or any other similar
index of liquid and readily marketable equity securities as determined
by the Commission; or
(B) An index that a covered swap entity's supervisor in a foreign
jurisdiction recognizes for purposes of including publicly traded
common equity as initial margin under applicable regulatory policy, if
held in that foreign jurisdiction;
(ix) Securities in the form of redeemable securities in a pooled
investment fund representing the security-holder's proportional
interest in the fund's net assets and that are issued and redeemed only
on the basis of the market value of the fund's net assets prepared each
business day after the security-holder makes its investment commitment
or redemption request to the fund, if the fund's investments are
limited to the following:
(A) Securities that are issued by, or unconditionally guaranteed as
to the timely payment of principal and interest by, the U.S. Department
of the Treasury, and immediately-available cash funds denominated in
U.S. dollars; or
(B) Securities denominated in a common currency and issued by, or
fully guaranteed as to the payment of principal and interest by, the
European Central Bank or a sovereign entity that is assigned no higher
than a 20 percent risk weight under the capital rules applicable to
swap dealers subject to regulation by a prudential regulator, and
immediately-available cash funds denominated in the same currency; and
(C) Assets of the fund may not be transferred through securities
lending, securities borrowing, repurchase agreements, reverse
repurchase agreements, or other means that involve the fund having
rights to acquire the same or similar assets from the transferee, or
(x) Gold.
(2) Prohibition of certain assets. A covered swap entity may not
collect or post as initial margin any asset that is a security issued
by:
(i) The covered swap entity or a margin affiliate of the covered
swap entity (in the case of posting) or the counterparty or any margin
affiliate of the counterparty (in the case of collection);
(ii) A bank holding company, a savings and loan holding company, a
[[Page 702]]
U.S. intermediate holding company established or designated for
purposes of compliance with 12 CFR 252.153, a foreign bank, a
depository institution, a market intermediary, a company that would be
any of the foregoing if it were organized under the laws of the United
States or any State, or a margin affiliate of any of the foregoing
institutions, or
(iii) 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).
(3) Haircuts. (i) The value of any eligible collateral collected or
posted to satisfy initial margin requirements shall be subject to the
sum of the following discounts, as applicable:
(A) An 8 percent discount for initial margin collateral denominated
in a currency that is not the currency of settlement for the uncleared
swap, except for eligible types of collateral denominated in a single
termination currency designated as payable to the non-posting
counterparty as part of the eligible master netting agreement; and
(B) The discounts set forth in the following table:
Standardized Haircut Schedule
------------------------------------------------------------------------
------------------------------------------------------------------------
Cash in same currency as swap obligation....................... 0.0
Eligible government and related debt (e.g., central bank, 0.5
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity less
than one-year.................................................
Eligible government and related debt (e.g., central bank, 2.0
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity
between one and five years....................................
Eligible government and related debt (e.g., central bank, 4.0
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity
greater than five years.......................................
Eligible corporate debt (including eligible GSE debt securities 1.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity less than one-year..........................
Eligible corporate debt (including eligible GSE debt securities 4.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity between one and five years..................
Eligible corporate debt (including eligible GSE debt securities 8.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity greater than five years.....................
Equities included in S&P 500 or related index.................. 15.0
Equities included in S&P 1500 Composite or related index but 25.0
not S&P 500 or related index..................................
Gold........................................................... 15.0
Additional (additive) haircut on asset in which the currency of 8.0
the swap obligation differs from that of the collateral asset.
------------------------------------------------------------------------
(ii) The value of initial margin collateral shall be computed as
the product of the cash or market value of the eligible collateral
asset times one minus the applicable haircut expressed in percentage
terms. The total value of all initial margin collateral is calculated
as the sum of those values for each eligible collateral asset.
(b) Variation margin--(1) Eligible collateral--(i) Swaps with a
swap entity. (A) A covered swap entity shall post and collect as
variation margin to or from a counterparty that is a swap entity only
immediately available cash funds that are denominated in: U.S. dollars;
(B) Another major currency; or
(C) The currency of settlement of the uncleared swap.
(ii) Swaps with a financial end user. A covered swap entity may
post and collect as variation margin to or from a counterparty that is
a financial end user any asset that is eligible to be posted or
collected as initial margin under paragraphs (a)(1) and (2) of this
section.
(2) Haircuts. (i) The value of any eligible collateral collected or
posted to satisfy variation margin requirements shall be subject to the
sum of the following discounts, as applicable:
(A) An 8% discount for variation margin collateral denominated in a
currency that is not the currency of settlement for the uncleared swap
except for immediately available cash funds denominated in U.S. cash
funds or another major currency; and
(B) The discounts for initial margin set forth in the table in
paragraph (a)(3)(i)(B) of this section.
(ii) The value of variation margin collateral shall be computed as
the product of the cash or market value of the eligible collateral
asset times one minus the applicable haircut expressed in percentage
terms. The total value of all variation margin collateral shall be
calculated as the sum of those values of each eligible collateral
asset.
(c) Monitoring obligation. A covered swap entity shall monitor the
market value and eligibility of all collateral collected and posted to
satisfy the margin requirements of Sec. Sec. 23.150 through 23.161. To
the extent that the market value of such collateral has declined, the
covered swap entity shall promptly collect or post such additional
eligible collateral as is necessary to maintain compliance with the
margin requirements of Sec. Sec. 23.150 through 23.161. To the extent
that the collateral is no longer eligible, the covered swap entity
shall promptly collect or post sufficient eligible replacement
collateral to comply with the margin requirements of Sec. Sec. 23.150
through 23.161.
(d) Excess margin. A covered swap entity may collect or post
initial margin or variation margin that is not required pursuant to
Sec. Sec. 23.150 through 23.161 in any form of collateral.
Sec. 23.157 Custodial arrangements.
(a) Initial margin posted by covered swap entities. Each covered
swap entity that posts initial margin with respect to an uncleared swap
shall require that all funds or other property that the covered swap
entity provides as initial margin be held by one or more custodians
that are not the covered swap entity, the counterparty, or margin
affiliates of the covered swap entity or the counterparty.
(b) Initial margin collected by covered swap entities. Each covered
swap entity that collects initial margin required by Sec. 23.152 with
respect to an uncleared swap shall require that such initial margin be
held by one or more custodians that are not the covered swap entity,
the counterparty, or margin affiliates of the covered swap entity or
the counterparty.
(c) Custodial agreement. Each covered swap entity shall enter into
an agreement with each custodian that holds funds pursuant to
paragraphs (a) or (b) of this section that:
(1) Prohibits the custodian from rehypothecating, repledging,
reusing, or otherwise transferring (through securities lending,
securities borrowing, repurchase agreement, reverse repurchase
agreement or other means) the collateral held by the custodian except
that cash collateral may be held in a general deposit account with the
custodian if the funds in the account are used to purchase an asset
described in
[[Page 703]]
Sec. 23.156(a)(1)(iv) through (xii), such asset is held in compliance
with this section, and such purchase takes place within a time period
reasonably necessary to consummate such purchase after the cash
collateral is posted as initial margin; and
(2) Is a legal, valid, binding, and enforceable agreement under the
laws of all relevant jurisdictions including in the event of
bankruptcy, insolvency, or a similar proceeding.
(3) Notwithstanding paragraph (c)(1) of this section, a custody
agreement may permit the posting party to substitute or direct any
reinvestment of posted collateral held by the custodian, provided that,
with respect to collateral posted or collected pursuant to Sec.
23.152, the agreement requires the posting party, when it substitutes
or directs the reinvestment of posted collateral held by the custodian.
(i) To substitute only funds or other property that would qualify
as eligible collateral under Sec. 23.156, and for which the amount net
of applicable discounts described in Sec. 23.156 would be sufficient
to meet the requirements of Sec. 23.152; and
(ii) To direct reinvestment of funds only in assets that would
qualify as eligible collateral under Sec. 23.156, and for which the
amount net of applicable discounts described in Sec. 23.156 would be
sufficient to meet the requirements of Sec. 23.152.
Sec. 23.158 Margin documentation.
(a) General requirement. Each covered swap entity shall execute
documentation with each counterparty that complies with the
requirements of Sec. 23.504 and that complies with this section, as
applicable. For uncleared swaps between a covered swap entity and a
counterparty that is a swap entity or a financial end user, the
documentation shall provide the covered swap entity with the
contractual right and obligation to exchange initial margin and
variation margin in such amounts, in such form, and under such
circumstances as are required by Sec. Sec. 23.150 through 23.161.
(b) Contents of the documentation. The margin documentation shall:
(1) Specify the methods, procedures, rules, inputs, and data
sources to be used for determining the value of uncleared swaps for
purposes of calculating variation margin;
(2) Describe the methods, procedures, rules, inputs, and data
sources to be used to calculate initial margin for uncleared swaps
entered into between the covered swap entity and the counterparty; and
(3) Specify the procedures by which any disputes concerning the
valuation of uncleared swaps, or the valuation of assets collected or
posted as initial margin or variation margin may be resolved.
Sec. 23.159 Special rules for affiliates.
(a) Initial margin. (1) Except as provided in paragraph (c) of this
section, a covered swap entity shall not be required to collect initial
margin from a margin affiliate provided that the covered swap entity
meets the following conditions:
(i) The swaps are subject to a centralized risk management program
that is reasonably designed to monitor and to manage the risks
associated with the inter-affiliate swaps; and
(ii) The covered swap entity exchanges variation margin with the
margin affiliate in accordance with paragraph (b) of this section.
(2)(i) A covered swap entity shall post initial margin to any
margin affiliate that is a swap entity subject to the rules of a
Prudential Regulator in an amount equal to the amount that the swap
entity is required to collect from the covered swap entity pursuant to
the rules of the Prudential Regulator.
(ii) A covered swap entity shall not be required to post initial
margin to any other margin affiliate pursuant to Sec. Sec. 23.150
through 23.161.
(b) Variation margin. Each covered swap entity shall post and
collect variation margin with each margin affiliate that is a swap
entity or a financial end user in accordance with all applicable
provisions of Sec. Sec. 23.150 through 23.161.
(c) Foreign margin affiliates. (1) For purposes of this section,
the term outward facing margin affiliate means a margin affiliate that
enters into swaps with third parties.
(2) Except as provided in paragraph (c)(3) of this section, each
covered swap entity shall collect initial margin in accordance with all
applicable provisions of Sec. Sec. 23.150 through 23.161 from each
margin affiliate that meets the following criteria:
(i) The margin affiliate is a financial end user;
(ii) The margin affiliate enters into swaps with third parties, or
enters into swaps with any other margin affiliate that, directly or
indirectly (including through a series of transactions), enters into
swaps with third parties, for which the provisions of Sec. Sec. 23.150
through 23.161 would apply if any such margin affiliate were a swap
entity; and
(iii) Any such outward facing margin affiliate is located in a
jurisdiction that the Commission has not found to be eligible for
substituted compliance with regard to the provisions of Sec. Sec.
23.150 through 23.161 and does not collect initial margin for such
swaps in a manner that would comply with the provisions of Sec. Sec.
23.150 through 23.161.
(3) The custodian for initial margin collected pursuant to
paragraph (c)(1) of this section may be the covered swap entity or a
margin affiliate of the covered swap entity.
Sec. 23.160 [Reserved]
Sec. 23.161 Compliance dates.
(a) Covered swap entities shall comply with the minimum margin
requirements for uncleared swaps on or before the following dates for
uncleared swaps entered into on or after the following dates:
(1) September 1, 2016 for the requirements in Sec. 23.152 for
initial margin and in Sec. 23.153 for variation margin for any
uncleared swaps where both--
(i) The covered swap entity combined with all its margin
affiliates; and
(ii) Its counterparty combined with all its margin affiliates, have
an average daily aggregate notional amount of uncleared swaps,
uncleared security-based swaps, foreign exchange forwards, and foreign
exchange swaps in March, April, and May 2016 that exceeds $3 trillion,
where such amounts are calculated only for business days; and where
(iii) In calculating the amounts in paragraphs (a)(1)(i) and (ii)
of this section, an entity shall count the average daily notional
amount of an uncleared swap, an uncleared security-based swap, a
foreign-exchange forward, or a foreign exchange swap between an entity
or a margin affiliate only one time and shall not count a swap or a
security-based swap that is exempt pursuant to Sec. 23.150(b) or a
security-based swap that is exempt pursuant to section 15F(e) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-10(e)).
(2) March 1, 2017 for the requirements in Sec. 23.153 for
variation margin for any other covered swap entity for uncleared swaps
entered into with any other counterparty.
(3) September 1, 2017 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both--
(i) The covered swap entity combined with all its margin
affiliates; and
(ii) Its counterparty combined with all its margin affiliates, have
an average daily aggregate notional amount of uncleared swaps,
uncleared security-based swaps, foreign exchange forwards, and foreign
exchange swaps in March,
[[Page 704]]
April, and May 2017 that exceeds $2.25 trillion, where such amounts are
calculated only for business days; and where
(iii) In calculating the amounts in paragraphs (a)(3)(i) and (ii)
of this section, an entity shall count the average daily notional
amount of an uncleared swap, an uncleared security-based swap, a
foreign-exchange forward, or a foreign exchange swap between an entity
or a margin affiliate only one time and shall not count a swap or a
security-based swap that is exempt pursuant to Sec. 23.150(b) or a
security-based swap that is exempt pursuant to section 15F(e) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-10(e)).
(4) September 1, 2018, for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both--
(i) The covered swap entity combined with all its margin
affiliates; and
(ii) Its counterparty combined with all its margin affiliates have
an average daily aggregate notional amount of uncleared swaps,
uncleared security-based swaps, foreign exchange forwards, and foreign
exchange swaps in March, April, and May 2018 that exceeds $1.5
trillion, where such amounts are calculated only for business days; and
where
(iii) In calculating the amounts in paragraphs (a)(4)(i) and (ii)
of this section, an entity shall count the average daily notional
amount of an uncleared swap, an uncleared security-based swap, a
foreign-exchange forward, or a foreign exchange swap between an entity
or a margin affiliate only one time and shall not count a swap or a
security-based swap that is exempt pursuant to Sec. 23.150(b) or a
security-based swap that is exempt pursuant to section 15F(e) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-10(e)).
(5) September 1, 2019 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both--
(i) The covered swap entity combined with all its margin
affiliates; and
(ii) Its counterparty combined with all its margin affiliates have
an average daily aggregate notional amount of uncleared swaps,
uncleared security-based swaps, foreign exchange forwards, and foreign
exchange swaps in March, April, and May 2019 that exceeds $0.75
trillion, where such amounts are calculated only for business days; and
where
(iii) In calculating the amounts in paragraphs (a)(5)(i) and (ii)
of this section, an entity shall count the average daily notional
amount of an uncleared swap, an uncleared security-based swap, a
foreign-exchange forward, or a foreign exchange swap between an entity
or a margin affiliate only one time and shall not count a swap or a
security-based swap that is exempt pursuant to Sec. 23.150(b) or a
security-based swap that is exempt pursuant to section 15F(e) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-10(e)).
(6) September 1, 2020 for the requirements in Sec. 23.152 for
initial margin for any other covered swap entity with respect to
uncleared swaps entered into with any other counterparty.
(b) Once a covered swap entity and its counterparty must comply
with the margin requirements for uncleared swaps based on the
compliance dates in paragraph (a) of this section, the covered swap
entity and its counterparty shall remain subject to the requirements of
Sec. Sec. 23.150 through 23.161 with respect to that counterparty.
(c)(1) If a covered swap entity's counterparty changes its status
such that an uncleared swap with that counterparty becomes subject to a
stricter margin requirement under Sec. Sec. 23.150 through 23.161 (for
example, if the counterparty's status changes from a financial end user
without material swaps exposure to a financial end user with material
swaps exposure), then the covered swap entity shall comply with the
stricter margin requirements for any uncleared swaps entered into with
that counterparty after the counterparty changes its status.
(2) If a covered swap entity's counterparty changes its status such
that an uncleared swap with that counterparty becomes subject to less
strict margin requirement under Sec. Sec. 23.150 through 23.161 (for
example, if the counterparty's status changes from a financial end user
with material swaps exposure to a financial end user without material
swaps exposure), then the covered swap entity may comply with the less
strict margin requirements for any uncleared swaps entered into with
that counterparty after the counterparty changes its status as well as
for any outstanding uncleared swap entered into after the applicable
compliance date under paragraph (a) of this section and before the
counterparty changed its status.
Sec. Sec. 23.162-23.199 [Reserved]
0
3. In Sec. 23.701 revise paragraphs (a)(1), (d), and (f) to read as
follows:
Sec. 23.701 Notification of right to segregation.
(a) * * *
(1) Notify each counterparty to such transaction that the
counterparty has the right to require that any Initial Margin the
counterparty provides in connection with such transaction be segregated
in accordance with Sec. Sec. 23.702 and 23.703 except in those
circumstances where segregation is mandatory pursuant to Sec. 23.157;
* * * * *
(d) Prior to confirming the terms of any such swap, the swap dealer
or major swap participant shall obtain from the counterparty
confirmation of receipt by the person specified in paragraph (c) of
this section of the notification specified in paragraph (a) of this
section, and an election, if applicable, to require such segregation or
not. The swap dealer or major swap participant shall maintain such
confirmation and such election as business records pursuant to Sec.
1.31 of this chapter.
* * * * *
(f) A counterparty's election, if applicable, to require
segregation of Initial Margin or not to require such segregation, may
be changed at the discretion of the counterparty upon written notice
delivered to the swap dealer or major swap participant, which changed
election shall be applicable to all swaps entered into between the
parties after such delivery.
PART 140--ORGANIZATION, FUNCTIONS, AND PROCEDURES OF THE COMMISSION
0
4. The authority citation for part 140 continues to read as follows:
Authority: 7 U.S.C. 2(a)(12), 12a, 13(c), 13(d), 13(e), and
16(b).
0
5. In Sec. 140.93, add paragraph (a)(6) to read as follows:
Sec. 140.93 Delegation of authority to the Director of the Division
of Swap Dealer and Intermediary Oversight.
(a) * * *
(6) All functions reserved to the Commission in Sec. Sec. 23.150
through 23.161 of this chapter.
* * * * *
Issued in Washington, DC, on December 18, 2015, by the
Commission.
Christopher J. Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants--Commission Voting Summary, Chairman's
Statement, and Commissioners' Statements
[[Page 705]]
Appendix 1--Commission Voting Summary
On this matter, Chairman Massad and Commissioner Giancarlo voted
in the affirmative. Commissioner Bowen voted in the negative.
Appendix 2--Statement of Chairman Timothy G. Massad
The rule this Commission is adopting today is one of the most
important elements of swaps market regulation set forth in the Dodd-
Frank Act. Although we have mandated clearing for standardized
swaps, there will always be a large part of the market that is not
cleared. This is entirely appropriate, as many swaps are not
suitable for central clearing because of limited liquidity or other
characteristics. Our clearinghouses will be stronger if we exercise
care in what is required to be cleared. However, we must take steps
to protect against such activity posing excessive risk to the
system. That is why margin requirements for uncleared swaps are
important.
The rule we are adopting today is strong and sensible. It
requires swap dealers and major swap participants (``covered swap
entities'' or ``CSEs'') to post and collect margin with financial
entities with whom they have significant exposures. It requires
initial margin, which is designed to protect against potential
future loss on a default, as well as variation margin, which serves
as mark-to-market protection. It allows for the use of a broad range
of types of collateral, but only with appropriate haircuts. It
requires a greater level of margin than for cleared swaps, given
that uncleared swaps are likely to be less liquid. It requires
segregation of margin with third party custodians, and prohibits
rehypothecation.
While there are costs to this rule, they are justified in light
of the potential risks that uncleared swaps can pose. We learned
this firsthand in the global financial crisis, which resulted in
dramatic suffering and loss for American families.
The swap activities of commercial end-users were not a source of
significant risk in the financial crisis, and we must make sure that
they can continue using the derivatives markets effectively and
efficiently. Accordingly, an important feature of our rule is that
these margin requirements do not apply to swaps with commercial end-
users. This was an element of our proposed rule and is in accordance
with the intent of Congress. Instead, our rule focuses on those
entities that create the greatest risks to our system through
uncleared swaps: The large financial institutions with the greatest
amount of swap activity.
Our rule is practically identical to the rules of the United
States banking regulators, and substantially similar to
international rules. Harmonization is critical to creating a sound
international framework for regulation. Shortly after I took office,
I committed to doing all we could to achieve such harmonization, and
we have succeeded. For example, a year ago there were significant
differences between proposals by the CFTC as well as the prudential
regulators on the one hand, and international regulators on the
other. But today, all these rules are substantially similar. This is
true with respect to a number of provisions, including a two-way
``post and collect'' obligation; the material swaps threshold that
determines when the requirements apply; the minimum transfer amount;
the types of permissible collateral; the haircuts used in valuing
types of collateral; the general provisions on models for
calculating margin; segregation requirements; and the use of
different currencies for collateral. We have also taken into account
concerns related to the timing of when margin must be posted and
made changes to address the complexities of cross-border
transactions.
Today's rule is designed to address the potential risks that can
arise if a CSE or large financial entity defaults on transactions
with another CSE or large financial entity. We are particularly
seeking to reduce the risk that such a default leads to further
defaults by those counterparties, given the interconnectedness of
our financial system. We became all too familiar with that risk in
2008. Margin is designed to reduce the risk of cascading defaults by
enabling the non-defaulting party to recover its loss. Some will
characterize this as expensive insurance, as both parties must post
initial margin as protection against potential future loss, even
though in default, only one would actually recover against the
margin. But we need only remember the costs of the crisis to our
economy to recognize that this is, on the contrary, quite sensible.
The issue of how our rule should apply to inter-affiliate
transactions has received a lot of attention. I believe we should
look at this issue in terms of the goals of the rule, which are
first and foremost to avoid the potential for the buildup of
excessive risk from bilateral transactions between unaffiliated
parties. Inter-affiliate transactions are not outward-facing and
thus do not increase the overall risk exposure of the consolidated
enterprise to third parties. Instead, they are typically a means for
the consolidated enterprise to centrally manage risk related to the
activities of multiple subsidiaries. Imposing the same third-party
transaction standards on these internal activities of consolidated
entities is likely to significantly increase costs to end-users
without any commensurate benefit. Nevertheless, we have imposed some
protections and requirements.
First, we must make sure that inter-affiliate transactions are
not used as a loophole or as a means to escape the obligation to
collect margin from third parties. This could occur, for example, if
an affiliate in a jurisdiction that does not have comparable margin
requirements enters into a swap with a third party without
collecting margin, and then enters into an affiliate swap to
transfer that risk. Our rule imposes a strong anti-evasion standard.
A CSE is required to collect margin from an affiliate if that
affiliate is, directly or indirectly, engaging in an outward facing
swap in a situation where it should be, but is not, collecting
margin. In addition, our proposal on the cross-border application of
our margin rule, which is the subject of a separate rulemaking, also
addresses this. The proposal provides that any affiliate that is
consolidated with a U.S. parent is subject to requirements to
collect margin from third parties no matter where the affiliate is
located and whether or not it is guaranteed by the U.S. parent.
We have seen how global financial institutions have changed
their business models to ``deguarantee'' the transactions of their
overseas swap dealers so as to circumvent certain U.S. requirements.
Whether guaranteed or not, swap risk created by an affiliate abroad
could harm our financial system. That is why we have a strong anti-
evasion standard in this rule and why we are addressing this through
the cross-border aspects of the rule. I hope that we can finalize
that part of the rule early next year.
In addition, our rule requires segregation of margin and
prohibits rehypothecation, which prevents the affiliate that created
the outward exposure from using the margin for something else, thus
leaving itself more vulnerable to a default.
Second, we have required that variation margin be exchanged for
all inter-affiliate swaps. This provides mark-to-market protection
to either side, and prevents the potential buildup of a liability
owed by one affiliate to another.
Third, we have required that inter-affiliate swaps be subject to
a centralized risk management program that is reasonably designed to
monitor and to manage the risks associated with such transactions.
Some have suggested that, even if inter-affiliate swaps do not
increase exposure to third parties, we should require initial margin
for all inter-affiliate swaps to enhance that internal risk
management. But that would be a very costly and not very effective
way for us as a regulator to enhance such risk management. For
example, it would not make sense to have a rule that required
initial margin on, say, a $100 million inter-affiliate swap, when
one affiliate could loan the other $100 million and not collect any
margin. Similarly, a CSE could collect Treasury securities (or other
non-cash collateral) from an affiliate as initial margin, but then
loan the same amount of other securities back to the affiliate in a
separate transaction which is not subject to requirements. The point
is, if the concern is the adequacy of central risk management, then
we should focus on that subject more generally. We should not
attempt to address it by imposing on all inter-affiliate trades an
initial margin requirement that is designed to address default risk
on trading relationships between unaffiliated parties.
It is also important to remember that the definition of
``affiliate'' in our rule is limited to consolidated entities. This
means that any swap with an affiliate that is not consolidated would
be subject to the same margin requirements as third party swaps.
This would be the case, for example, if a swap dealer enters into a
swap with a mutual fund managed by an affiliate.
The fact that we are not generally requiring an exchange of
initial margin in inter-affiliate transactions is also consistent
with the rule this Commission adopted in 2013, which provided an
exception to the clearing mandate for inter-affiliate transactions.
In that rulemaking, the Commission considered,
[[Page 706]]
but decided against, requiring the exchange of initial margin or
variation margin as a condition for electing the exemption. It did
so out of a concern that such requirements ``would limit the ability
of U.S. companies to efficiently allocate risk among affiliates and
manage risk centrally.'' A requirement to exchange initial margin on
all uncleared inter-affiliate transactions would effectively
contravene the inter-affiliate clearing exemption, as it would
likely be cheaper to clear the inter-affiliate swap. However, I
think the case for variation margin is different, and that is why I
support imposing a general requirement for exchange of variation
margin for inter-affiliate swaps. While this goes further than what
the Commission did in 2013, I believe it is a necessary and
reasonable addition to the overall protections of the rule.
In addition to the goal of minimizing systemic risk, I also
considered our desire to harmonize with the prudential regulators
and international standards as much as possible, so that we do not
create inconsistencies in the regulatory framework or incentives for
regulatory arbitrage. The prudential regulators' rules require the
exchange of variation margin in inter-affiliate transactions, as
ours do. They did not require the two-way exchange of initial
margin; instead they required a ``collect only'' approach. This is
similar to what federal law already requires, as Section 23 A and B
of the Federal Reserve Act imposes requirements on inter-affiliate
transactions by insured depositary institutions designed to protect
the insured depository institutions. Those requirements do not apply
to CSEs subject to our rule. In addition, if we were to adopt a
collect only approach to initial margin, it would result in the two-
way approach for transactions between the CFTC's CSEs and the CSEs
subject to the prudential regulators' rules that the prudential
regulators did not adopt. Instead, we have required the posting of
initial margin to affiliated CSEs regulated by the prudential
regulators to ensure consistency with the requirements of the
prudential regulators' rules. By doing so, we can help enforce the
prudential regulators' goal and the existing Section 23 framework.
With respect to international harmonization, we expect the rules
to be adopted soon by Europe and Japan to not require initial or
variation margin for inter-affiliate swaps. Similarly, the joint
Basel Committee on Banking Supervision and the International
Organization of Securities Commissions standards agreed upon in 2013
stated that the exchange of initial or variation margin for inter-
affiliate swaps is ``not customary'' and expressed concern that
imposing such requirements would result in ``additional liquidity
demands.'' Our rule is somewhat more conservative than the
international standards, but I believe the differences are not so
great as to create significant international disparities.
In conclusion, the differences in our views on inter-affiliate
margin do not reflect differences in the level of concern about the
safety of the system or avoiding the problems of the past. They
reflect differences in our analysis of what is accomplished by
inter-affiliate initial margin. I believe the rule we are adopting
today is a strong and sensible approach that will contribute to the
strength and resiliency of our financial system.
Appendix 3--Dissenting Statement of Commissioner Sharon Y. Bowen
I commend the staff, the Chairman, and Commissioner Giancarlo
for their work on this final rule. This rule has many benefits for
the American public and is an important step towards further girding
the financial system. Unfortunately, as compared to our September,
2014 proposal and the rule passed by the prudential regulators, this
final rule fails to meet statutory intent and it puts swap dealers
we regulate at greater risk in times of financial stress because of
its treatment of interaffiliate margin.
In 2008, our financial system was brought to its knees as a
tidal wave of financial risk washed away the savings of many,
destroyed confidence in the financial system, and swept away
platitudes about large, sophisticated, financial players' ability to
manage their own credit risks. This crisis was considerably
compounded by derivatives transactions that were unregulated and
woefully under-collateralized.
While these large players were bailed out by taxpayers, today
they have returned to record profits. Many of those same taxpayers
had no similar help. No recourse to the financial institutions that
harmed them. No help to pick up the pieces and rebuild a financial
future.
In the aftermath, the international regulatory community
recognized that margin requirements for uncleared swaps are a
critical safeguard against repeating these mistakes. They provide
covered entities with protections against counterparty default.
Crucially, initial margin is a protection paid by the ``defaulter.''
These defaulter-paid protections help entities recognize the risk
they take and impose on others. Variation margin, on the other hand,
force entities to recognize losses they have already incurred.
Together, variation margin and initial margin reduce systemic risk
and excess leverage. They help ensure the parties have the capacity
to perform on the swap over time.
In 2010, the Dodd Frank Wall Street Reform and Consumer
Protection Act (``Dodd Frank'') recognized the higher risk swap
dealers faced from using uncleared swaps. Dodd Frank mandated margin
requirements to protect the safety and soundness of swap dealers
using uncleared swaps.
In 2011, the Group of Twenty (G20) added margin requirements on
uncleared derivatives to the global financial reform agenda.
In September, 2013, following the G20 agenda, the Basel
Committee on Banking Supervision (``BCBS'') and International
Organization for Securities Commissions (``IOSCO'') released a
framework for margin requirements for uncleared derivatives (the
``BCBS/IOSCO Framework'').\1\ This framework highlighted the
increased risk posed by uncleared derivatives as the ``same type of
systemic contagion and spillover risks'' \2\ involved in the 2008
financial crisis. The Framework also found that margin requirements
for uncleared derivatives would promote central clearing.\3\
---------------------------------------------------------------------------
\1\ BCBS/IOSCO, Margin requirements for non-centrally cleared
derivatives (``BCBS/IOSCO Framework'') (September 2013).
\2\ Id. at 2.
\3\ Ibid.
---------------------------------------------------------------------------
In September, 2014, the Commission re-proposed its 2011 rule on
uncleared margin, updating it to reflect the Framework and working
with the prudential regulators to develop a proposal that was
consistent with theirs.
Unfortunately, the rule before us is a considerable retreat from
the September proposal. This final rule provides an exemption for
swap dealers, excusing them from collecting initial margin when
entering into transactions with most affiliated parties including
prudentially regulated swap dealers, i.e., swap dealers that are
also banks. It also includes, in most cases, under-capitalized
affiliates, foreign affiliates, and even unregulated affiliates.
As the prudential regulators noted in their recently released
final rule, these swaps ``may be significant in number and notional
amount.'' \4\ As I understand from our staff, interaffiliate
transactions likely make up nearly half of all uncleared
transactions by notional volume.
---------------------------------------------------------------------------
\4\ 80 FR 74840 (November 30, 2015) at 74889.
---------------------------------------------------------------------------
Initial margin functions like a performance bond. Collected from
your counterparty, it helps ensure that even as one party defaults
on you, you will be able to perform on your obligations to others.
Posted and collected across the financial system, it is a critical
shock absorber for the bumps and potholes of our financial markets
and for the risk of contagion and spillovers.
The large financial institutions that benefit from this
exemption have tremendously complicated organizational structures,
webs of hundreds, sometimes thousands, of affiliates spread across
the globe. These complicated structures allow these banks to shift
risk across the globe through different legal entities in their
quest to earn higher returns on capital.
The difference in political, financial, and legal systems across
these interconnected, international affiliate webs makes it
difficult, likely impossible, to fully predict how risk unfolds
across the global entity in a period of severe financial stress.
Think of immunizations. We have them to protect our population
against the risk of infectious disease, not just for us as
individuals, but to keep disease from spreading across our
communities. Immunizations are not always enough, people still get
sick, but they are a vital protective measure. People do forgo them,
perhaps hoping that they either are not going to get sick, or if
they do, that they can be treated. But, we know, hope is not enough.
The whole point of immunizations is protecting against dangerous,
but preventable, risks.
Initial margin fulfills a similar role. Legally, the affiliates
we are talking about here are separate entities, even if they are
part of a larger company structure. If their transactions across
affiliates create risk, that risk should be addressed. For uncleared
[[Page 707]]
swaps, initial margin helps immunize individuals, institutions and
ultimately the whole financial system from financial disease and
contagion.
In November of this year, the prudential regulators decided to
allow, subject to conditions, dealers to collect but not post
initial margin with affiliates. The prudential regulators noted this
accommodation would meet the twin goals of ``protect[ing] the safety
and soundness of covered swap entities in the event of an affiliated
counterparty default'' while not ``permit[ting] such inter-affiliate
swaps . . . to remain unmargined and thus to pose a risk to systemic
stability.'' According to the statute, our rules are to be
comparable, ``to the maximum practicable'' to those of our fellow
prudential regulators.\5\
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\5\ 7 U.S.C. 6s(e)(3)(D)(ii).
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While this rule today is, in many respects consistent with that
of the prudential regulators, regarding interaffiliate initial
margin it is neither comparable to that of the prudential
regulators, nor does it protect safety and soundness of swap dealers
we oversee. It places the swap dealers we regulate, and thus, their
customers, at unnecessary risk in times of financial stress.
The situation of a CFTC-regulated swap dealer transacting with a
prudentially regulated swap dealer is particularly problematic. Not
only does the CFTC-regulated swap dealer not have the benefit of
collecting initial margin, it has to post initial margin to the
prudentially-regulated swap dealer. For entities with high volumes
of affiliate transactions, this can leave these CFTC-regulated swap
dealers in a huge hole in the case of default. By not collecting
initial margin, this rule places the swap dealers we regulate at
greater risk in times of severe financial stress. That cannot be
consistent with the intent of a statute mandating us to protect the
``safety and soundness'' of our swap dealers.
By not requiring the collection of interaffiliate initial margin
for this significant number of trades, we lose a vital financial
shock absorber that is intended to help immunize institutions and
the system against the risk of default.
We should not minimize the risk of this action. One could say
that having our swap dealers collect initial margin is not necessary
because a large financial institution is never going to let one of
its affiliates go under. Do we want to risk the health of our
economy on that bet? Especially since, relying on financial entities
to properly risk manage, without regulatory limitations, did not
work in 2008?
The rationale noted in this rule for allowing this loophole
seems to be in order to reduce the margin amount collected by the
overall enterprise. But, we are charged with protecting the ``safety
and soundness'' of swap dealers.\6\ We need to address the risks
that cause a particular swap dealer to fail. Especially, those risks
that might cause a swap dealer to fail to meet its obligations to
its customers or protect its customers' funds.
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\6\ 7 U.S.C. 6s(e)(3)(A)(i).
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I do not know, for a particular swap dealer, what circumstances
might arise that would send it careening towards another financial
crash. I cannot predict whether collecting interaffiliate initial
margin will be enough to protect the swap dealer and ultimately its
customers. I do know that having collateral in the form of initial
margin makes it more likely the swap dealer will meet its
obligations than not having it.
This decision seems to reflect a forgetfulness about how we, as
a country, allowed the last financial crisis to happen. It is easy
to believe that large, complex financial institutions can manage
their risks. They are smart people. They make a lot of money. They
have to know what they are doing.
However, the risks we are dealing with are hard to quantify.
They are the kinds of risks that humans have shown, throughout
history, they are quite poor at managing.
Most institutions for whom these transactions are relevant,
failed in 2008 to manage the risk of these transactions. This action
today seems to be a return to blindly trusting in large financial
institutions' ability and willpower to manage their risks
adequately. Are we really willing to make that bet again?
I am not.
Our prudential colleagues have agreed that initial margin is the
correct tool to manage the risks of transactions across affiliates.
We should not be trying to guess whether a large, complex financial
institution's global risk controls will be sufficient to protect the
swap dealers we regulate. Our failure to provide comparable
protection for our swap dealers is inexplicable to me.
I have been responsible for dealing with customers who have lost
their life savings when complex financial entities collapse. I
cannot vote for a rule that places the swap dealers we regulate, and
most importantly, their customers, at risk. Accordingly, I vote no.
Appendix 4--Statement of Commissioner J. Christopher Giancarlo
Today's final rule regarding margin requirements for uncleared
swaps is far from perfect. The Commission had the unenviable task of
harmonizing its rule with the prudential regulators' rules and with
standards issued by the Basel Committee on Banking Supervision and
the International Organization of Securities Commissions (BCBS/
IOSCO). While there are particular provisions of the final rule that
I do not support, I think the final rule is far better balanced than
the previous proposal.
Much of the discussion in finalizing this rule has been focused
on margin requirements for inter-affiliate swaps. That discussion
must begin with the recognition that inter-affiliate swaps
transactions do not involve transactions between distinct financial
institutions that was at issue in the 2008 financial crisis and do
not pose the systemic risk that the Dodd-Frank Act \1\ was
ostensibly designed to address. Congress expressed no particular
intention to subject inter-affiliate transactions to clearing or
inter-affiliate margin.
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\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. 111-203, 124 Stat. 1376 (2010).
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Accordingly, the CFTC adopted a rule in April 2013 to exempt
certain inter-affiliate swaps from mandatory clearing.\2\ That
rulemaking, supported by former Chairman Gensler and Commissioners
Wetjen, Chilton and O'Malia, recognized that inter-affiliate swaps
provide an important risk management role within corporate groups.
They enable use of a single conduit on behalf of multiple affiliates
to net affiliates' trades, which reduces the overall risk of the
corporate group and the number of outward-facing swaps into which
the affiliates might otherwise enter. This, in turn, reduces
operational, market, counterparty credit and settlement risk.\3\
Rather than increasing risk, inter-affiliate swaps allow entities
within a corporate group to transfer risk to the group entity best
positioned to manage it.
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\2\ Clearing Exemption for Swaps Between Certain Affiliated
Entities, 78 FR 21750 (Apr. 11, 2013); 17 CFR 50.52.
\3\ Id. at 21753.
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Moreover, in exercising its authority under Section 4(c) of the
Commodity Exchange Act to exempt qualifying inter-affiliate swaps
from the mandatory clearing requirement, the Commission found that
the exemption promotes responsible financial innovation, fair
competition and is consistent with the public interest.\4\ It
further found that the exemption, which was conditioned on having
certain risk mitigating measures in place,\5\ would not have a
material effect on the Commission's ability to discharge its
regulatory responsibilities.\6\
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\4\ Id. at 21754.
\5\ For example, the clearing exemption may be elected only if
the affiliates' financial statements are consolidated, which
increases the likelihood that the affiliates will be mutually
obligated to meet the group's swap obligations; the affiliates must
be subject to a centralized risk management program; and outward-
facing swaps must be cleared or subject to an exemption or exception
from clearing. Id. at 21753.
\6\ Id. at 21754.
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When the CFTC issued its proposed rule in September 2014, I
noted that subjecting inter-affiliate swaps to the higher costs of
uncleared margin \7\ could not be logically or prudentially
justified with the clearing exemption for inter-affiliate swaps that
the Commission adopted in 2013.\8\ The
[[Page 708]]
Commission's 2013 findings remain valid on this issue. I am aware of
no facts that have come to light that would change the original
assessment made by our predecessor Commission.
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\7\ The costs of posting margin for uncleared swaps will likely
be substantially higher than the costs associated with clearing. For
example, the minimum liquidation time for cleared agricultural,
energy and metals swaps is one-day for purposes of calculating
initial margin, and five days for cleared interest rate and credit
default swaps. Commission Regulation 39.13(g)(2). Under the final
rule, initial margin for uncleared swaps may be calculated under
either a standardized table-based method or a model-based method.
Under the table-based method, initial margin for commodity swaps
must equal 15 percent of gross notional exposure. The model-based
method requires a ten-day close out period for all swaps regardless
of the underlying liquidity characteristics.
\8\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants; Proposed Rule, 79 FR 59898, 59936 (Oct. 3,
2014) (Statement of Commissioner J. Christopher Giancarlo),
available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2014-22962a.pdf.
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In fact, since issuing the proposed rule for notice and comment,
an independent cost-benefit analysis of the rule recommended, among
other things, exempting inter-affiliate swaps from initial margin
requirements as a means to reduce the ``excessively onerous'' impact
of the rule on competition, price discovery and overall market
efficiency without allowing additional systemic risk.\9\ I concur
with that recommendation.
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\9\ Cost-Benefit Analysis of the CFTC's Proposed Margin
Requirements for Uncleared Swaps, NERA Economic Consulting (Dec. 2,
2014), available at http://www.nera.com/content/dam/nera/publications/2014/NERA_Margin_Requirements_Uncleared_Swaps.pdf.
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Earlier this year, I testified before the U.S. House of
Representatives Committee on Agriculture Subcommittee on Commodity
Exchanges, Energy, and Credit. In response to a question, I
explained that the cost of any requirement to impose initial margin
in inter-affiliate transactions would have two likely impacts:
first, it would raise the cost of commercial risk hedging for
American end-users; and second, it would encapsulate risk in the
U.S. marketplace and thus increase the risk of systemic hazard in
American financial markets.\10\
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\10\ Hearing before the Subcommittee on Commodity Exchanges,
Energy, and Credit of the Committee on Agriculture, House of
Representatives, 114th Congress, First Session, Serial No. 114-7,
Transcript at 193-194 (Apr. 14, 2015), available at http://agriculture.house.gov/uploadedfiles/114-07_-_93966.pdf.
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The final rule before us today is not na[iuml]ve or reckless
concerning inter-affiliate swaps transactions. It recognizes that
they are not without risk and sets appropriate safeguards. First,
the rule requires operation of a centralized risk management program
for such swaps. Second, variation margin will be required. Third,
the rule requires covered swap entities to collect initial margin
from non-U.S. affiliates that are not subject to comparable initial
margin collection requirements for their own outward-facing swaps
with financial entities. These measures appropriately address the
risks associated with uncleared inter-affiliate swaps.\11\
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\11\ AIG often did not post initial margin or pay variation
margin on its outward facing swaps. See Opening Statement of
Commissioner Michael V. Dunn, Public Meeting on Proposed Rules Under
Dodd-Frank Act (Apr. 12, 2011). Both are required under today's
rule.
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In other regards, I am satisfied that the threshold for
measuring material swaps exposure has been raised from $3 billion to
$8 billion, which brings our requirement roughly in line with the
BSBS/IOSCO standard of [euro]8 billion.\12\ I am also pleased that
the swaps of commercial end-users, agricultural and energy
cooperatives that are classified as financial institutions and small
banks will not be subject to the margin requirements if they qualify
for an exclusion or exemption. That is one small assist to America's
remaining small banks to get their heads back above water in the
toppling wake of the Dodd-Frank Act.
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\12\ I note an inconsistency between the $8 billion de minimis
threshold for purposes of determining who must register as a swap
dealer or major swap participant and the $8 billion threshold for
measuring material swaps exposure. Foreign exchange swaps, foreign
exchange forwards and hedging swaps must be included in the
calculation of material swaps exposure; they are not included in
calculating the de minimis threshold.
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I disagree, however, with the definition of ``financial end
user,'' which is overly broad. It includes entities that are
unlikely to act as counterparties to swaps such as floor brokers,
introducing brokers and futures commission merchants acting on
behalf of customers, among others. These entities may not ultimately
be captured by the rule because they are unlikely to have material
swaps exposure triggering application of the rule, but I question
the logic behind their inclusion. Good regulation means precisely
crafted rules, not ones that are deliberately overly-broad.
I also continue to object to the ten-day liquidation horizon
that must be incorporated into initial margin models for all types
of uncleared swaps. The ten-day requirement is a made up number that
is not tailored to the true liquidity profile of the underlying swap
instruments. I call upon my fellow regulators to revisit this issue
as we gain more experience with initial margin models.
Another item that requires further Commission action is to
codify by rule the no-action letters providing clearing relief to
certain Treasury affiliates acting as principal.\13\ The prudential
regulators were unwilling to recognize the no-action relief in their
final rules, but have indicated that if the Commission acts to
exclude these entities by rule, they would also be excluded from the
prudential regulators' rules. The Commission should act to issue a
rule without delay.
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\13\ See CFTC No-Action Letter No. 13-22 (Jun. 4, 2013); CFTC
No-Action Letter No. 14-144 (Nov. 26, 2014).
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In addition, I remain concerned about the cross-border
implications for this rule, which remain unfinished because they
were proposed separately from the rule finalized today.\14\ As I
stated at the time of the cross-border rule proposal, I have many
concerns and questions surrounding that rulemaking, including: (1)
The shift away from the transaction-level approach set forth in the
July 2013 Cross-Border Interpretive Guidance and Policy Statement;
(2) the revised definitions of ``U.S. person'' (defined for the
first time in an actual Commission rule) and ``guarantee'' and how
these new terms will be interpreted and applied by market
participants across their entire global operations; (3) the scope of
when substituted compliance is allowed; and (4) the practical
implications of permitting substituted compliance, but disallowing
the exclusion from CFTC margin requirements for certain non-U.S.
covered swap entities.\15\
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\14\ See Margin Requirements for Uncleared Swaps for Swap
Dealers and Major Swap Participants--Cross-Border Application of the
Margin Requirements; Proposed Rule, 80 FR 41376 (Jul. 14, 2015),
available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2015-16718a.pdf.
\15\ Id. at 41407.
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An appropriate framework for the cross-border application of
margin requirements for uncleared swaps is essential if we are to
preserve the global nature of the swaps market. I reiterate a few of
my concerns with the yet-to-be-finished cross-border element of the
margin for uncleared swaps regime because that proposal and this
final rule must work in harmony. We must avoid further fragmenting
the global swaps markets by imposing another regulatory framework
that is inconsistent, confusing or burdensome. Doing so will only
result in yet another competitive disadvantage between American
institutions and their international counterparts.
I am disappointed that the Commission decided to treat the
results of portfolio compression of legacy swaps as new swaps
subject to the margin rule at this time. In 2013 the Division of
Clearing and Risk (DCR) determined that it would not recommend
enforcement action for the failure of market participants to submit
to clearing amended or replacement swaps that are generated as part
of a multilateral portfolio compression exercise and are subject to
required clearing, provided that certain conditions are met.\16\
Staff recognized in issuing the no-action relief that ``multilateral
portfolio compression allows swap market participants to net down
the size and/or number of outstanding swaps, and decrease the number
of outstanding swaps or the aggregate notional value of such swaps,
thereby reducing operational risk and, in some instances, reducing
counterparty credit risk.'' \17\
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\16\ CFTC Letter No. 13-01.
\17\ Id. at 2.
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Portfolio compression is of great benefit to the safety and
soundness of the market. It should be incentivized, not penalized.
Treating swaps created by compressing legacy swaps as new swaps
subject to margin requirements may well discourage portfolio
compression. Moreover, it is inconsistent with the DCR staff no-
action relief. This is a missed opportunity. I urge the Commission
to revisit this issue prior to implementation of the margin
requirements.
From my perspective, the most objectionable aspect of today's
rule is its foundation in the superficial logic that, if the cost of
margining uncleared swaps is forced high enough, then market
participants will use more cleared instruments.\18\ That foundation
is not supported by either reason or experience. If no clearinghouse
is willing to clear a particular swap, then no amount of punitive
cost will enable it to be cleared.
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\18\ See Chair Janet L. Yellen, Opening Statement on the Long-
Term Debt and Total Loss-Absorbing Capacity Proposal and the Final
Rule for Margin and Capital Requirements for Uncleared Swaps, Board
of Governors of the Federal Reserve System, Oct. 30, 2015, available
at http://www.federalreserve.gov/newsevents/press/bcreg/yellen-statement-20151030a.htm; see also Madigan, Peter, US Margin Rules
Threaten Clearing Bottleneck, Risk.net, Dec. 14, 2015.
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I know this because I was involved before the financial crisis
in one of the first
[[Page 709]]
independent efforts by non-Wall Street banks to develop a central
clearing house for credit default swaps.\19\ For years, I have
expressed my support for increased central counterparty clearing of
swaps \20\ and continue to support it where appropriate. Yet, I also
recognize that central counterparty clearing is not a panacea for
counterparty credit risk.\21\ As regulators, we must be
intellectually honest and acknowledge that there are legitimate and
vital needs for both cleared and uncleared swaps markets in a
modern, complex economy.
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\19\ See, e.g., GFI Group Inc. and ICAP plc To Acquire Ownership
Stakes In The Clearing Corporation, PRNewswire, Dec. 21, 2006,
available at http://www.prnewswire.com/news-releases/gfi-group-inc-and-icap-plc-to-acquire-ownership-stakes-in-the-clearing-corporation-57223742.html; see also, Testimony Before the H.
Committee on Financial Services on Implementation of the Dodd-Frank
Wall Street Reform and Consumer Protection Act, 112th Cong. 8 (2011)
(statement of J. Christopher Giancarlo) (``In 2005, GFI Group and
ICAP Plc, a wholesale broker and fellow member of the WMBAA, took
minority stakes in the Clearing Corp and worked together to develop
a clearing facility for credit default swaps. That initiative
ultimately led to greater dealer participation and the sale of the
Clearing Corp to the Intercontinental Exchange and the creation of
ICE Trust, a leading clearer of credit derivative products.'').
\20\ See Testimony Before the H. Committee on Financial Services
on Implementation of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, 112th Cong. 8 (Feb. 21, 2011), available at dia/pdf/
021511giancarlo.pdf; see also WMBAA Press Release, WMBAA Commends
Historic US Financial Legislation, Jul. 21, 2010, available at
http://www.wmbaa.com/wp-content/uploads/2012/01/WMBAA-Dodd-Frank-Law-press-release-final123.pdf.
\21\ See CFTC Commissioner J. Christopher Giancarlo, Pro-Reform
Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-
Frank (Jan. 29, 2015), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/sefwhitepaper012915.pdf.
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As I have previously said,\22\ uncleared swaps allow businesses
to avoid basis risk and obtain hedge accounting treatment for more
complex, non-standardized exposures. Uncleared swaps are an
unmatched tool for customized risk management by businesses,
governments, asset managers and other institutions whose operations
are essential to American economic growth. Their precise risk
transfer utility generally cannot be replicated with standardized
cleared derivatives without resulting in improper or imperfect
hedges or hedges that fail hedge accounting treatment under U.S.
GAAP.
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\22\ See Opening Statement of Commissioner J. Christopher
Giancarlo, Open Meeting on Proposed Rule on Margin Requirements for
Uncleared Swaps and Final Rule on Utility Special Entities, Sept.
17, 2014, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement091714.
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Today's rule also reflects a disingenuous reading of the Dodd-
Frank Act to favor cleared derivatives over uncleared swaps. In
fact, there is no provision in the law directing regulators to set
punitive levels of margin to drive hedging market participants
toward cleared products. Imposing punitive margin levels will hazard
a range of adverse consequences from raising the commercial cost of
risk hedging to reducing trading liquidity in uncleared swaps
markets and incentivizing movement of products otherwise unsuitable
for clearing into clearinghouses into which counterparty risk is
already increasingly concentrated. More critically, punitive margin
on uncleared swaps will increase the amount of inadequately hedged
risk exposure on America's corporate balance sheets exacerbating
volatility in earnings and share prices.
Yet, I know that my voice alone cannot reverse the course of the
present prevalence of ``macro-prudential'' regulation that
prioritizes systemic stability over investment opportunity, market
vibrancy and economic growth. Only time will show that systemic risk
cannot be managed through centralized economic planning. In fact,
rather than being managed, systemic risk is being transformed today
from counterparty credit exposure to jarring volatility spikes and
liquidity risk across the breadth of financial markets, with
ramifications that will be even harder to manage in the future.
Unfortunately, today's rule will not reverse these trends. I
will vote for the rule, not because it is the right prescription for
uncertain markets, but because it is much better than originally
proposed and less harmful than likely alternatives.
I commend the CFTC staff for their hard work, thoughtfulness
and, ultimately, the generally improved rulemaking that is before us
today.
[FR Doc. 2015-32320 Filed 1-5-16; 8:45 am]
BILLING CODE 6351-01-P