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On September 3, the Board of Governors of the Federal Reserve System (“Board”), the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit Administration and the Federal Housing Finance Agency (collectively, the “Prudential Regulators”) voted to re-propose rules to implement Sections 731 and 764 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) (a draft of which has been published online – the “Draft Proposal”).1 The Draft Proposal would impose initial and variation margin requirements on prudentially regulated swap dealers, security-based swap dealers, major swap participants and major security-based swap participants (“Covered Swap Entities”) entering into uncleared swaps and security-based swaps.
As expected, the Draft Proposal varies substantially from an earlier 2011 proposal and largely tracks standards recommended by G-20 regulators under the joint auspices of the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) in September 2013.2 In particular, the Draft Proposal implements the BCBS-IOSCO recommendation to require two-way posting of both initial and variation margin by requiring Covered Swap Entities to both collect and post initial and variation margin with certain counterparties under specified circumstances. To this end, the Draft Proposal provides new terms defining “financial end users” and “other counterparties” and generally limits the mandatory margin requirements to situations where a Covered Swap Entity faces a financial end user or another swap dealer or MSP.
The Draft Proposal is the third proposal from a major financial jurisdiction to implement margin requirements for derivatives based on the BCBS-IOSCO Framework, the other two proposals being that of the European Union and of Japan.3 A draft of the rulemaking has been posted to the Board website. Comments on the Draft Proposal will be due 60 days following the date on which it is published in the Federal Register.
Below is a brief summary of key points based on an early review of the Draft Proposal, with notes highlighting areas where the Draft Proposal appears to differ from the EU Margin RTS in important respects.
The Draft Proposal provides some welcome relief to non-financial end users by (i) simplifying and clarifying the line between financial and non-financial end users and (ii) providing non-financial end users a broader carve-out than proposed in 2011. With that said, the scope provisions are still complex. Perhaps more importantly, they differ from the European Margin RTS along a number of dimensions. These inconsistencies will impose substantial burdens on market participants who trade across national borders, and may lead to market fragmentation.
The treatment of FX products could also lead to some arguably odd results. For example, an entity that enters into a small amount of “swaps” but a large amount of Treasury-exempted FX products could become subject to the initial margin requirements on an accelerated basis.
The compliance dates are broadly consistent with the Framework and the EU Margin RTS.6 However, the threshold for application of initial margin requirements after 2019 is substantially lower ($3 billion vs. EUR 8 billion) than in the EU Margin RTS. In addition, the calculation that will be required under these rules would differ from the calculation that would be required under the EU Margin RTS as (i) the phase-in for initial margin requirements is based on dollars rather than euros, (ii) the scope of covered products differs (in particular with regard to OTC securities options) and (iii) the definition of “affiliates” differs somewhat from the analogous European definitions. If the relevant regulators fail to reconcile these differences in final rules, they are likely to materially increase the complexity of managing the transition, and could increase market fragmentation.
We also note that basing margin requirements on the consolidated activities of separate legal entities is likely to raise difficult issues of operational and strategic co-operation between entities that may be under common “control” for purposes of the relevant definition, but in fact operate independently and may not have identical ownership.
Finally, we note that the proposed compliance date for variation margin requirements is very aggressive and may be impractical as the Prudential Regulators (and their U.S. and non-U.S. counterparts) appear to be materially underestimating the logistical and documentational changes that will be required to implement these requirements.7
While the Draft Proposal does not include a requirement to impose cross-currency haircuts on variation margin (which was proposed by the EU Margin RTS and is generally viewed by market participants as highly problematic), it does so at the cost of narrowly limiting the list of eligible collateral. Depending on final rules, this approach may create difficult conflicts when Covered Swap Entities face counterparties regulated in other jurisdictions.
In addition, the justification of the proposed treatment of historical trades is unclear as it would seem to disincentivize the use of master netting agreements. Nor is it clear that this requirement can be imposed as a practical matter, given that there is no requirement to segregate variation margin.
The Draft Proposal’s list of eligible collateral types differs from that provided in the EU Margin RTS, as each set of regulations tends to privilege local assets. The approach to eligible collateral is also substantially simpler than that in the EU Margin RTS in several respects, including that (i) it would not generally impose an requirement to monitor external credit ratings or produce internal credit quality and/or volatility assessments to determine eligibility and haircuts (though the Farm Credit Administration and the Federal Housing Finance Agency would impose credit quality requirements), (ii) it would not impose concentration limits and (iii) it would employ a relatively simple approach to avoiding “wrong-way risk.”
As with variation margin, the justification of the proposed treatment of historical trades is unclear and is likely to be a major disincentive to placing historical trades under the same bankruptcy netting agreement as new trades.
The questions of how thresholds will be allocated may also prove quite problematic, particularly in situations where affiliates are not under completely common ownership and operate, effectively, independently.
An ongoing theme of implementing margin requirements for uncleared derivatives has been the need for, and the difficulties in achieving, regulatory consistency, or at least coordination, across jurisdictions. The Draft Proposal takes some steps towards this, but there continue to be inconsistencies and conflicts between the approaches taken by different jurisdictions. At the Board open meeting to discuss the Draft Proposal, Board governors and staff stressed that discussions between regulators across jurisdictions are ongoing and that the Board would look to further discuss with their counterparts in other jurisdictions the responses received for the differing margin proposals.
We also note that the limited deference given to non-U.S. law may be problematic for subsidiaries of U.S. holding companies seeking to compete outside the United States if the subsidiary has a parent guarantee.
1 See Draft Federal Register Notice – Margin and Capital Requirements for Covered Swap Entities, available at http://www.federalreserve.gov/aboutthefed/boardmeetings/20140903openmaterials.htm. The Board also posted a Staff memorandum outlining the Draft Proposal (“Board Summary”).
2 Margin Requirements for Non-centrally Cleared Derivatives (September 2013), available at http://www.bis.org/publ/bcbs261.htm (“BCBS-IOSCO Framework” or “Framework”).
3 See 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 (April 14, 2014) (“EU Margin RTS”) and 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 (July 3, 2014) (Japanese proposal).
5 “Control” is defined for these purposes to be (i) ownership, control, or the power to vote 25% or more of a class of voting securities, (ii) ownership or control of 25% or more of total equity, or (iii) control of the election of a majority of directors or trustees.
6 The Framework and EU Margin RTS call for a phase-in as follows: (i) 2015 - €3 trillion; (ii) 2016 - €2.25 trillion; (iii) 2017 - €1.5 trillion; (iv) 2018 - €0.75 trillion; and (v) 2019 and beyond - €8 billion. The Draft Proposal indicates that the lower amount to be used on a going-forward basis is due to a Board staff recommendation based on additional data and analyses that have been conducted since the Framework’s publication. See Draft Proposal at 73-74 (requesting comment on the same).
7 See, e.g., Letter dated August 18, 2014 from the International Swaps and Derivatives Association, Inc. to the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (addressing concerns relating to the December 2015 effective date), available at http://www2.isda.org/attachment/Njg5Nw==/WGMR%20MarginTiming%20final%2018082014%20(2).pdf.
8 This formulation of the margin “requirement” applicable to end users was the Prudential Regulators’ way of complying with the provisions of Dodd-Frank that, on the one hand, require swap dealers to collect margin, but, on the other hand, exempted certain end users from the requirement of posting margin. In short, the amount of margin that “must” be collected from end users may be zero.