On April 14, 2011, the CFTC released its proposed rules governing margin requirements for uncleared swaps entered into by non-bank swap entities. This newsflash provides an update to our earlier memorandum that summarized margin rules proposed on April 12, 2011 by the U.S. banking regulators and compared those rules to what was known about the CFTC proposal at that time.
The CFTC proposal is similar, but not identical, to the banking regulators' proposal. Both sets of rules require the swap dealers and major swap participants ("swap entities") under their jurisdiction to collect margin from most counterparties. Although swap entities are not required to post margin to their counterparties (subject to limited exceptions), the requirement that swap entities collect margin from other swap entities in practice requires swap entities to post margin to these entities. The amount of margin required to be collected, the frequency of collection of variation margin and the segregation requirements for collected margin depend primarily on the type of counterparty.
Overview of the Differences Between the Proposals
The two proposals differ in a number of significant ways.
- Treatment of Nonfinancial End User Counterparties. The prudential regulators would require a swap entity to collect initial and variation margin from nonfinancial end users when the swap entity’s exposure to such an end user exceeds credit limits determined by the swap entity. The CFTC has no such requirement.
- Approved Models for Calculating Initial Margin. Both sets of rules allow swap entities to use models to calculate initial margin requirements, subject to prior regulatory approval based upon specific quantitative criteria. The prudential regulators would permit swap dealers to seek approval for proprietary models, but the CFTC would limit approved models to those that are (i) used by a derivatives clearing organization, (ii) used for margining uncleared swaps by an entity subject to regular assessment by a prudential regulator or (iii) made available for licensing to any market participant by a vendor.
- Non-Model Initial Margin Calculations. The prudential regulators provide a grid for initial margin calculations where a model is not used. Under the CFTC's proposed rules, a swap entity not using an approved model for initial margin calculations must look to similar cleared swaps and double the initial margin requirement of the cleared swap that is most similar to the uncleared swap; if there is no similar cleared swap, the swap entity would multiply by 4.4 the initial margin requirement of the futures contract most similar to the cleared swap and most likely to be used to hedge the uncleared swap. Under this alternative method, portfolio-based reductions may be permitted. However, such reductions will not be recognized across asset classes (except between currencies and interest rates), and no reduction can exceed 50%.
- Initial Margin Segregation Requirements. Both sets of proposed rules would require initial margin collected for transactions between two swap entities to be custodied at an independent third-party custodian subject to the same insolvency laws as the collecting swap entity. Both sets of proposed rules would, in addition, prohibit the custodian from rehypothecating the collateral or investing it in assets other than certain permitted eligible assets. However, the CFTC's proposed rules, but not the prudential regulators' proposed rules, would prohibit a swap entity from posting as margin for another product any initial margin received by a swap entity from all swap counterparties, not just that from other swap entities.
- Calculating Variation Margin. The CFTC proposal, but not the prudential regulators' proposal, requires that any calculation of variation margin be independently verifiable.
- Treatment of Pre-effectiveness Swaps. Both proposals would apply the initial margin requirements only to swaps entered into on or after the effective date of the rule. However, the prudential regulator's proposal, but not the CFTC's proposal, would allow, but not require, swap entities to calculate initial margin on a portfolio basis and include all swaps under the relevant master agreement entered into before effectiveness of the rule. The swap entity could not pick and choose individual swaps to include in the calculation. The CFTC's proposal has no such provision, though it does request comment on the issue. The prudential regulators' proposal, but not the CFTC's proposal, would apply variation margin requirements to pre-effectiveness swaps when calculating variation margin on a portfolio basis. The CFTC notes that it expects capital requirements to apply to pre-effectiveness swaps.
- Extraterritorial and Interaffiliate Application. Unlike the prudential regulators' proposal, the CFTC's proposal provides no exception from margin requirements for foreign registered swap entities when effecting swaps with other foreign entities. Like the prudential regulators' proposed rules, the CFTC's proposal has no guidance on, or exemption from, application of its margin rules to interaffiliate trades.
As noted in our prior memorandum, the CFTC has not released a proposal for capital requirements for those non-bank entities that will be subject to CFTC-prescribed capital rules. While the CFTC's proposing release indicates that the comment period on the margin rules will expire 60 days after publication of the proposal in the Federal Register (which is expected to occur shortly), the CFTC has separately stated that the comment period on the margin rules and the capital rules will be aligned to allow market participants to review each before commenting on either. Comments on the prudential regulators' proposal are due June 24.