Why firms need to follow plans for uncleared swaps

ByJulian Hammar and James Schwartz, of counsel at Morrison & Foerster.

Lastautumn, the Commodity Futures Trading Commission (CFTC) and five US prudentialbanking regulators released proposed rules for margin requirements foruncleared swap transactions for the entities subject to their regulation.

Themargin requirements, when finalised, will play a significant role indetermining the economics of the post-Dodd-Frank uncleared swaps market,including the extent to which market participants may favour or disfavouruncleared swaps in comparison with other types of transactions. If implementedin their proposed form, the rules will pose many challenges for marketparticipants.

Boththe CFTC and the Prudential Regulators released proposals for margin in 2011.Since that time, however, an international consensus has grown around the policyframework for margin, stated in a series of papers released by the BaselCommittee on Banking Supervision and the Board of the InternationalOrganization of Securities Commissions, the last of which was published inSeptember, 2013 (BCBS/IOSCO Framework). With some significant exceptions, which we note below, the proposedrules are broadly consistent both with the BCBS/Iosco Framework and with eachother.

Althoughthe proposed rules by their terms apply directly to swap dealers, major swapparticipants, security-based swap dealers, and major security-based swapparticipants (also known as covered swap entities or CSEs), the measures theywould require of CSEs would significantly change the economics of the unclearedswaps market not only for CSEs, but also for many of their financialcounterparties.  Among other things, the proposedrules would address the following key areas.

Firstly,they would require CSEs to bilaterally exchange initial margin with other CSEsas well as a broad range of financial end users whose use of swaps meet anotional amount-based threshold or “material swaps exposure”. All such initialmargin would need to be segregated and not subject to rehypothecation or otheruse.

Therules would also require CSEs to exchange variation margin with CSEs and with abroad array of financial end users, without regard to the existence of materialswaps exposure. They would also require cash to be used as variation margin.

Underthe proposed requirements, the calculation of initial margin could be made viaeither a model-based or table-based method. They would also permit offsets inrelation to either initial margin calculations or variation margin calculationswhen such offsets relate to swaps that were subject to the same “eligible masternetting agreement”.

Lastly,they would provide for staggered compliance dates for initial margin, and applyto swaps transacted prior to a relevant compliance date, if such swaps were subjectto the same eligible master netting agreement as swaps transacted after acompliance date.

The proposedrules present a number of important issues for market participants. Perhapsmost significant is the proposed rules’ definition of “material swaps exposure”--theaggregate notional amount at which initial margin requirements would becomeeffective for financial end users. This amount is defined as $3 billion in theproposed US rules, as opposed to the much higher €8 billion in the BCBS/IoscoFramework. As a result, US parties to swaps may be disadvantaged in comparisonwith non-US market participants, and non-US parties could have good reason toshun the US market. 

Moreover, severalof the provisions contained in the proposed rules would require CSEs toaggregate notional amounts with affiliates. The aggregation requirement wouldaffect not only the key “material swaps exposure” definition but also thedefinition of “initial margin threshold” (the amount of initial margin belowwhich no transfer of initial margin is required), and the phase-in schedule forinitial margin.  Affiliation for thesepurposes would be defined to be as little as 25 percent ownership or control. Aggregationof notional amounts exposures across diverse affiliated entities, includingthose over which there is little ownership or control, would be difficult toaccomplish, and would likely require the implementation of new systems. 

Anotherkey issue is the requirement that variation margin be provided in the form ofcash, which is not required in other jurisdictions such as the European Unionand Japan. This could help push swaps market liquidity into non-USjurisdictions and require investment managers to liquidate securities, thuscausing tracking errors and, in certain cases, could even introduce currencybasis risk.

Further,the manner in which initial margin is proposed to be calculated could lead tomisleadingly high calculations of initial margin. The proposed rules wouldrequire calculations based on an assumed close-out period of 10 business days,an assumed period expressly intended to disfavor uncleared swaps, and moreprolonged than the period that most closeouts of uncleared swaps actuallyrequire. The proposed rules also restrict the nature of the offsets availablein initial margin calculations by requiring each swap to be placed in onecategory and not permitting offsets even of truly like exposures across suchcategories.

In additionto these issues, the important definition of “eligible master netting agreement”contained in the proposed rules, as well as the proposed rules’ requirement forcustodial agreements for initial margin, would require CSEs to meet a poorlydefined but apparently heavy due diligence burden. The manner in which theproposed rules may apply to pre-compliance date swaps also would incentiviseparties to negotiate separate eligible master netting agreements for new swaps,and thus could increase risk rather than reduce it.

Whatever one might think of the proposed rules, theyindicate the daunting complexity that regulators face in imposing marginrequirements on uncleared swaps, to say nothing of the challenges ofinter-jurisdictional harmonisation. Looking at the big picture, absent majorand unexpected changes, the proposed rules, when finalised, will go a long waytoward further de-risking one of the major markets blamed for exacerbating thefinancial crisis.

One hopes that the US regulators will determine they canresponsibly discharge their duties without imposing on US market participantsmargin requirements exceeding those imposed by regulators in other jurisdictions-- whether by means of the US regulators’ definition of “material swapsexposure,” their unusually low bar for affiliation, or otherwise. Suchdeviations from the BCBS/Iosco Framework would likely disadvantage US marketparticipants and further balkanise swaps trading activity.