US Prudential Regulators finalise non-cleared margin rules

Two of the US prudential regulators[1], the FDIC and the OCC, have voted to jointly adopt final rules regarding the exchange of initial and variation margin for uncleared swaps. The rules will apply to entities that are i) under the supervision of a prudential regulator ii) have registered with the CFTC or SEC as a swaps dealer or major participant. The final rules amount to some 280 pages, requiring some time to definitively analyse, although a preliminary scan confirms that they contain little deviation from the September 2014 proposed rules and remain in line with the wider BCBS-IOSCO framework. An initial summary follows:

Timeline: the margin rules will effective as 1 April 2016. Implementation is passed in according to the following schedule:

• 1 September 2016 – IM and VM for swaps where both CPs have material swaps exposure > $3 trn. Exposure counted over business days in March/April/May 2016
• 1 March 2017– VM for swaps with a Swap Entity
• 1 September 2017– IM and VM for swaps where both CPs have material swaps exposure > $2.25 trn. Exposure counted over business days in March/April/May 2016
• 1 September 2018– IM and VM for swaps where both CPs have material swaps exposure > $1.5 trn. Exposure counted over business days in March/April/May 2016
• 1 September 2019– IM and VM for swaps where both CPs have material swaps exposure > $.75 trn. Exposure counted over business days in March/April/May 2016
• 1 September 2020– IM for any other Swap Entity

Application: The Margin Rule continues to apply only to “financial end users”, swaps between entities that fall outwith this category are exempt. Financial end users are i) entities that undertake financial activities that require registration or charter under state or federal law ii) pooled investment vehicles iii) equivalent non-US entities. Mandatory IM and VM will apply to swaps between two swap entities or between a swap entity and a financial user with “material swaps exposure”. IM will not apply to those swaps between a swap entity and a financial end user with assets below the material swaps exposure, VM will still apply. Financial entities with assets of $10bn. or less that use swaps solely to hedge will be exempt from mandatory margin requirements. All five regulators also adopted an interim final rule implementing the Terrorism Risk Insurance Program Reauthorization Act of 2015, section 302 of which amends the Dodd-Frank Act to exempt from margin requirements those categories that already benefit from an exemption to the clearing rules[2]. The complex set of exceptions effectively exempt small financial entities, cooperatives and non-financial commercials. Note that structured finance vehicles and covered bond issuers are explicitly included as financial end users.

Cross-border: for transactions in jurisdictions that do not allow IM segregation, the relevant prudential regulator may exempt a US or non-US covered entity from the obligation to post IM.

Thresholds: the final rule’s material swaps exposure threshold has been increased to $8bn., this aggregate notional figure will include those affiliates which will be consolidated under GAAP.

Initial Margin Collateral: broadly in line with the proposal, the list of IM eligible collateral are those assets deemed to be HQLA by the prudential regulators, generally: government debt, high-rated corporate debt and equity, money market funds that hold UST etc. Cross-currency haircuts will apply unless the collateral is in the currency of settlement or the termination currency specified in the master netting agreement for default or close-out payments. Rehypothecation of mandatory IM will not be permitted and it must be segregated with a non-affiliated custodian.

Variation Margin Collateral: The VM eligible collateral list has been expanded on that of the proposal. Transactions between two swap entities may posted in: USD, the swap’s “currency of settlement” (the currency in which payments are made) and 10 other “major currencies”. Transactions that include a financial end user may be collateralized by all the HQLA assets available for IM. Non-cash margin denominated in a currency other than the currency of settlement will be subject to an 8% haircut.

Netting: If an “eligible master netting agreement” exists, VM and IM may be calculated net across a portfolio. Eligibility in this context requires legal opinions that the relevant MNA cannot act to stay close-out rights, except temporarily under national legislation. Netting will therefore not be applicable for those entities for which an opinion may not be available such as; pension plans, insurance companies, municipalities etc.

Change of Status: Status change, eg. crossing the $8bn MSE threshold, and consequent rule application depend on the direction. If the change is towards more comprehensive margin rules, the rules will apply only to those transaction entered into after the change. If the change is towards less comprehensive margin rules eg. a financial end user’s outstanding aggregate notional falls below $8bn., the margin rules (or lack thereof) will apply to all swaps in a portfolio.

Affiliate Swaps: “Affiliate” will be defined according to GAAP financial consolidation rules. Margining will be one-way between affiliates. Affiliate swaps will only be counted once in calulating the group aggregate. A covered swap entity will only collect IM in a transaction with an affiliate. Each affiliate may be allotted a threshold up to $20mln.

The revisions go some way to closing the regulatory arbitrage window, the MSE is now roughly in line with Europe, and in alleviating concerns over inter-affiliate transactions.; the remaining three prudential regulators are virtually certain to adopt the same final draft within a short time. Market participants will be keen to judge the consonance between the above outline and forthcoming rules from the CFTC and SEC, who are yet to finalise. Chairman Massad of the CFTC recently indicated that the Agency is on course to complete by the end of the year.

[1] The Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve, Comptroller of the Currency, Farm Credit Administration and Federal Housing Finance Agency (the “Regulators”)

[2] i) Non-financial entity exempt under Section 2(h)(7)(A) CEA or Section 3C(g)(1) SEA ii) Cooperative entity exempt under Section 4(c)(1) CEA iii) Treasury affiliate acting as agent exempt under Section 2(h)(7)(D) CEA or Section 3C(g)(4) SEA

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