Margin Rules for Uncleared SWAPS

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U.S. bank regulators recently adopted final rules establishing
initial and variation margin requirements for uncleared swaps (Final
Margin Rules). These rules apply to regulated entities such as banks and
subsidiaries of bank holding companies that are swap dealers, major
swap participants, security-based swap dealers, and major security-based
swap participants. As a result, most of the major swap dealers in the
United States are subject to the new requirements and most of their
counterparties on such transactions, therefore, will be required to post
margin. For purposes of this update, we will focus on the rules as they
apply to swap dealers and the impact on their counterparties.

Background

The Final Margin Rules were adopted in accordance with the
requirements under the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank). As adopted, the Final Margin Rules
establish only minimum initial and variation margin requirements and do
not prevent a swap dealer from collecting or posting margin beyond the
amount required thereunder.

Compliance with the variation margin requirements begins September 1,
2016. There is a four-year staggered implementation period for initial
margin requirements depending on whether both the swap dealer's and the
counterparty’s notional amount of swap activity exceed a designated
“volume threshold.” The last staggered compliance date is September 1,
2020.

Types of Swap Dealer Swap Counterparties

The Final Margin Rules distinguish among four types of swap
counterparties with which a swap dealer may transact: (1) counterparties
that are swap dealers; (2) counterparties that are financial end users¹ who,
together with their affiliates, have a material swaps exposure (an
aggregate average notional amount calculated in accordance with the
Final Rules that exceeds $8 billion); (3) counterparties that are
financial end users who, together with their affiliates, do not have a
material swaps exposure; and (4) other counterparties such as corporate
end users that generally trade swaps in order to hedge commercial risk,
sovereigns, and multilateral development banks.

Swap Entities and Financial End Users

Initial Margin Requirements

Under the Final Margin Rules, a swap dealer that transacts with
another swap dealer or a financial end user that has a material swaps
exposure will be required to collect from that entity, on a daily basis,
the minimum required amount of initial margin calculated using a
prescribed method of calculation. 

A swap dealer also will be permitted to establish a threshold amount
on a counterparty-by-counterparty basis for initial margin below which
the swap dealer (together with its affiliates) will, at all times, be
unsecured in relation to a counterparty and its affiliates. The maximum
threshold allowed under the rules is $50 million. The Final Margin Rules
are silent on how a swap dealer and its counterparty should allocate
the designated threshold amount.

Variation Margin

The Final Margin Rules address variation margin in connection with
swaps entered into with a counterparty that is a swap dealer or a
financial end user with or without a material swaps exposure. A swap
dealer will be required, on a daily basis, to collect variation margin
from, or post variation margin to, such counterparty in an amount equal
to the increase or decrease, as applicable, in the value of the swap
since the counterparties’ last exchange of variation margin. A swap
dealer will be required to collect the full amount of required variation
margin subject to a minimum transfer amount, if applicable.

Minimum Transfer Amount

The Final Margin Rules provide for a permitted minimum margin
transfer amount that cannot exceed $500,000. A swap dealer, therefore,
will not be obligated to post initial or variation margin to, or collect
initial or variation margin from, any type of counterparty unless and
until the requisite aggregate amount of initial and variation margin
exceeds $500,000 (or such lower amount as the parties to the swap may
agree). Subject to any applicable initial margin threshold, the entire
amount of the required margin will be required to be collected or posted
once the minimum transfer amount is surpassed.

Other Counterparties

The regulators adopted interim final rules regarding application of
the Final Margin Rules to counterparties that qualify for an exception
or exemption from clearing their trades, such as corporate end users,
and small banks, savings institutions, and credit unions with assets
less than $10 billion that were exempted from clearing by the Commodity
Futures Trading Commission(CFTC). In general, the interim rule, if
adopted in its form, will not require a swap dealer to post margin to,
or collect margin from, such counterparties. Comments to this interim
final rule were due by January 31, 2016.

Types of Eligible Collateral

Under the Final Margin Rules, variation margin, if required, must be
posted in cash. Initial margin, on the other hand, may be posted in cash
or certain other prescribed types of debt securities.

Segregation of Collateral

The Final Margin Rules require that any collateral posted by a swap
dealer to its counterparty (other than variation margin) be held at a
third-party custodian. Only initial margin that a counterparty is
required to post to a swap dealer, however, is required to be held at a
mutually agreed upon third-party custodian. Such custodian cannot be an
affiliate of the swap dealer or counterparty. The Final Margin Rules
provide that the parties need to execute a custodial agreement and that
such agreement needs to be enforceable even in bankruptcy, and include
provisions that prohibit the custodian from rehypothecating, repledging,
reusing, or otherwise transferring the funds held by it.

Documentation

The Final Margin Rules require swap dealers to execute documentation
with each entity that is a swap dealer or financial end user that
contractually provides for the collection and posting of initial and
variation margin between the parties. The documentation is required to
provide for, among other things, the method of valuing each swap and
resolving disputes regarding swap valuations or valuations of assets
posted as margin. Compliance with CFTC or SEC rules regarding the
documentation of swaps and security-based swaps, as applicable, will
satisfy the rules regarding documentation under the Final Margin Rules.
It is expected that swap dealers may require amendments to existing
documentation to ensure compliance with the applicable rules.

Cross-Border Application

In light of the global nature of derivative transactions, the Final
Margin Rules provide that application of the margin rules will not apply
to foreign non-cleared swaps of a foreign swap dealer.²  In
addition, a foreign swap dealer trading with a U.S. entity will be
permitted to comply with a foreign regulatory framework for non-cleared
swaps to the extent that the regulators have jointly approved such
framework. The Final Margin Rules also will not require compliance with
rules regarding segregation of initial margin by certain foreign
branches of swap dealers and foreign subsidiaries if it is impracticable
due to the foreign regulations to which such entity is subject.

Special Rules for Affiliates

The Final Margin Rules addressed the posting of initial and variation
margin between affiliates. In general, affiliates are not required to
collect initial margin among themselves for non-cleared swaps. However,
such affiliates will be required to collect and post variation margin.