In October, the prudential regulators (i.e., the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Farm Credit Administration, and the Federal Housing Finance Agency) approved a final version (the “Final Rule”) of the September 2014 re-proposed rule generally imposing initial and variation margin requirements on certain banks and their counterparties in connection with non-cleared swaps and non-cleared security-based swaps.^[1]  The Commodity Futures Trading Commission (“CFTC”) adopted its own final margin rules for uncleared swaps applicable to entities subject to its jurisdiction (i.e., non-bank swap dealers and non-bank major swap participants) on December 16, 2015, many significant provisions of which are substantially similar to those in the Final Rule.  The Securities and Exchange Commission (“SEC”) has proposed, but not finalized, margin rules for uncleared security-based swaps applicable to entities subject to its jurisdiction (i.e., non-bank security-based swap dealers and non-bank major security-based swap participants).

The Final Rule imposes, inter alia, the requirements summarized below on a registered swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant (each, a “swap entity”) that is subject to regulation by at least one of the prudential regulators (such a swap entity, a “covered swap entity”):

Initial margin collection (by a covered swap entity):

• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is either (i) a swap entity or (ii) a “financial end user with material swaps exposure,” the covered swap entity must collect an “initial margin collection amount” less any “initial margin threshold amount” (each, as described below).
  • The covered swap entity may calculate the “initial margin collection amount” either in accordance with the standardized margin schedule set forth in the Final Rule or through an internal margin model satisfying certain criteria and approved by the relevant prudential regulator.^[2]
  • The covered swap entity may (but is not required to) establish and apply an “initial margin threshold amount” against the counterparty on a consolidated basis (i.e., the aggregate credit exposure resulting from all non-cleared swaps and non-cleared security-based swaps between, on the one hand, the covered swap entity and its affiliates and, on the other hand, the counterparty and its affiliates) of up to $50 million.
  • The covered swap entity is not required to collect initial margin unless and until the total amount to be collected exceeds a minimum transfer amount of $500,000.
  • Initial margin collected by the covered swap entity is required to be segregated at a third-party custodian and generally may not be reused or rehypothecated.
  • If changes in portfolio composition or any other factors result in a change in the required initial margin amounts, the covered swap entity must collect additional initial margin on at least a daily basis.
• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user with material swaps exposure, the covered swap entity is required to collect initial margin “at such times and in such forms and amounts (if any), that the covered swap entity determines appropriately addresses the credit risk posed by the counterparty and the risks of such non-cleared swap or non-cleared security-based swap.”^[3]

Initial margin posting (by a covered swap entity):

• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a financial end user with material swaps exposure, the covered swap entity must post at least the amount of initial margin that the covered swap entity would be required, by the requirements described above, to collect if the covered swap entity were in the place of the counterparty.
  • The covered swap entity is not required to post initial margin unless and until the total amount to be posted exceeds a minimum transfer amount of $500,000.
  • Initial margin posted by the covered swap entity is required to be segregated at a third-party custodian and generally may not be reused or rehypothecated.
  • If changes in portfolio composition or any other factors result in a change in the required initial margin amounts, the covered swap entity must post additional initial margin on at least a daily basis.
• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a swap entity, the Final Rule does not require the covered swap entity to post initial margin. However, it is expected that the swap entity counterparty will be required, pursuant to the margin rules applicable to it (i.e., those of the prudential regulators, the CFTC, or the SEC, as applicable), to collect initial margin from the covered swap entity.
• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user with material swaps exposure, the Final Rule does not require the covered swap entity to post initial margin.

Variation margin collection and posting (by a covered swap entity):

• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a either (i) a swap entity or (ii) a financial end user (regardless of whether that financial end user has material swaps exposure), the covered swap entity must collect and post a “variation margin amount,” meaning the cumulative mark-to-mark change in value of the swap, adjusted for variation margin previously collected or posted.
  • The covered swap entity is not required to collect or post variation margin unless and until the total amount to be collected or posted exceeds a minimum transfer amount of $500,000.
  • Variation margin must be transferred at least once per business day, with no threshold of uncollateralized exposure.
  • Variation margin is not required to be segregated at a third-party custodian and may be reused or rehypothecated.
• With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user, the covered swap entity is required to collect (but is not required to post) initial margin “at such times and in such forms and amounts (if any), that the covered swap entity determines appropriately addresses the credit risk posed by the counterparty and the risks of such non-cleared swap or non-cleared security-based swap.”^[4]

Definitions.

The Final Rule lists various types of entities that constitute “financial end users,” including, for example, an entity that “is, or holds itself out as being, an entity, person, or arrangement that raises money from investors, accepts money from clients, or uses its own money primarily for the purpose of investing or trading or facilitating the investing or trading in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets.”^[5]

An entity has “material swaps exposure” if it and its affiliates have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps with all counterparties for June, July, and August of the previous calendar year in excess of $8 billion.^[6] The Final Rule states that using June, July, and August of the previous year, instead of a single as-of date, “is appropriate to gather a more comprehensive assessment of the financial end user’s participation in the swaps market, and address the possibility that a market participant might ‘window dress’ its exposure on an as-of date.”^[7]

Eligible collateral.

With respect to initial margin, eligible collateral includes: cash; debt securities that are issued or guaranteed by the U.S. Department of the Treasury or by another U.S. government agency, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, or a multilateral development bank; certain U.S. Government-sponsored enterprises’ debt securities; certain foreign government debt securities; certain corporate debt securities; certain listed equities; shares in certain pooled investment vehicles; and gold.

With respect to variation margin: (i) for swaps between a covered swap entity and a swap entity, eligible collateral is limited to immediately available cash denominated in U.S. dollars, another major currency, or the currency of settlement for the swap; and (ii) for swaps between a covered swap entity and a financial end user (regardless of whether that financial end user has material swaps exposure), the same forms of collateral that are permitted for initial margin, as described above, also constitute eligible collateral for variation margin.

Cross-border application.

None of the foregoing margin requirements are applicable to a swap with respect to which none of the covered swap entity, the counterparty, or any party that guarantees either party’s obligations under the swap is: (i) a U.S.-organized entity (including a U.S. branch, agency, or subsidiary of a foreign bank) or U.S.-resident natural person; (ii) a branch or office of a U.S.-organized entity; or (iii) a swap entity that is directly or indirectly controlled by a U.S.-organized entity.

Compliance timeline.

The foregoing initial and variation margin requirements would be applicable in accordance with following timeline:

• September 1, 2016: Variation margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps (“covered swaps”) for March, April, and May of 2016 exceeding $3 trillion.
• March 1, 2017: Variation margin in all other cases where such margin requirements apply.
• September 1, 2016: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2016 exceeding $3 trillion.
• September 1, 2017: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2017 exceeding $2.25 trillion.
• September 1, 2018: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2018 exceeding $1.5 trillion.
• September 1, 2019: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2019 exceeding $0.75 trillion.
• September 1, 2020: Initial margin in all other cases where such margin requirements apply.

Comparison to the Prudential Regulators’ Margin Rules.

The Final Rule is generally similar to the prudential regulators’ margin rules. Notably, for example, the “financial end user” definition was not modified to exclude structured finance vehicles or covered bond issuers, despite emphatic requests from commenters. However, there are several significant differences between the Final Rule and the re-proposed margin rules, including:

1. The initial margin threshold amount was reduced from $65 million to $50 million.
2. The minimum transfer amount was reduced from $650,000 to $500,000.
3. Certain changes were made to the requirements applicable to inter-affiliate transactions, including requiring a covered swap entity to collect but, unlike the re-proposed margin rules, not requiring it post initial margin when transacting with an affiliate.
4. The term “affiliate” (used for various purposes, including calculating the initial margin thresholds, material swaps exposure and the threshold amounts related to the compliance timeline) was defined consistently with accounting standards, whereas the re-proposed margin rules used the definition from section 2(k) of the Bank Holding Company Act (i.e., “controls, controlled by, or under common control with”).
5. The average daily aggregate notional amount threshold for “material swaps exposure” was increased from $3 billion to $8 billion.
6. The compliance timeline was generally delayed.
7. Certain prongs of the “financial end user” definition were expanded, whereas others were narrowed.
8. Required variation margin for a swap between a covered swap entity and a financial end user was expanded from cash-only to also include various types of securities and other assets.

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^[1] Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,840 (November 30, 2015).  The prudential regulators’ re-proposed margin rules were summarized in a previous Derivatives in Review posting (available here).

^[2] The International Swaps and Derivatives Association, Inc. (ISDA) is developing a “standard initial margin model” (“SIMM”), which is a standardized method for calculating initial margin on uncleared swaps.  The SIMM was discussed in a previous Derivatives in Review posting (available here).

^[3] Final Rule, at 74,902-03.

^[4] Id., at 74,903.

^[5] Id., at 74,901.

^[6] Although foreign exchange swaps and forwards are relevant for determining whether “material swaps exposure” exists with respect to a party, foreign exchange swaps and forwards are not subject to the prudential regulators’ margin requirements. Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (November 20, 2012).

^[7] Final Rule, at 74,857.