On October 8th, ISDA sent pre-proposal comments (the “ISDA Comments”) to the CFTC regarding the segregation of collateral for uncleared swaps in light of the rulemaking the CFTC will undertake to implement Section 724(c) of the Act.[1] The ISDA Comments note that ISDA had published in March, along with SIFMA and the Managed Funds Association (“MFA”), a white paper (the “White Paper”) describing various approaches that may be used to segregate collateral other than variation margin (most commonly, “Independent Amounts” under an ISDA Credit Support Annex) for the benefit of a dealer in respect of uncleared derivatives transactions.[2] The White Paper discussed three approaches that could be used for these purposes, two of which contemplated bilateral custodial relationships (i.e., between the dealer and custodian) and one of which contemplated a tri-party custodial arrangement (i.e., among the dealer, counterparty and custodian). As the ISDA Comments note, each approach has its advantages and disadvantages. For example, the tri-party approach may provide more robust protections for counterparties, but a bilateral approach would be less costly and complex to administer and would present fewer technical legal issues. The ISDA Comments recommend that the CFTC collateral segregation rules should allow dealers (and “major swap participants,” as defined in the Act) to make available to counterparties both bilateral and tri-party collateral arrangements, effectively allowing counterparties to choose an arrangement based on the cost-benefit considerations that they deem important.
The ISDA Comments further propose that the CFTC rules permit swap dealers (and major swap participants) to agree with their counterparties, based on the facts and circumstances that are relevant to their relationship, how certain issues related to collateral segregation should be resolved, including (i) the custodian to be used; (ii) the fees to be paid by the counterparty; (iii) which party will bear the risk of loss upon a custodian insolvency or performance failure (note that this risk is allocated to a secured party under the boilerplate ISDA Credit Support Annex); (iv) the form in which collateral may be posted; and (v) if cash is posted, how and where it will be invested and held and how gains and losses on such investments will be allocated and distributed. Finally, the ISDA Comments note that Section 763 of the Act contains collateral segregation provisions for security-based swaps that are virtually identical to those set forth for swaps under Section 742, but that the Act does not specifically require the CFTC to conduct a joint rulemaking with the SEC on collateral segregation. The ISDA Comments urge the Commissions to consult closely in their respective rulemakings to avoid inconsistent requirements that could introduce unnecessary costs, inefficiencies and the potential for unintended risks.
On October 27th, SIFMA also sent a comment letter (the “SIFMA Comments”) to both Commissions on several topics, including the segregation of collateral for uncleared swaps. The SIFMA Comments note that there is currently no industry-wide standard for third-party custody of margin and that such custodial arrangements raise additional risks for swap dealers. As a result, the SIFMA Comments recommend that the Commissions provide industry members with their views regarding the treatment of collateral supporting uncleared swaps “at an early date” to facilitate firms’ efforts to establish the necessary infrastructure to comply with contemplated rules. The SIFMA Comments further recommend that the suggestions set forth in the ISDA Comments be considered, including that the Commissions engage in close collaboration to avoid inconsistent requirements.
[1] The relevant segregation provisions, which are found in Section 724(c) of the Act, begin on page 309. In relevant part, this subsection provides as follows:
”(l) SEGREGATION REQUIREMENTS.—
”(1) SEGREGATION OF ASSETS HELD AS COLLATERAL IN UNCLEARED SWAP TRANSACTIONS.—
”(A) NOTIFICATION.—A swap dealer or major swap participant shall be required to notify the counterparty of the swap dealer or major swap participant at the beginning of a swap transaction that the counterparty has the right to require segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty.
”(B) SEGREGATION AND MAINTENANCE OF FUNDS.—At the request of a counterparty to a swap that provides funds or other property to a swap dealer or major swap participant to margin, guarantee, or secure the obligations of the counterparty, the swap dealer or major swap participant shall—
”(i) segregate the funds or other property for the benefit of the counterparty; and
”(ii) in accordance with such rules and regulations as the Commission may promulgate, maintain the funds or other property in a segregated account separate from the assets and other interests of the swap dealer or major swap participant.
”(2) APPLICABILITY.—The requirements described in paragraph (1) shall—
”(A) apply only to a swap between a counterparty and a swap dealer or major swap participant that is not submitted for clearing to a derivatives clearing organization; and
”(B)(i) not apply to variation margin payments; or
”(ii) not preclude any commercial arrangement regarding—
”(I) the investment of segregated funds or other property that may only be invested in such investments as the Commission may permit by rule or regulation; and
”(II) the related allocation of gains and losses resulting from any investment of the segregated funds or other property.
”(3) USE OF INDEPENDENT THIRD-PARTY CUSTODIANS.—The segregated account described in paragraph (1) shall be—
”(A) carried by an independent third-party custodian; and
”(B) designated as a segregated account for and on behalf of the counterparty.
[2] For a summary of the White Paper, see DMIR March 2010.