CME and LCH Amend Rulebooks on Variation Margin

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Cleared derivatives are generally characterized as being either “collateralized-to-market” (“CTM”) or “settled-to-market” (“STM”) in connection with the mitigation of counterparty credit risk resulting from movements in mark-to-market value. Under the CTM approach, transfers of variation margin are characterized as daily “collateral” transfers, with the transferring party having a right to reclaim the collateral (a financial asset) and the receiving party having the obligation to return the collateral (a financial liability), as well as a legal right to liquidate the collateral in the event of a close-out.

Under the STM approach, variation margin reflects daily “gain” to the receiving party that is actually settled. Despite the settlement of the gain on a daily basis, the derivative’s underlying economic terms remain the same (in other words, there is no amendment or recouponing of the trade).  However, unlike the CTM approach, variation margin transferred is not regarded as pledged collateral securing obligations between the parties.  Rather, variation margin is deemed to “settle outstanding exposure” between them (with no right to reclaim or obligation to return the variation margin) and, after that settlement, the mark-to-market between the parties resets to zero.

Market participants historically have taken a CTM approach, accounting for variation margin transfers as collateral transfers. However, each of the Chicago Mercantile Exchange (“CME”) and LCH.Clearnet Limited (“LCH”), which act as central clearing parties (or “CCPs”) in the cleared derivatives market, recently amended their rules to characterize variation margin transfers as STM.[1]  CME’s amended rules specifically state the following:

All payments in satisfaction of outstanding exposure must be paid in cash or any other form of payment approved by the Clearing House Risk Committee; shall be settlement (within the meaning of CFTC Rule 39.14); and shall be final, irrevocable and unconditional no later than when the correct Clearing House bank account at the relevant settlement bank is debited or credited with the payment. Payments in satisfaction of outstanding exposure shall not constitute “property, cash, securities or collateral deposited with the Clearing House” . . . .[2]

A CCP’s rules generally apply to transactions cleared by a clearing member through the CCP. In turn, CCP rules (whether by incorporation under the customer agreements or otherwise) generally apply to transactions cleared by a customer’s clearing member through the CCP.

In May 2016, the Accounting Policy Committee (the “Accounting Policy Committee”) of the International Swaps and Derivatives Association, Inc. (“ISDA”) published a whitepaper addressing the potential accounting impact of the proposed rulebook changes.[3]  On November 30, 2016, representatives of ISDA met with members of the Staff of Office of the Chief Accountant of the Securities Exchange Commission (the “Staff”) to discuss the implications of the rulebook changes.  Finally, on January 4, 2017, ISDA delivered a confirmation letter[4] to the Staff outlining and confirming certain matters from the November 2016 meeting.

This confirmation letter memorialized ISDA’s understanding that the Staff “does not object” to the conclusions of the Accounting Policy Committee outlined in the whitepaper, as supplemented. These conclusions include, inter alia, that the rulebook changes should result in the presentation of variation margin as “settlement of the derivative exposure” as opposed to collateral against it because the “timing, amount, and uncertainty of cashflows related to the STM derivative contract is considered a single unit-of-account for purposes of applying the accounting and presentation guidance in ASC 815 [Derivatives and Hedging].”  In other words, STM derivatives contracts cleared through CME should be considered as a “single unit-of-account” (instead of two units-of-account: the derivative unit-of-account and the collateral unit-of-account), with the variation margin transfers being cash flows of the derivative itself.  Under the STM approach, variation margin does not constitute collateral, and so, there is no “financial asset” for the pledgor’s right to reclaim collateral or “financial liability” for the secured party’s obligation to return collateral.[5]

[1] See generally CME Rule 814 and LCH Regulation 57A.  Note that CME’s amended rules, which became effective on January 3, 2017, are mandatory, whereas LCH’s rules allow clearing members to elect whether to have the CTM approach or STM approach govern. See LCH Regulation 55(b) (“The registration of a SwapClear Contract as a SwapClear CTM Contract or a SwapClear STM Contract shall be determined by the Clearing House on the basis of an election made by the relevant SwapClear Clearing Member either generally, with reference to a particular account or on a case-by-case basis in accordance with the Procedures.”)

[2] CME Rule 814 (citations omitted).

[3] See Accounting Impact of CCPs’ Rulebook Changes to Financial Institutions and Corporates (May 27, 2016).  This whitepaper was supplemented on September 16, 2016 and October 20, 2016.

[4] See Confirmation Letter Related to ISDA Accounting Committee Whitepaper “Accounting Impacts of CCPs’ Rulebook Changes to Financial Institutions and Corporates May 2016” and subsequent submissions (January 4, 2017).

[5] The confirmation letter summarized a total of six conclusions, including that the change in accounting for a derivative from two units-of-account to a single unit-of-account would not require the de-designation (in other words, termination) or re-designation of any hedging relationships.