This is the first installment of the Financial Entity Update, focusing on issues relevant to a broad range of financial market participants that
trade swaps but that are not swap dealers or commercial end users under Dodd-Frank. We begin with the first of a series of updates on the CFTC’s
margin rules for uncleared swaps.
First, a housekeeping note: To clarify our intended audience, in the Financial Entity Update we will address issues germane to entities that trade swaps
but are neither dealers nor commercial end users. This includes a broad and diverse group of entities that are impacted to a greater degree than end users
by Dodd-Frank (DF) and the European Market Infrastructure Regulation (EMIR) but not to the same degree as swap dealers (SDs) or major swap participants
(MSPs). In regulatory terms that are unpacked further below, these swap-market participants are “financial entities” or “financial end users” that occupy
the space between swap dealers and commercial end users.
Had Plato Traded Swaps: First, Know Thyself
On June 29, 2015, the Commodity Futures Trading Commission (CFTC) proposed a rule for the cross-border application of
its margin requirements for uncleared swaps. The rule supplements the CFTC’s proposed rule from October 2014 containing
substantive requirements related to the exchange of margin for uncleared swaps (together, the Margin Rules). The Margin Rules apply to SDs and MSPs that do
not have a prudential regulator (Covered Swap Entities, or CSEs). Federal banking regulators separately proposed a similar rule that would apply to entities under their regulation.
However, the Margin Rules would significantly change the economics of uncleared swaps for “financial end users” that trade with CSEs. What is a “financial
Financial End Users
Under the Margin Rules, a “financial end user” is an entity that is not a CSE but that falls into one of several enumerated categories, including banks and
depository institutions, businesses licensed or registered as credit or lending entities, broker-dealers, investment advisers, registered investment
companies, private funds, commodity pools, commodity pool operators, commodity trading advisors, futures commission merchants, certain employee benefit
plans, insurance companies, entities that raise money for the purpose of investing or trading, and foreign entities that would constitute one of the
foregoing if organized under the laws of the United States or any state.
Notably, this definition differs from the term “financial entity” that is used in the CFTC’s mandatory swap clearing requirement. There, the term includes a
catch-all referring to entities “predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature,”
as defined in Section 4(k) of the Bank Holding Company Act. This catch-all has been particularly challenging and confusing for certain market participants
to apply. By contrast, in its Margin Rules the CFTC described specifically the types of entities that it considers “financial end users.” In most
circumstances, a “financial entity” would also be a “financial end user”; however, financial market participants should be aware that the terms do not
fully align in all cases. For example, smaller community banks and savings institutions with total assets of $10 billion or less are exempted from the
CFTC’s definition of “financial entity” but nonetheless would be “financial end users” for the purpose of the Margin Rules.
Second, Know Thy Notionals
Material Swaps Exposure
Under the Margin Rules CSEs would be required to exchange variation margin with financial end users. In addition, CSEs would be required to exchange
initial margin with financial end users that have “material swaps exposure.” Material swaps exposure exists where an entity and its affiliates have
an average daily aggregate notional amount of uncleared swaps (including swaps, security-based swaps, and FX forwards and FX swaps) for June, July
and August of the prior year (the Notional Test) that exceeds $3 billion. Significantly, affiliation for these purposes would be defined to be as little as
25 percent ownership or control.
The Notional Test requires aggregating exposures across diverse entities and may be difficult to apply. Asset managers may face particular challenges
because the level of control under the definition of affiliate does not necessarily translate into transparency with respect to swaps exposures. For
example, it is unclear how the Notional Test would be applied where a pension plan has several managed accounts, each managed by a different investment
adviser. Each adviser has a limited view of the exposures of the pension as a whole. Similarly, if a pension invests in a vehicle and, as a result of such
investment, the pension has the ability to vote 25 percent of a class of shares, then any other investments that the pension has that are at the same
percentage level will be “affiliates.” As a result, an asset manager may be unable to identify all affiliates of a vehicle if investors’ other investments
implicate unknown vehicles for the purpose of the Notional Test.
Importantly, the Notional Test includes FX forwards and FX swaps, which are otherwise exempt from the definition of “swap” pursuant to the Department of
Treasury’s 2012 determination and would not be subject to the Margin Rules generally.
Initial Margin Threshold
CSEs are also required to collect initial margin from a financial end user to the extent that the initial margin that would be posted to the CSE and its
affiliates by the financial end user and its affiliates exceeds $65 million. There is no requirement for a CSE to collect initial margin from a financial
end user under this threshold. This determination could require new systems to monitor aggregate exposures and ownership percentages across affiliates or,
in the context of funds, across master-feeder structures.
Phase-in of Requirements
Compliance with the initial margin requirements is to be phased-in depending on the following level of notional exposures of the parties:
- December 1, 2015, where the Notional Test exceeds $4 trillion for both the CSE combined with its affiliates, and the financial end user combined with its
- December 1, 2016, where the Notional Test exceeds $3 trillion for both the CSE combined with its affiliates, and the financial end user combined with its
- December 1, 2017, where the Notional Test exceeds $2 trillion for both the CSE combined with its affiliates, and the financial end user combined with its
- December 1, 2018, where the Notional Test exceeds $1 trillion for both the CSE combined with its affiliates, and the financial end user combined with its
- December 1, 2019, where the Notional Test exceeds $3 billion for both the CSE combined with its affiliates, and the financial end user combined with its
Variation margin requirements take effect December 1, 2015, irrespective of the notional exposures of the parties.
Notably, BCBS/IOSCO and European regulators recently delayed implementation of initial margin requirements by nine months and variation margin requirements
by nine to 15 months, depending on the notional exposures of the parties. It remains to be seen whether the CFTC will follow. Given the fragmentation
issues that may arise if margin requirements were implemented in the U.S. and EU at different times, it would not be surprising to see the CFTC similarly
delay its implementation schedule.
The Margin Rules are an important development for swap-market participants. As with certain other DF regulations, although the rule is directly applicable
to CSEs, entities that trade with CSEs are indirectly impacted. As a result, financial end users may face requests from CSEs for information and possibly
for representations as to status under the Margin Rules. Particularly, financial end users should consider how to implement systems to calculate and
monitor notionals across affiliates. Please contact one of the authors or your regular McGuireWoods lawyer if you have questions about how margin
requirements may impact your swap-trading activities.