This is the final article in a series on the U.S. Commodity Futures Trading Commission’s (CFTC’s) proposed margin rules for uncleared swaps (CFTC Margin Rules), with a particular focus on the rules as they relate to swap market participants that are neither swap dealers nor commercial end users.
For a refresh on key definitions, please see our first installment on the CFTC Margin Rules summarizing the definitions of “covered swap entity,” (CSE) “financial end user”and “material swaps exposure.” Our second, third and fourth installments in the series addressed collateral requirements, custody of initial margin (IM) and margin calculation, respectively.
In this installment we summarize the cross-border regimes proposed by the CFTC and recently finalized by the U.S. banking agency “prudential regulators” in their joint final rule governing uncleared swaps margin, adopted on October 22, 2015 (Bank Margin Rules). We conclude with a cross-jurisdictional survey of key provisions in certain uncleared derivatives margin rules, including those proposed in Canada and Europe, along with recommended action points for financial end users.
CFTC’s Cross-Border Approach
What is the Matrix?
The CFTC issued its proposed framework for applying its CFTC Margin Rules to cross-border activities on June 29, 2015 (CFTC Cross-Border Proposal). The CFTC Cross-Border Proposal contains a limited exclusion from the CFTC Margin Rules for a non-U.S. CSE that (i) is not a “foreign consolidated subsidiary” (FCS), i.e. it does not consolidate financial statements with an ultimate parent that is a U.S. person; (ii) does not trade through a U.S. branch; and (iii) is not guaranteed by a U.S. person. This exclusion applies only to uncleared swaps between such non-U.S. CSE and a non-U.S. person that is neither an FCS, a U.S. branch of a non-U.S. CSE nor guaranteed by a U.S. person.
The CFTC Cross-Border Proposal differs in material respects from the CFTC’s Cross-Border Guidance issued in July 2013 (Existing Guidance). For instance, the CFTC Cross-Border Proposal contained a narrower definition of “U.S. Person” than under the Existing Guidance. The definition of U.S. Person in the Existing Guidance included a look-through test of collective investment vehicles that were neither organized nor had their principal place of business in the U.S. but were majority-owned by U.S. persons. That test was dropped in the CFTC Cross-Border Proposal in response to concerns by asset managers and others about the difficulty of determining majority U.S. ownership at any given point in time. It is not clear whether the CFTC will modify its Existing Guidance in order to make its definition of U.S. person consistent with other regulators, or adopt its own more expansive definition of U.S. person.
The matrix below summarizes the application of the CFTC Cross-Border Proposal as it applies to financial end users. If certain types of CSEs, such as non-U.S. CSEs, whose obligations under the relevant swap are not guaranteed by a U.S. person, receive substituted compliance determinations by the CFTC, then foreign margin requirements would apply to some degree to such parties’ margin arrangements in lieu of U.S. requirements.
|TYPE OF CSE
|FINANCIAL END USER
|U.S. CSE or Non-U.S. CSE (including U.S. branches of a non-U.S. CSE and any FCS) whose obligations under the swap are guaranteed by a U.S. person
|U.S., for all aspects (i.e. all CFTC Margin Rules would apply)
|U.S., for IM collected by CSE
|Substituted compliance potentially available, for IM posted by CSE
|U.S., for variation margin (VM)
|FCS whose obligations under the swap are not guaranteed by a U.S. person or U.S. branch of a non-U.S. CSE whose obligations under the swap are not guaranteed by a U.S. person
|Substituted compliance potentially available for all aspects
|Non-U.S. CSE (that is not an FCS or a U.S. branch of a non-U.S. CSE) whose obligations under the swap are not guaranteed by a U.S. person
|Substituted compliance potentially available for all aspects
Prudential Regulators’ Cross-Border Approach
That’s the sound of inevitability…
Like the CFTC’s Cross-Border Proposal, the Bank Margin Rules exempt “foreign non-cleared swaps” where neither counterparty, nor any guarantor of a counterparty, is an entity that is (i) organized under U.S. law (a U.S. entity); (ii) a branch, office or subsidiary of a U.S. entity; or (iii) a U.S. branch, office or subsidiary of a foreign bank. Swaps not subject to this exemption may be eligible for substituted compliance with a foreign margin regime for foreign CSEs and U.S. branches of foreign banks transacting with U.S. counterparties, provided such foreign CSEs or U.S. branches are not guaranteed by a U.S. entity. U.S. CSEs, including foreign branches of U.S. CSEs, are not eligible for substituted compliance. Like the CFTC Cross-Border Proposal, the Bank Margin Rules substituted compliance would apply only if the prudential regulators determined the foreign jurisdictions requirements are comparable.
Unlike the CFTC’s Cross-Border Proposal, the Bank Margin Rules do not contain an express U.S. person definition that is analogous to the CFTC’s. Rather, the exemption above provides a bright-line rule that certain financial end users not incorporated in the U.S., such as offshore collective investment vehicles, will not be considered U.S. persons for the purpose of determining the applicability of the Bank Margin Rules. If the final CFTC cross-border approach does not align with the Bank Margin Rules in this respect, CSEs and asset managers will face added complexity across counterparty pairs.
The Matrix is everywhere.
The cross-border application of the uncleared swaps margin rules is a significant challenge for the industry given the potential gaps or inconsistencies among approaches. For a comparative survey of key areas of the Bank Margin Rules, the CFTC Margin Rules and the rules proposed by Canadian and European regulators, please click here. Further increasing the complexity of complying with uncleared swaps margin rules, the U.S. Securities and Exchange Commission (SEC) margin rules, originally proposed in November 2012 (SEC Margin Rules), have yet to be re-released. The SEC Margin Rules will add a third U.S. approach that CSEs and financial end users that trade security-based swaps will need to address.
Recommended Actions for Financial End Users
There is a difference between knowing the path and walking the path.
Although the first compliance deadline is not until September 2016, implementation will be a resource-intensive process for CSEs and their counterparties. Specific action points that non-CSEs can begin taking include:
- Determine if the relevant entity is a financial end user under the Bank Margin Rules, and, when finalized, the CFTC Margin Rules.
- Identify all affiliates based on the consolidation test set out in the Bank Margin Rules. Asset managers should be aware that funds in a seeding period and managed accounts will need careful consideration. Monitor the CFTC’s approach to defining affiliates, as its original approach was based on the concept of control, contrary to the Bank Margin Rules.
- If an entity is a financial end user, calculate aggregate gross notional values for uncleared swaps, uncleared security-based swaps, FX forwards and FX swaps for the relevant months to determine material swaps exposure and estimate compliance dates. Portfolio reconciliation and portfolio compression take on added significance to agree on valuation calculations and reduce outstanding notional exposure. The calculation should be systematized and repeatable.
- Determine what rules are implicated by the trading relationships: are the financial end user’s counterparties U.S. or non-U.S. CSEs? Are any guarantees in place? Is the counterparty a branch office or an FCS, are such CSEs prudentially regulated, and are they swap dealers and/or security-based swap dealers?
- Monitor ISDA’s WGMR Implementation Initiative and be prepared to amend existing Credit Support Annexes (CSAs) and provide additional self-disclosure, which may be effected through an industry protocol using the ISDA Amend tool and/or separately negotiated through bilateral documentation.
- If an entity is a financial end user with material swaps exposure, segregated IM arrangements must eventually be implemented – consider getting a head start. CFTC Rule 23.701 already requires that swap dealers notify counterparties of the right to elect segregated IM at an unaffiliated custodian. Determine which custodians to use and bear in mind that pressure on custodial capacity will increase as IM deadlines draw near, which may limit the opportunity to negotiate custody agreements if segregated IM is implemented at the eleventh hour.
- Grandfathering of pre-compliance date swaps and the staggered phase-in applying to IM and VM separately mean that multiple CSAs may eventually exist under a single ISDA Master Agreement. Collateral management systems may need to be modified to accommodate multiple CSAs under single ISDA Master Agreement because many collateral management systems currently require time-consuming manual procedures to accommodate more than one CSA under a single ISDA Master Agreement. Collateral management systems may also need updates to handle new segregated IM arrangements.
Regulators in the U.S., E.U., Canada and other jurisdictions are moving rapidly to finalize rules governing margin requirements for uncleared derivatives in time for compliance deadlines. The U.S. banking regulators recently issued final rules, and financial end users should be prepared for the CFTC and SEC to follow suit. In 2016, banks, fund managers and insurance companies will need to commit resources toward the implementation of compliant margin arrangements with their CSE counterparties. Please contact one of the authors or your regular McGuireWoods lawyer if you have questions about how margin requirements may apply to your business.